QANTAS AIRWAYS LIMITED ACN SUBMISSION TO THE AUSTRALIAN COMPETITION AND CONSUMER COMMISSION

Transcription

1 QANTAS AIRWAYS LIMITED ACN SUBMISSION TO THE AUSTRALIAN COMPETITION AND CONSUMER COMMISSION AIRSERVICES AUSTRALIA S DRAFT PRICE NOTIFICATION OF INCREASES IN CHARGES May 2002

2 2 TABLE OF CONTENTS Executive summary 1. Introduction 5 2. Background 5 3. Assessment of issues Charging principles Efficiency of Airservices Australia s operations Traffic volumes International comparisons Rate of return Structure of prices Impact on users Conclusion 25 Annexes Annex A Annex B Annex C Annex D Annex E Principles for charging and cost recovery CAA summary of preliminary response to the application from National Air Traffic Services to increase its charges Key assumptions for rework of Airservices Australia s Justification for price increases National Air Traffic Services Ltd (NATS) Licence Condition 11 (Service Standard) Financial information

3 3 Executive Summary Qantas Airways Limited (Qantas) is a substantial user of the services provided by Airservices Australia. Accordingly, Qantas and its customers (passenger and persons transporting freight) are directly affected by the prices charged by Airservices Australia. Qantas believes that it is readily apparent that Airservices Australia s proposed price increases are not justified. Furthermore, with continued focus on improvements in productivity by Airservices Australia, prices could realistically fall in nominal terms over the next five years, with revenues still remaining sufficient to meet efficient costs. On this basis, the Australian Competition and Consumer Commission should not allow Airservices Australia s proposed price increases. In addition, Airservices Australia should be required to provide detailed information on their costs and revenues by service, location and by commercial, non-commercial and Community Service Obligations. The main findings from an assessment of Airservices Australia s Draft Price Notification are: a number of assets should be excluded from Airservices Australia s fixed asset base in determining efficient prices for the RPT sector. Furthermore, Airservices Australia needs to detail the type, number, value and cost of fixed assets by both service and location to allow the Commission to assess the efficiency of Airservices' fixed asset base; a forward-looking approach to Airservices Australia s pricing should recognise anticipated benefits, especially cost savings, from planned capital expenditure. It is necessary therefore for Airservices Australia to provide further information on the anticipated costs and benefits associated with planned and previous capital expenditure; although a proportion of Airservices Australia s costs may be fixed, previous cost initiatives have demonstrated that the base is flexible. Thus, given the movements in activity drivers and the flow-on to revenue, it does not appear that Airservices Australia has attempted to fully adjust costs in line with activity movements; while Airservices Australia has made efforts towards reducing its level of operating costs, these appear to have only removed previous inefficiencies and brought the cost base into alignment with that of a more efficient service provider; Airservices Australia has undertaken a number of efforts to reduce their cost base. However, consideration must be given to the nature of each mitigation strategy. It is believed that strategies for reductions in discretionary expenditure should be maintained to some extent while customers, such as the international airlines, continue to be in a state of financial difficulty; it appears that there is further scope for Airservices Australia to reduce staff levels in line with activity decreases. If Airservices Australia believes that it is necessary to maintain a given level of staffing in anticipation of activity rebounds, then this should also be reflected in revenue or activity growth from other initiatives; given Indirect Operational Costs and Other Support Costs comprise approximately 22% of total expenditure for , the composition and allocation base for such costs should be fully transparent. The use of an Activity Based Costing methodology would best facilitate this; Airservices Australia is not subject to the same incentives to minimise costs as other Government organisations and commercial firms operating in competitive markets. If they were, Airservices Australia could be reasonably expected to achieve real reductions in operating costs in the order of at least 5% per annum for the next five years; it is inappropriate for price rises to be granted on the basis of lower industry activity. In competitive markets, downturns in demand lead to cost cutting, price reductions and/or lower returns to the industry, and not price increases by suppliers to the final market;

4 4 Airservices Australia s forecast of traffic volumes is conservative. Qantas alone has the potential to absorb all of the projected domestic growth through its aircraft procurement programme as well as the projected 0.6% international growth; Airservices Australia s application of the Building Block approach overestimates a number of key parameters in estimating allowable revenues. This is evidenced by Standards and Poor s 20 May 2002 Sovereign equivalent rating of AAA to Airservices Australia; if the traffic forecasts of Airservices Australia are accepted, the reduction in risk associated with the conservative forecasts should also be reflected in further lowering the required rate of return; and Airservices Australia should be required to fully cost the provision of its Community Service Obligations. Any revenue shortfall greater than the present $7 million in Commonwealth subsidies should be funded by a reduction in the return to the shareholder.

5 5 1 Introduction Airservices Australia (AsA) has proposed price increases to its enroute, terminal navigation and fire fighting services, with an average increase of 5.1%. This is opposed by the airlines, the International Air Transport Association (IATA) and the Board of Airlines Representatives Australia (BARA). As the 6% discount in charges previously offered by AsA has been in place for more than 12 months, AsA must submit its proposed price increase for consideration to the Australian Competition and Consumer Commission (the Commission) in accordance with the Prices Surveillance Act 1983 (PS Act). The following submission to the Commission provides Qantas view on AsA s proposed price increase. It is structured to reflect the Commission s Issues Paper. 2 Background AsA was established in July 1995 as a Government Business Enterprise (GBE), by the Air Services Act 1995 (AS Act) with reporting and accountability arrangements set out in the Commonwealth Authorities and Companies Act 1997 (CAC Act). According to AsA s Corporate Profile, in 1997 AsA s status was amended to a Commercial Authority. AsA is the only Commercial Authority in Australia. In addition, the Commonwealth Government in 1999 released a Policy Statement, A Measured Approach to Aviation Safety Reform. Attachment B to the Policy Statement contains a Charter Letter, which provides further guidance on the governance, pricing and environmental responsibilities of AsA. 1 One of the main implications of this change is that AsA s Community Service Obligations (CSOs) do not need to be specially identified, costed and funded. AsA is a strategic critical monopoly supplier to the aviation industry, with the principal air traffic control and airspace management functions of: aeronautical information; communications; radio navigation aids; search and rescue alerting; and airport rescue and fire fighting services. In addition, on behalf of the Bureau of Meteorology and the Department of Transport and Regional Services, AsA collects the Meteorological Service Charge and the Noise Levy Charge, respectively. Qantas is a major user of the services provided by AsA. In , total Qantas payments to AsA are likely to be in the order of $265m, $55m of which is for the Meteorological and Noise Levies. The balance of $210m is 40% of AsA s total forecast revenue. Price Regulation of Airservices Australia AsA is a declared entity under the PS Act. In assessing price notifications from declared organisations, Section 17(3) of the Act specifies that the Commission is to have regard to: the need to maintain investment and employment, including the influence of profitability on investment and employment; 1 The Hon John Anderson, MP, Deputy Prime Minister, Minister for Transport and Regional Services, Charter Letter, October 1999.

6 6 the need to discourage a person who is in a position substantially to influence a market for goods or services from taking advantage of that power in setting prices; and the need to discourage cost increases arising from increases in wages and changes in conditions of employment inconsistent with principles established by relevant industrial tribunals. 3 Assessment of Issues Qantas has structured this submission on the basis of the Commission s Issues Paper. However, before addressing each issue, the matter of charging principles is discussed as a basis for assessing the issues raised by the Commission. 3.1 Charging Principles The directions contained in the AS Act and Charter Letter indicate that AsA is required to pursue both commercial and non-commercial objectives. For example, the AS Act refers to the need for AsA to earn a reasonable rate of return on its assets (Section 13), while the Charter Letter emphasises the importance of small business, particularly in rural and regional areas. AsA s submission describes some of the non-commercial services it provides. In assessing the issues raised by the Commission, it is useful to outline some charging principles, against which AsA s submission can be assessed. A number of principles have been developed for the purposes of determining the structure and level of charges by monopoly suppliers to the air transport industry. These principles, shown in Annex A, generally cover the common themes of efficiency in costs, reasonable returns to owners and transparency of information. For the purposes of assessing AsA s preliminary pricing proposal, suggested charging principles are: the service provided should represent an efficient supply of that service or facility; transparency must exist in the allocation of costs between services; AsA should earn a reasonable rate of return in normal circumstances, which does not reflect monopoly prices; AsA should not earn a reasonable rate of return on its non-commercial services and CSOs instead it should only recover actual costs in a transparent manner similar to that required by the Government for mandated airport security requirements; each user pays an appropriate share of costs it consumes ( user pays ), as endorsed by the Commonwealth Government; and proposed investments by AsA are undertaken in consultation with the aviation industry, with each project detailing anticipated costs and benefits. These charging principles are consistent with the criteria contained in section 17(3) of the PS Act in that they allow AsA to earn a reasonable return on its investment, encourage cost minimisation and promote efficient new investment to improve the capacity and/or quality of service provided. 3.2 Efficiency of Airservices Australia s Operations AsA has improved the efficiency of some of its operations in recent years. This has been achieved through internal restructuring, changes to its business methodologies (Business Transition) and air traffic volume increases. AsA is yet to fully advise the airlines in relation to the efficiencies to be gained from the introduction of new technology, such as the Australian

7 7 Advanced Air Traffic System (TAAATS) that was agreed to and funded by the airlines. Based on an assessment of the various costs contained in AsA s proposal, together with consideration of the incentives for AsA to minimise costs, it is apparent further efficiency gains can be achieved. The following three sections discuss the efficiency of AsA s fixed assets, the level of operating costs and AsA s incentive and effectiveness to contain and reduce costs. The efficiency of Airservices Australia s fixed asset base AsA has estimated the value of its non-current assets at around $400m. A substantial component of AsA s revenue relates to the need to maintain and improve the asset base, as well as provide for a reasonable return to its Government shareholder. Evidence indicates the fixed asset base of AsA contains a number of assets that should be excluded for the purposes of determining prices for the Regular Public Transport (RPT) sector of the aviation industry. This is because the current asset base includes a number of assets that are not required by RPT operators. As noted by the former Ansett Holdings Limited ( AHL ): In February 2000 Airservices Australia[ s] minister announced withdrawal of a project to review its network of ground based navigation aids in regional locations. As with the subsidisation of GA [General Aviation] and regional towers the AHL group is funding the operating and capital costs of a large number of navigation aids not required for our operations but are maintained for use by other members of the aviation industry. 2 A study undertaken by the Australian Air Transport Association (AATA) two years ago into the amount of aeronautical infrastructure, such as Non Directional Beacons (NDBs) and other Navigation Aids, actually required by the airlines found evidence of the potential to achieve significant savings. The analysis indicated that a large number of assets should be excluded from the asset base in considering efficient prices for the RPT sector. At the time of the withdrawal of the review project, the AATA estimated that between 50% and 75% of NDBs and 10% of other Navigation Aids were not required for RPT operations. With the increases in technology that study needs to be reviewed and updated. Time precludes that being achieved for this submission. Unfortunately, the AsA submission does not contain details on the type and number of fixed assets by service and location. Hence, it is difficult to fully determine the extent to which AsA s fixed asset base would be reduced if it were optimised consistent with the pricing principles detailed earlier. Finding: A number of assets should be excluded from Airservices Australia s fixed asset base in determining efficient prices for the RPT sector. Furthermore, Airservices Australia needs to detail the type, number, value and cost of fixed assets by both service and location to allow the Commission to assess the efficiency of Airservices fixed asset base. New Capital Projects The pricing proposal by AsA appears to pay insufficient attention to the role of its planned investment in new capital projects. In its Waypoint 2002 Consultative Forum Industry Pack, AsA has indicated its intention to spend some $75m in on capital projects. 3 2 Ansett Holdings Limited, Submission to the Productivity Commission Inquiry into Government Cost Recovery, November 2000, p Airservice Australia, Waypoint 2002, 2002, p. 18.

8 8 It is recognised that AsA must invest in capital projects to maintain and improve its efficiency and/or quality of service to users. This is reinforced by the fact that some of the productivity gains achieved by AsA in recent years were underpinned by efficiencies gained by investment in technology. That said, there has been inadequate consultation between AsA and the airlines on the merit of the proposed projects and, in particular, the potential benefits flowing to users. Hence, to properly assess the efficiency of AsA's operations, information on each capital project is required to determine: the improvements in the capacity and/or quality of services provided to users; and anticipated efficiencies (cost savings) to be achieved in AsA s operations. In addition, each capital project should also be subject to a post-implementation review, to provide an analysis of planned and actual costs, timeframes for implementation, and the type and level of benefits achieved. Finding: A forward-looking approach to Airservices Australia s pricing should recognise anticipated benefits, especially cost savings, from planned capital expenditure. It is necessary therefore for Airservices Australia to provide further information on the anticipated costs and benefits associated with planned and previous capital expenditure. The Level of Operating Costs Included in Airservices Australia s Proposal As noted by AsA, the majority of its costs relate to operating expenses, which exceed $300m per year. 4 An examination of the proposed level of operating costs raises issues in the following areas: Activity and cost; Other cost efficiencies; AsA s profit mitigation strategy; Staff levels; AsA s justification for price increases; Allocation of costs; and Independent reviews. Activity and Cost Consideration must be given to the key drivers of operating expenditure. For AsA, these would include: changes in aircraft movements; changes in landed tonnage; inflation (increases in CPI); and expansion into new market areas. 4 Airservices Australia, 2002, p. 15.

9 9 AsA maintains that the level of both aircraft movements and landed tonnage has been negatively impacted by the events of September This is reflected in revenue movements as shown in Table 1, yet this has not translated into a concurrent decline in operating expenditure. Table 1 Revenue and expenditure movements 2000/ / / /02 Variance : 2001/02 Forecast Actual Budget Plan Forecast v prior yr v budget v plan Revenue % -9.3% -6.2% Expenses % -4.4% -1.3% Sources: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002, AsA Annual Reports As shown above, revenue is forecast to decrease by 10.8% compared to , yet expenses are only forecast to decrease by 1.7%, inclusive of $45.3m in profit mitigation cost reductions. Without factoring in such reductions, it is interesting to note the movements in AsA s underlying cost base in Table 2. Table 2 Revenue and expenditure movements excluding the impact of non-recurring profit mitigation strategies 2000/ / / /02 Variance : 2001/02 Forecast Actual Budget Plan Forecast v prior yr v budget v plan Revenue % -9.3% -6.2% Expenses % 4.4% 7.9% Sources: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports Despite the key cost drivers having a significant impact on revenue of around 10%, costs have moved significantly in the opposite direction. Finding: Although a proportion of Airservices Australia s costs may be fixed, previous cost initiatives have demonstrated that the base is flexible. Thus, given the movements in activity drivers and the flow-on to revenue, it does not appear that Airservices Australia has attempted to fully adjust costs in line with activity movements. Other Cost Efficiencies Despite the cost reductions achieved by AsA, the Compound Annual Growth Rate over the five years from through to the budgeted outcomes for indicates that expenses have moved generally in line with revenue (Table 3). Table 3 Compound annual growth of revenues and expenses 1998/ / / / /03 Actual Actual Actual Fcst Budget CAGR over 5 Years Revenue % -1.2% 0.2% -3.2% -10.0% 7.5% Expenses % -4.3% -1.9% -8.9% -0.6% 5.5% Sources: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports

10 10 This signals that whilst AsA has achieved cost reductions, it has only been to the extent of alignment with revenues, that is, to remove prior inefficiencies. No further rationalisation of the cost base appears to have been realised. (Note: The above figures exclude abnormal items, where they exist, such as provisions for early retirement benefits or written-down values of disposed assets. Although accounting policy no longer requires such items to be separately disclosed, their inclusion may distort the underlying operating position of Airservices given that most items are not recurring in nature, nor reflective of the true revenue/expense situation. The information for and may include expenditure or revenue items that are one-off in nature. However, given the limited data made available it is assumed that revenue and expenditure levels reflect the base operating position.) Finding: While Airservices Australia has made efforts towards reducing its level of operating costs, these appear to have only removed previous inefficiencies and brought the cost base into alignment with that of a more efficient service provider. An International Comparison NAV CANADA, the Canadian counterpart to Airservices, is a privately owned, commercial organisation that has been severely impacted by September 11. It is a company which is faced with mounting losses, even after mitigation strategies. Yet NAV CANADA has taken a pro-active approach to drive costs out of its business going forward, as evidenced from comments at their recent Annual General Meeting: Simply increasing our rates to cover our shortfall is not an option...nav CANADA cannot simply rely on our monopoly status... and simply increase rates to our customers to cover the mounting losses... they are on the financial ropes, trying to cope with the biggest crisis in civil aviation history. They just cannot afford to pay higher rates. 5 Although NAV CANADA put forward an increase in charges of 6% in December, it went only one-fifth towards recovering the CA$145m shortfall. Other initiatives included substantial ongoing cost reductions and additional revenue initiatives. UK National Air Traffic Services (NATS) is another air traffic service provider cited by AsA for also seeking a 5% increase because of post September 11 traffic decreases. However, the UK regulator, the CAA, has objected to such an increase and called for responses from airlines and interested parties. While there are many differences between the privatised and economic regulated UK NATS and AsA, there are also many similarities and instructive lessons. (The CAA summary is at Annex B.) The full version of the Consultation on CAA s preliminary conclusions is available on the CAA website Airservices Australia's Profit Mitigation Strategy In an attempt to mitigate the impacts of the September events, AsA undertook numerous initiatives including those outlined in Table 4. Table 4 Airservices profit mitigation strategy Temporary suspension of employer superannuation contributions (defined benefit fund) Revised asset re-financing arrangements Review of depreciation rates and asset lives $3.0m $12.0m $5.8m 5 Notes for an Address by John W Crichton, President and CEO of NAV CANADA, to the AGM April :

11 11 Reduced Travel Increased staff leave, management pay reduction, delay in recruitment Other discretionary expenditure savings TARGET COST REDUCTION $2.0m $14.1m $8.4m $45.3m Source: AsA submission: Appendix 6. While noting the effort by AsA to reduce its level of costs, it is noted: The temporary suspension of employer superannuation contributions is of minimal benefit given that it is a Defined Benefit Fund. Deferral would need an accrual and/or note in the annual report. This is not a real cost saving. The strategies of reduced travel and other discretionary expenditure savings should be continued. What is required is step changes in productivity. Finding: Airservices Australia has undertaken a number of efforts to reduce their cost base. Consideration, however, must be given to the nature of each mitigation strategy. It is believed that the strategies for reductions in discretionary expenditure should be maintained to some extent while customers, such as the international airlines, continue to be in a state of financial difficulty. Staff Levels AsA has achieved significant reductions in staff numbers since as a result of numerous programmes aimed at improving efficiencies. Manpower expenditure is one of the primary drivers of AsA s cost base. For the Financial Year, staff costs accounted for approximately 64% of total expenditure. It is imperative therefore to ensure that staffing levels and mixes are optimised. Optimisation of workforce mix, including increased use of part time and casual staff, provides better flexibility to meet changes in activity. It is an essential tool to maximise the efficiency of the manpower cost base. AsA experienced significant decreases in its level of activity as a result of September This had a clear impact on revenue, yet did not have a similar effect on staff numbers, as demonstrated in Figure 1. Figure 1 Staff numbers and revenue trends $mil / / / /02F 2002/03P 4,000 3,700 3,400 3,100 2,800 2,500 Staff Numbers Revenue Staff Numbers

12 12 Source: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports I The impact and rebound from September 2001 was a 3.3% contraction in revenue, accompanied by a 1.1% increase in staff numbers (Table 5). Table 5 Revenue and staff 2000/ /02F 2002/03P Actual Fcst Budget Revenue % 7.5% Staff N um bers 2,862 2,792 2, % 3.5% Source: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports Further staff reductions can be obtained through the closure of towers that are assessed as not required by the airlines and the Civil Aviation Safety Authority. In addition, towers that are manned during airline curfew hours, such as Adelaide, could be downgraded to a Mandatory Broadcast Zone releasing critical air traffic control staff. (Note: The generous contribution of AsA's staff who undertook a voluntary 5% reduction in remuneration and accepted leave and/or leave without pay has already been commended in other forums. The staff response to the September 2001 tragedies is not be confused with the assessment of AsA s overall efforts in this area.) Finding: It appears that there is further scope for Airservices Australia to reduce staff levels in line with activity decreases. If Airservices Australia believes that it is necessary to maintain a given level of staffing in anticipation of activity rebounds, then this should also be reflected in revenue or activity growth from other initiatives. AsA s Waypoint presentation covered cost increases of $17.5m as a result of certified agreement salary increases and other staff costs. In this current environment, it seems unreasonable to grant wage increases without at least some form of productivity improvement as a trade off. Indeed, as outlined in the Commission s Statement of Regulatory Approach to Price Notification, it is considered that the Commission is more likely to not object to prices where wage increases are associated with improvements in productivity. 6 As seen below, this includes very little in the way of offsetting productivity gains with virtually the full amount included in the plan (Table 6). Manpower Expenditure Movement $ Movement % Table 6 Manpower expenditure 2000/ /02F 2002/03P Actual Fcst Plan (56.997) (8.332) (15.2%) (2.6%) 5.6% Sources: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports 6 Australian Competition and Consumer Commission, Draft Statement of Regulatory Approach to Price Notifications, 1998, p. 4.

13 13 Airservices Australia's Justification for Price Increases As no detailed price break-up has been provided in the AsA submission, reliance has been placed on Waypoint 2002 presentations and discussions, and on data previously provided by AsA. As displayed in Table 7, this information detailed the rationale behind the proposed average charge increase of 5.1%. Analysis suggests the proposed price increases could be avoided if AsA were to amend their methodologies. AsA could in fact continue to deliver discounts. Below is a re-working of AsA s justification, which includes three perspectives (Table 7): 1. AsA: details of information as provided by AsA with the net increase in prices of 5.1%. 2. Scenario 1: a conservative re-modelling of the Airservices' data, holding all factors constant except for an expected 5% benefit from improvements in AsA s cost base. This result still displays an effective net zero change in prices. 3. Scenario 2: a more assertive re-modelling with the inclusion of several further assumptions. This result indicates further discounts of around 5%. The key assumptions for Scenarios 1 and 2 are contained in Annex C. Table 7 Rework of Airservices Australia s justification for price increases Airservices Scenario 1 Scenario 2 Forecast Revenue/Activity Loss (11.8%) a Growth in Activity for 2002/ b Increase in Profit from Other Commercial Revenue c Value of Wage Increases c Reduction in staff costs d Reduction in depreciation e Other Cost Savings F Reduction in EBIT target AsA Price Increase (5.1%) to cover gap see below Further Opportunities: g Increase in Government Subsidy!! Shortfall/(Surplus) without quantifying! (0.4) 24.9 Implied Price Increase/(Decrease) 0.1% (5.2%) Sources: AsA Price Justification as presented; Qantas estimates. Allocation of Costs Information provided by AsA contained little indication of how costs (variable and fixed) are allocated in order to determine the proposed pricing structure and associated price levels. This means it is not possible to assess the structure and level of prices proposed by AsA against the charging principles discussed earlier. The importance of clearly documenting the allocation of costs across services for public sector organisations such as AsA is well documented. As noted by the Commonwealth Competitive Neutrality Complaints Office:

14 14 Among other things, this would involve ensuring that agencies properly document the way they allocate costs to their business units. Public sector reforms such as accrual accounting and output budgeting will also improve the accountability of managers and encourage better investment decisions in the future. 7 The provision of such data would appear to be readily available from AsA: Airservices restructured its prices to replace the incumbent network based charging regime with that of a location specific pricing (LSP) structure for each of its TN and ARFF services at each location around Australia. Each location was transformed into a separate profit centre headed by a business manager who was made accountable for both operational and financial performance. 8 In accordance with the aforementioned charging principles: the costs applied to each service should be efficient; and there should be transparency in the allocation of costs between services. Traditional costing methods are based on the assumption that direct labour and direct expenses are the major components of costs and thus should be used as the basis for allocations. It does not focus on activities as the fundamental cost objects; it assumes a relationship between overhead and the volume-based measure, and can be considered generic. Activity Based Costing (ABC) however, provides a more accurate way of assigning the costs of indirect and support resources to business processes, products, services and customers by focussing on activities as the basis for cost assignment. ABC is especially useful in businesses with high levels of overhead costs, where a single driver cannot explain such costs. Currently, there is little understanding regarding the allocation of costs within Airservices. It would seem that for example, airways systems costs may be allocated on the basis of maintenance hours, consumables for equipment or engineering hours. Comments have been made to the effect that overhead costs are allocated on a more traditional costing basis of direct expenses. However, given the high proportion of such expenses, this may not be the most accurate allocation method. Finding: Given Indirect Operational Costs and Other Support Costs comprises approximately 22% of total expenditure for , the composition and allocation base for such costs should be fully transparent. The use of Activity Based Costing methodology would best facilitate this. Independent Reviews An independent report was commissioned for the Civil Aviation Safety Authority (CASA), prepared by Russell V. Smith, July 1998 titled Airport Firefighting Services in Australia, from which several key conclusions can be drawn: 9 AsA s staff levels are extremely high it is a reasonable assessment that the 16 airports staffed by Airservices are overmanned by an estimated 150 to 200 firemen; 7 Commonwealth Competitive Neutrality Complaints Office, Cost Allocation and Pricing, Canberra, October 1998, p. ix. 8 Airservice Australia, Preliminary Pricing Proposal to the Australian Competition and Consumer Commission, May 2002, p Russell V. Smith, Airport Firefighting Services in Australia, Report for the Civil Aviation Safety Authority, July 1998.

15 15 AsA s costs are so inordinately high the single cause of this situation is that there is a monopoly provider and charging authority for airport firefighting services; AsA offers some advantages as a unitary provider, but the advantages are overwhelmed by the overhead costs generated in providing the generous standard of service at 16 airports; and a primary disadvantage would remain with AsA overall exposure to industrial pressures. Airservices Australia s Incentive to Contain and Reduce Costs While AsA has improved its operational efficiency in recent years, there is still substantial scope for improved performance. Also, the current governance and economic regulatory regimes do not appear to provide AsA with sufficient incentives to contain and reduce costs. In reaching this conclusion, it is noted that: a substantial proportion of AsA s efficiencies were achieved through the implementation of the Business Transformation process. The airlines are yet to be briefed on the efficiencies remaining from the ongoing TAAATS implementation; the previous poor operational efficiency of AsA made for a number of easy gains, and hence continued pressure is required to ensure improved performance. AHL has previously noted that: in 1998 Airservices Australia confirmed with AHL the operations and cost base of the air traffic service provider did include significant operational inefficiencies. If these inefficiencies were to be removed this would translate to a 20 to 30% reduction in air traffic services charges over time ; 10 while some of AsA s services may become contestable in the future, it is not until actual contestability occurs that sufficient incentives will exist for all potential cost savings to be achieved; as noted earlier, AsA has not quantified potential cost savings from planned capital expenditures; and the current regulatory arrangements under the PS Act, where AsA can seek price increases based on increasing costs, provides little incentive for AsA to minimise costs and operate efficiently. On the basis of the above points and aforementioned capital equipment and staff savings, Qantas considers it appropriate that AsA continues to set targets for real reductions in operating costs in the order of at least 5% per annum for a further five years. Finding: Airservices Australia is not subject to the same incentives to minimise costs as other Government organisations and commercial firms operating in competitive markets. If it was, Airservices Australia could be reasonably expected to achieve real reductions in operating costs in the order of at least 5% per annum for the next five years. Service Quality Given the short time frame available to prepare this submission, only limited comment is provided on the quality of service achieved by AsA. AsA has not entered into a Service Level Agreement (SLA) with the airlines. Thus, while AsA undertakes some monitoring of its performance, there is no formal mechanism that links service quality to prices charged. 10 Ansett Holdings Limited, 2000, p. 8.

16 16 It appears that other air navigation service providers are more advanced than AsA in developing robust and comprehensive performance monitoring regimes. The service standards being developed by UK NATS to satisfy their licence requirement have recently been supplied to AsA for their review. (A discussion paper is provided for information at Annex D.) 3.3 Traffic Volumes A key issue in relation to AsA s pricing proposal is post-september 2001 forecast traffic volumes. As discussed below, lower traffic volumes do not justify price increases and AsA s forecast traffic activity is conservative. The Appropriateness of Lower Volumes as a Case for Increased Prices A question raised by the Commission is whether AsA should be allowed to increase prices because lower than expected traffic volumes have suppressed its profitability. In competitive markets, the prices charged by suppliers to customers do not increase because of lower than expected activity levels. Instead, all suppliers to the aviation industry strive to reduce costs. Aeronautical services are a critical element of the air transport industry. If monopoly suppliers, such as AsA, increase prices in the face of falling activity levels it will only serve to further depress demand. Even if the current lower activity levels become permanent, it is not a justification for suppliers to the air transport industry to raise prices. Permanent lower activity levels indicate that the value of air transport to the community has fallen, which in turn lowers the level of return suppliers can realistically expect to achieve on their current investments. For companies listed on the stock exchange, this occurs through a reduction in the share price. For unlisted companies with no share price, the target rate of return may fall. The Commission has also commented on this issue in respect of its recent decision on Harbour Towage: In a competitive market, all companies would be forced to cut costs and lower prices in response to a demand fall 11 Were the Commission to accept the conservative traffic forecasts proposed by AsA, it would be considered necessary to incorporate a mechanism to return any excess profits achieved through higher traffic. Airways New Zealand incorporates such a mechanism in its agreements with the airlines. Finding: It is inappropriate for price rises to be granted on the basis of lower industry activity. In competitive markets, downturns in demand lead to cost cutting, price reductions and/or lower returns to the industry, and not price increases by suppliers to the final market. The Reasonableness of Airservices Australia s Forecast for Activity Growth The submission postulates a 2% overall growth for The 5 + % domestic growth may be low. Qantas has already announced the purchase and delivery of four A , an extra six B717 and the balance of 15 B between now and June 2003 for domestic operations. The A , B717 and the last five B may not be in the AsA calculations. The international growth of only 0.6% also appears conservative. Qantas will take delivery of six B ER at 414 tonnes, but will retire only five B at 378 tonnes. Other factors 11 Australian Competition and Consumer Commission, Adsteam Marine Price Notification Statement of Reasons, Public Register, February 2002, p. 16.

17 17 such as the use of the B on Tasman routes and the internal transfer of four B767 to Australian Airlines will also see further, even if marginal, increases in international income for AsA. The May 2002 IATA Industry Briefing shows a steady claw back of capacity by the international airlines. Strongest recovery is in the Asia-Pacific region. The Briefing includes Lessons from the Gulf War which may be used as a comparator for post-september 11 traffic predictions: On both occasions passenger traffic growth turned sharply negative in the initial month (September 2001 and January 1991), fell further negative in the following month and then began a gradual recovery. In 1991 positive monthly growth (against prior year) was resumed after 7 months. However the rate of recovery has been slower in this downturn, and at the current rate positive growth is not likely to be evident until September The histogram contained in AsA s submission is understood. 13 However, AsA has been consistently conservative in its projections. September 2001 aside, there is no reason to suggest the current projections will be different from previous outcomes. Consideration of actual outcomes against planned projections can provide good insight into the adequacy and efficiency of a company s forecasting processes. It can highlight where a company may consistently over or under estimate aspects of its financial measures, and provide a useful tool in assessing budgets or forecasts. For this example, revenue provides a reasonable proxy by which activity levels can be gauged (Table 8). Despite the lack of available AsA data in respect of prior forecasts available to the public, the data for the available periods displays, September 2001 aside, an apparent trend to underestimate activity. Table 8 Historic conservatism of Airservices Australia 1999/ / /02 Fcst* Actual var Plan* Actual var Plan* Budget** Fcst** v plan v budg Revenue % % % -9.3% EBIT% 10.9% 13.0% 11.9% 16.3% 12.3% 12.4% 7.5% Sources: AsA Corporate Plan July 2000 June 2005; Waypoint Presentation 2002; AsA Annual Reports Whilst it is normal business practice to err on the side of conservatism, a realistic approach is essential and historic data assists in indicating the extent of such practices. Finding: Airservices Australia s forecast of traffic volumes is conservative. Qantas alone has the potential to absorb all of the projected domestic growth through its aircraft procurement programme as well as the projected 0.6% international growth. 3.4 International Comparisons Preliminary benchmarking of AsA's prices against overseas providers indicates that apart from the Russian Federation (currently undertaking a massive equipment upgrade program) and New Zealand s continental charge, AsA s enroute charges are higher than other benchmarked countries (Table 9). Table 9 Country Enroute cost comparison (cost per 100km) Charge in Australian Dollars DHC International Air Transport Association, May 2002 Industry Briefing, Airline Industry Trends Since September 11 th, Aviation Information and Research, May 2002, p AsA, May 2002, p. 15.

18 18 Australia (AsA) Australia (AsA proposed) Canada New Zealand New Zealand Oceanic Russian Federation South Africa Source: Estimates derived from IATA Airport and Air Navigation Charges Manual. It should be noted that the NZ domestic or continental airspace is different from Australian airspace. In New Zealand the distances between landing ports is shorter than in Australia, which means the ability to recover income for the similar level of services provided is more difficult. This should result in higher prices in New Zealand. The fact that New Zealand and Australian charges are similar demonstrates the lower cost of Airways New Zealand s services. The South African and New Zealand Oceanic charges are of special interest as these Air Traffic Management (ATM) providers could become potential competitors to AsA in the contestability of enroute services in the Tasman and Indian Ocean. 3.5 Rate of Return Budgeted and Accounting Returns The following comments are offered on the various budgeted and accounting returns contained in the pricing proposal. Financial Performance Financial performance measures must take a holistic approach and consider both balance sheet and profit and loss indicators. They must also incorporate an efficiency performance measure and/or price regulation to discourage inappropriate cost structures and inefficiencies, especially in the case of monopoly providers. Measures used are generally self-explanatory and include: NPAT/Sales: indicates level of profitability compared to sales volumes; NPAT/Total Assets (excluding cash): indicates level of returns generated from invested capital (asset base); NPAT/Equity: indicates level of profitability generated from invested shareholders funds (equity); and EBIT/Operating Revenues (Sales): reflective of operational efficiencies exclusive of extraneous factors such as tax and interest. As previously discussed, it is usually more meaningful to exclude abnormals, such as provisions for early retirement benefits or written-down values of disposed assets, when calculating financial performance measures. Although accounting policy no longer requires such items to be separately disclosed, their inclusion may distort the underlying operating position of AsA given that most items are not recurring in nature nor reflective of the true revenue/expense situation. It is also necessary to note that reliance on financial performance measures that are related to sales is not considered an appropriate means for determination of a reasonable rate of return. Return measures by their very nature should relate to an input, such as equity or assets.

19 19 For this exercise, averages on AsA's measures should exclude the year due to the large restructuring provision of $200 + m. This item is generally non-recurring and thus not reflective of the underlying performance of AsA. The average still covers three years of data plus AsA s budget projections for and thus provides means for an adequate assessment. It more accurately reflects AsA s management practice since the introduction of their Business Transformation programme (Table 10). Table 10 Financial performance of Airservices 1999/ / /02F 2002/03B Avg 2 year 99/00-00/01 Avg 4 year NPAT/Sales NPAT/Total Assets NPAT/Equity EBIT/Sales Source: AsA submission to the ACCC, p. 19 Comments on the comparative data are as follows: given the lack of forecast data for comparable firms, it is necessary to rely on historic data to provide comparison; the use of average weighted revenues is considered unnecessary given that the financial measures used already incorporate relativity measure; the impact of September 2001 will result in significant losses for many of the international airlines, thus further deteriorating the averages; and financial comparisons are made with other air traffic providers, airlines, Other Transport Bodies and other Commonwealth GBEs. The exclusion of Telecommunications is deliberate as it is not a suitable industry proxy. It is considered that a more meaningful comparison would be via extension of the analyses to include additional airlines to give a broader coverage of the aviation industry, as this is the primary sector in which AsA operates. While it is accepted that there is not a valid overall Aviation Industry benchmark, it is still important to consider the performance of Airservices compared to airlines, given that the airlines are the customers of air traffic management providers and thus provide the closest industry proxy. Similar drivers impact both business types, as evidenced from the events of September 11 and the Ansett collapse. AsA s price justification is on the basis of these activity movements. Generally, it is impossible to find a proxy that will exactly match AsA, due to the myriad of variables present. A comparison over the two financial years for which data is adequate and available for both AsA and other bodies ( and ) is displayed in Table 11. Table 11 Measures % NPAT/Sale s Financial Performance Comparisons - Summary Airservic ATM Airlines Australia es Providers n Transport Engineeri ng C/wealth GBE NPAT/Asse ts NPAT/Equit

20 20 y EBIT/Sales Source: AsA submission to the ACCC. It can be seen that AsA s financial performance measures are somewhat higher than these comparisons: NPAT/Sales: AsA's 7.5% versus the Airline Average of 0.1% versus the Overall Average of 4.8%; NPAT/Assets: AsA's 9.1% versus the Airline Average of 0.3% versus the Overall Average of 6.5%; NPAT/Equity: AsA's 19.6% versus the Airline Average of 3.9% versus the Overall Average 14.6%; and EBIT/Sales: AsA's 14.7% versus the Airline Average of 3.9% versus the Overall Average of 8.2%. AsA has continued sound financial performance over all periods, even factoring in the results of (excluding the one off abnormal impact of the restructuring costs). Only AsA, GBE or monopolies can achieve such results in adverse circumstances. A significant point made by AsA in their submission was that they should be compared to Australian Telecoms, Engineering and Transport rather than other ATM providers because elements of those industries were included in their cost base. Notwithstanding the comments on Telecoms, it should be noted that other ATM providers would also have these elements within their cost base. Further information can be deduced from the financial information contained in Annex E. Building Block Approach AsA has applied the Building Block approach to determining allowable revenues for the calender year. From this application, AsA claims that they are actually under-recovering on their regulated Airways Revenues in by some $36m. In assessing the validity of AsA s application of the Building Block approach, key issues include the: valuation of assets; operating and maintenance expenses; and weighted average cost of capital (WACC) value. AsA has chosen to increase the value of its non-current assets by 10%. This was done on the basis that: Preliminary research into the impact of the Depreciated Optimised Replacement Cost (DORC) methodology would appear to suggest Airservices assets would be more highly valued. 14 As discussed earlier, AsA s fixed asset base contains assets that should be excluded for the purposes of determining prices for the RPT sector. Hence, there appears to be little justification for the 10% increase in valuation. In addition, the fixed asset base should be allocated across services in accordance with the Commonwealth Government s endorsed policy on user pays principles. 14 Airservices Australia, May 2002, p. 41.

21 21 AsA increased the level of operating and maintenance costs by 5% on the basis of the risks associated with managing a large and technically complex delivery of service. 15 AsA provides little evidence to justify why its risk profile cannot be captured through its WACC. It is also unclear why the five per cent risk factor was applied to all operating and maintenance costs, especially those relating to its day to day operations, such as administration. Also it is not clear if AsA has included planned capital expenditure in its operating and maintenance costs. These costs should be included as part of the fixed asset base. On the limited information available, it appears AsA has overestimated its risk profile in developing its WACC. This is evidenced in the first instance with the application of an Asset Beta of 0.95 to In addition, it appears that AsA has applied the risk factor twice, once in operating and maintenance expenditure and again in the WACC. The issue of a reasonable WACC for suppliers to air transport and many other industries has been thoroughly examined in previous decisions by the Commission and hence is not discussed extensively in this submission. However, it is noted that Airservices has derived an asset beta from quantitative analysis of the correlation between underlying demand (enroute activity) with the performance of the economy (Gross Domestic Product). 16 The validity of this analysis is questionable, given that AsA is seeking to increase prices on the basis of lower activity levels. Furthermore, Standards and Poor s (S&P) has assigned its AAA long-term rating to AsA s planned $100m medium-term note issue. 17 S&P noted that the underlying credit profile of AsA is high investment grade, the AAA rating is strengthened by the implicit support of the government Privatisation of AsA is not on the government s agenda. 18 AsA s assessment of its financial position was given in a recent briefing to the Australian Financial Review: Our profit after tax last year was a record $55.9 million on turnover of $582.7 million. This year, we re looking to achieve about $20 million after tax on turnover of $520 million We ve done exceptionally well in what was going to be a loss-making situation to make a profit without resorting to a price increase 19 For information, an updated WACC developed by the Board of Airlines Representatives Australia (BARA) for Sydney Airport Corporation Limited is provided in Table 12. This WACC can be considered an appropriate benchmark for AsA, given the common monopoly status of the two organisations. Finding: Airservices Australia s application of the Building Block approach overestimates a number of key parameters in estimating allowable revenues. This is evidenced by Standards and Poor s 20 May 2002 Sovereign equivalent rating of AAA to Airservices Australia. It should be noted that if the traffic forecasts of Airservices Australia are accepted, the reduction in risk associated with the conservative forecasts should also be reflected in further lowering the required rate of return. 15 Airservices Australia, May 2002, p Airservices Australia, May 2002, p AAA is usually reserved for Sovereign Ratings for countries such as the United Kingdom, United States of America, Canada and Australia. The highest rated Australian airport is SACL at A+(Watch Negative). The highest of 24 world airlines is Qantas Airways Ltd at BBB+ (Negative A-2) Standards and Poor s Airservices Australia A$100 MTN issue rated AAA, 20 May Australian Financial Review, Airservices sets out to sell aviation, 13 May 2002, p. 24.

22 22 Table 12 Parameters Values for the WACC Airservices Australia WACC parameter Value Nominal risk free rate 5.61 Inflation 2.42 Nominal cost of debt 6.61 Debt premium 1.00 Gearing D:E 60:40 Market risk premium 5.50 Asset Beta 0.40 Equity Beta 0.86 Debt Beta 0.09 Corporate tax rate 30 CAPM nominal equity return 10.4 Dividend imputation 1.0 Nominal WACC (vanilla) 8.11 Real WACC (vanilla) 5.55 Post tax nominal WACC 5.67 Post-tax real WACC 3.18 Notes: Based on BARA s multi-till WACC parameters with updated inflation and risk free rates as at March These rates may have changed since Airservices Australia lodged its prices notification with the ACCC. Source: Board of Airlines Representative Australia (2000), BARA Submission to the ACCC on SACL s Draft Pricing Proposal. Appropriateness of Comparisons AsA has provided a range of financial measures to demonstrate the appropriateness of the level of return it is seeking to achieve. There is no one, or group of tools that can provide a definitive measure of the financial performance of an organisation such as AsA. While noting the AsA s preference for its accounting-based benchmarks, other organisations have questioned the appropriateness of their application. As argued by the Steering Committee on National Performance Monitoring of Government Trading Enterprises (SCNPMGTE): Accounting income (EBIT) is essentially based on past earnings. Its components are determined according to a set of standards and principles, established by the accounting profession, which are designed to facilitate the verification and assessment of financial accounts. These standards and principles can, however, result in different estimations of accounting income depending on the approach used and the method adopted to revalue assets. "ARR [Accounting Rate of Return] is often poorly correlated with a market-based measure of return. Moreover, accounting profit may be subject, as are most forms of information, to strategic manipulation. ARR can therefore provide incorrect valuations (and thus performance assessment) and management decisions by misrepresenting the underlying ability of an investment to generate future cash flows. 20 Also the Commission has raised concerns with the use of accounting based measures of return. As noted in its recent consideration of price increases by Adsteam Marine: The Commission notes that there are a number of complications in determining a margin by this means. First, this methodology appears to be no more precise than benchmarking a firm s cost of capital with publicly available information. Second, EBIT/Revenue is an accounting measure and therefore the benchmarks will tend to reflect, among other things, costs based on the historic cost of assets. The application 20 Steering Committee on National Performance Monitoring of Government Trading Enterprises, An Economic Framework for Assessing the Financial Performance of GTEs, July 1996, p. 12.

23 23 of these benchmarks to the Adsteam methodology of cost based on asset values that are adjusted for inflation or for market conditions may be problematic. 21 Based on advice from the Commission, AsA has also applied the Commission s Building Block approach. The rate of return measure used in this approach is a WACC. As noted by the Commission: In its regulatory decisions to date the Commission has consistently applied the building block approach as a forward-looking concept, considering projected efficient costs rather than historical costs. 22 An assessment is made below on all of the measures contained in AsA s pricing proposal. It may be that in its Draft Decision, the Commission will state its preferred measure(s) for assessing the financial performance of AsA. Additional Discussion Management Commentary Management commentary often provides interesting insight into the performance of a business. Thus, it is interesting to consider the management commentary on business performance in the Airservices Annual Report for Emphasis is placed on the continued improving trend in Earnings Before Interest and Tax (EBIT)/Total Sales. (p16) This commentary displayed the following graph, depicting such a trend (Figure 2). Figure 2 Earnings Before Interest and Tax/Total Sales (%) Source: AsA Annual Report 2001, p. 16 The figures referred to in the graph exclude the aforementioned abnormal expenses. Exclusion of Relevant Information AsA has consistently recouped more revenue than its operating costs. The inclusion of abnormal items such as restructuring provisions and large asset revaluations, distorts the ability to adequately assess AsA s actual operating performance. 3.6 Structure of Prices In this submission, comment is provided on the extent to which the current structure and level of prices is consistent with the charging principles described earlier. 21 Australian Competition and Consumer Commission, February 2002, p Australian Competition and Consumer Commission, Sydney Airports Corporation Ltd, Aeronautical Pricing Proposal, Decision, May 2001, p. 55.