How Heathrow is happy to pay way over the odds, to increase its RAB, allowing more revenue
The City Editor of the Financial Times, Jonathan Ford, has written about how the reasons for Heathrow’s anticipated costs for its possible 3rd runway. The cost of £17 billion, or now £15 billion are exceptional. But Jonathan explains how Heathrow’s investors seem happy to spend so much. It is because of the curious incentives that operate in the topsy-turvy world of utility financing. As with most ventures that have monopolistic aspects, Heathrow is not subject to ordinary restraints on capital expenditure. The principal check is the willingness of the airport’s regulator, the Civil Aviation Authority, to sign off on the mechanism by which these costs can be recovered from captive airline customers through passenger charges. Heathrow often pays far above the going rate for building, new technology etc, because this adds to the airport’s regulated asset base (RAB) on which it gets an allowed return, and thus permits it predictably to expand its own revenues. Since taking over BAA in 2006, Ferrovial has been extremely active, tripling Heathrow’s RAB to £15bn. It is a system that has allowed the airport’s owners to finance these expansions with vanishingly little equity capital. Heathrow is encouraged to fund everything with debt by a regulatory system that allows it to keep the gains from financial engineering. Heathrow’s owners hope to shrug off the risks of completion, but transfer them on to customers.
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The gold-plated reason for Heathrow’s bloated runway costs
System allows owners to finance expansions with little equity capital
By JONATHAN FORD (FT)
25.3.2018
In the long and rancorous debate about expanding runway capacity in Britain’s crowded south-east, it often feels as if surprisingly little energy is devoted to containing the project’s extraordinary cost.
Not only is the front-running option by far the most expensive of the three: at £14bn the so-called third runway dwarfs the £9.7bn that might be devoured by the “Hub” extended runway alternative at Heathrow, as well as the £8bn-£9bn that expansion at Gatwick could absorb. It also takes the longest to bring into commission and thus entails financing that huge sum for longer than the other schemes until all the additional revenue-bearing traffic finally arrives.
Of course, the planners and politicians may have social or environmental reasons for pursuing the most gold-plated project. But it is also striking how relaxed Heathrow’s investors are about funding this extra expense, even over an alternative cheaper option at their own airport. They seem happy to spend billions more to achieve roughly the same outcome in terms of traffic growth.
That, it should be said, is not because they are unusually generous or public-spirited people. Rather, it comes down to the curious incentives that operate in the topsy-turvy world of utility financing. These make the highly priced scheme extremely attractive for financiers. The snag is that these private gains come at the travelling public’s expense.
As with most ventures that have monopolistic aspects, Heathrow is not subject to ordinary restraints on capital expenditure. The principal check is the willingness of the airport’s regulator, the Civil Aviation Authority, to sign off on the mechanism by which these costs can be recovered from captive airline customers through passenger charges.
The regulator’s own review of capital investment has uncovered evidence of bloated costs at the airport. A smoking shelter at Terminal 2 was priced at £1m — more than twice the “normal” price for such a structure. When Heathrow priced new automated bag drop machinery at £150,000 per unit, IAG, the owner of British Airways, market tested the proposal and came up with a price of £40,000. Sources close to Heathrow say it contends the latter comparison on the grounds that the IAG number ignores labour costs.
The key point though is that each dollop of capital spending adds to the airport’s regulated asset base (RAB) on which it gets an allowed return, and thus permits it predictably to expand its own revenues. Since taking over BAA in 2006, the investor group led by the Spanish construction company Ferrovial has been extremely active, tripling Heathrow’s RAB to £15bn.
It is a system that has allowed the airport’s owners to finance these expansions with vanishingly little equity capital. Debt providers are so sure that revenues will always be forthcoming that they have willingly stumped up for the capex. Meanwhile, Heathrow is encouraged to fund everything with debt by a regulatory system that allows it to keep the gains from financial engineering.
Since 2006, shareholders’ funds have declined from £6.3bn to £922m, partly through capital returns as the old BAA sold off six of its seven airports for almost £5bn. Over the same period, long-term debts have climbed from £6bn to £13.1bn. Heathrow’s gearing ratio presently stands at 87 per cent of RAB — higher than the most aggressive water companies, whose unsustainable leverage is now falling.
Obliging regulators have even helped the airport to finance giant investments such as the Terminal 2 rebuild by allowing it in effect to charge customers up front for these improvements. As the infrastructure expert Martin Blaiklock has pointed out, this approach goes against the fundamental principles of infrastructure provision. It allows owners not only to shrug off the risks of completion, but transfers them on to customers, who have little or no means of managing those risks.
Over the past decade, charges per passenger at Heathrow have doubled in real terms to £20 as travellers have been unwittingly bailed in to fund the expansion first of Terminal 5 and then Terminal 2. This bulge was supposed to subside as each investment project completed. It has not.
When Amsterdam’s Schiphol airport built its sixth runway at the turn of the millennium, the project cost in the hundreds of millions of euros. Building in the south east of England was always likely to be expensive, given the proximity to London. But the inflation is still extraordinary.
Before waving through yet more regulatory incentives to ensure the gold-plated expansion of London’s hub airport, politicians might ask whether these lures are contributing to unacceptable inflation in Britain’s already bloated infrastructure costs.
Jonathan Ford
https://www.ft.com/content/3668a0a4-2ec7-11e8-9b4b-bc4b9f08f381
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See earlier:
Sunday Times commentary on Heathrow: the cash machine with an airport attached
The Sunday Times reports that under a complex (perverse) incentive system, Heathrow is encouraged to spend as much as it can on developing the site. Heathrow’s investors earn returns based on the size of its “regulatory asset base” (RAB), under a formula set by the CAA. So the more the airport spends, the more its owners can earn. It gives an example of £74,000 to cut down 3 trees, which is at least 20 times the normal price. These costs of developing the airport are recouped through passenger charges, and also set off against UK tax. The Sunday Times questions the efficiency, governance and transparency of the management of Heathrow. It says the airport is demanding an insurance policy against the risk that the project goes wrong, and wants the CAA to ensure it will be compensated by airlines and passengers if there are unanticipated difficulties (eg. construction delays, or lower than anticipated passenger numbers or revenue). Scrutiny of Heathrow’s spending has been inadequate, there is no audit of the RAB, to show how the figure of £15.8bn for the expansion project is calculated, and Heathrow has not provided a detailed cost breakdown for the runway plans.
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