2013

The Commercial Context Module: BS3353 Assignment Case Study: Proposed Thames Estuary Airport Hub Project

David Aime Masvosvere Student ID: 1113855 3/24/2013

EXECUTIVE SUMMARY Calls for a new airport for London and the UK have been heard for decades. Each time a proposal has been made alternative measures to avoid building an airport in the London Thames estuary have been sought. Now however, cries to have this airport structure in the Thames have been voiced ever more loudly by London mayor Boris Johnson, Lord Foster and a few others. The main issue of contention with the project has been the sketchy financials along with environmental concerns. These environmental concerns despite having been echoed by many a British politician pale in comparison to the financiability and logistical matter. As will be noted in this document in quotes and extracts from BBC articles, Government literature and consultancy reports by economist firms among others, presently this project is just too risky and lacks detail in areas where necessary. A report prepared for the House of Commons Transport Select Committee deals a huge blow to the project, claiming it would be a risky investment. It says that because the value of the investment is significantly negative an investor would be likely not to touch the project. A public subsidy of 10-30 billion would be needed to get the airport built, the report by economics consultancy Oxera suggests. The reports authors have calculated the value of a new airport at 15.6 billion by calculating revenues from passenger charges and taking out operating costs. In todays money it would have costs of 43.7 billion, leaving a significant gap that would need to be made up. If Heathrow were to close as the result of a Thames Estuary airport being built, the final compensation bill could be as high as 20 billion. Thomas of Foster + Partners, the architects behind plans for the worlds biggest airport on the Isle of Grain, will answer questions on the proposal, which has an estimated cost of 50 billion.1

http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary_airport.aspx

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CONTENTS EXECUTIVE SUMMARY2 TABLES AND FIGURES USED..4 PART A..5 1. Overview.5 2. COSTS ...7 3. AIRPORT VALUE.8 4. AIRPORT COST9 5. ARR..9 6. IRR9 7. NPV .10 8. PAYBACK PERIOD11 PART B.12 1. PURCHASING AND SUPPLY12 2. COMMERCIAL ISSUES AND RELATED RISKS IN THE TENDERING AND CONTRACT PHASES...16 2.1 IDENTIFYING NEED AND PLANNING PURCHASE.16 2.2 SELECTING TENDERER..17 2.3 CONTRACT MANAGEMENT...17 CONCLUSIONS.20 RECOMMENDATIONS 21 REFERENCES21 BIBLIOGRAPHY OF SOURCES CONSULTED BUT NOT DIRECTLY REFERRED TO WITHIN THE WORK...22

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TABLES AND FIGURES USED Constrained and unconstrained Demand Cost estimate Airport value Cost forecast NPV Cash flow Model Procurement Cycle Procurement process The city of London in 2009 proposed to have the following structure for procurement Procurement Strategy

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PART A 1. Overview In assessing whether a new hub airport would be commercially feasible, the first deliberation is the extent of future demand from passengers and freight. Forecasts estimate the revenue that could be earned from a new airport, and hence the expected cash flows. The UK Department for Transport (DfT) published official projections in January 2013 of constrained and unconstrained future UK aviation demand.

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As seen above forecasts for traffic have been lowered substantially since 2007. Also it is worth noting that on top of providing services to presently constrained traffic, if all traffic that would otherwise have used Heathrow Airport were to be moved to a new airport, there would be an additional 85m passengers per annum (mppa) available for the new hub in 2050 that is with the assumption that a 100% transfer, from Heathrow happens. Economics consultancy firm Oxeras analysis, scenarios where Heathrow closed assume 100% from Heathrow to the Thames Airport hub, whereas if Heathrow remains open no transfer is assumed. It is also likely that abstraction from Gatwick and Stansted Airports is a concern, which jointly is projected to provide 70mppa in 2050, though full abstraction is improbable. It is important to note that, Oxeras base-case scenario has been to assume that there is no abstraction from these airports and, in a high-case scenario, that there is abstraction of traffic from full-service carriers at Gatwick (30%) and Stansted (3%) that will transfer to the new hub. These assumptions should cover the full range of likely outcomes, with the outturn level of traffic transfer likely to be somewhere in between.2

http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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2. COSTS It is pertinent to note that due to the number of proposal with varying specification (i.e. number of runways etc) costs estimates vary. Oxera collated cost estimates from a few proposals adjusting for inflation where necessary as is seam below.

As seen above a new airport in the Thames Estuary would probably cost in the range of 20 billion to 50 billion. The reason for a wide range of cost estimates comes primarily from conflicting estimates with regard to surface access costs. As most of the proposals outlined are indicative only, it remains unclear whether this accounts for optimism bias. Repercussions of optimism bias on cost projections are a great concern as they can result in cost overruns in the order of 50% to 100% for major infrastructure Projects Oxeras analysis assumes that a new UK hub airport would open and be fully functional in around 2025, which, from the proposals to date, appears to be a reasonable base case, although it is likely that a staged opening would occur in practice.3 An important aspect that most miss to mention and Oxera also noted, was the lack of details on compensation in the event that Heathrow is closed, this was not addressed in many of the proposals. With the current value of Heathrows regulatory asset base (RAB) around 13 billion, with past estimates having suggested that total compensation for the closure of Heathrow could be as high as 20 billion taking into account compensation to airlines, this is a major aspect in regard to the Thames airport project cost worth noting. The Thames Estuary proposal will not have location compensation to worry about but there is a prospect for the incurrence of environmental costs as many have opposed the project on an environmental basis.

http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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3. AIRPORT VALUE According to Oxera the resulting figure came about by estimating revenues from forecast passengers with the assumption that each paid the forecast charges net of operating costs. After this, revenues are then calculated using todays money with a discount factor reflecting the time value of money between now and the period when the airport is operational. Then result of this calculation is 15.6 billion.

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4. AIRPORT COST Using data from the same Economic consultancy firm the following was discovered. With use of a comparable basis the calculation takes a cost estimate for a four-runway hub which is slated above 70 billion inclusive of compensation, this cost is then calculated in todays money using a discount factor. If an assumption of an investment programme over time duration of ten years till 2025, with compensation after the new airport becomes operational, the resultant cost is 43.7 billion.

5. ACCOUNTING RATE OF RETURN (ARR ) This is an appraisal technique that considers a simple estimate of a project's or investment's profitability, subtracting money invested from returns without regard to interest accrual or applicable taxes. This method is widely used for investment appraisals and capital budgeting decisions. How to reach a decision is simple, one easy way is to accept projects with an accounting rate of return that is higher than the cost of capital and reject those that do not. With regard to the Thames project using ARR is difficult due to the uncertainty of the financials. The expected returns and capital investment required are yet to be determined. However it would be a more than competent technique for a project of this magnitude. 6. INTERNAL RATE OF RETURN (IRR) This method of appraisal works along with Net Present Value (NPV) as it is the discount rate at which the NPV of costs of the investment equals the net present value of the of the investment. Hence it is a method of capital budgeting which can calculate IRR and compare it with cut off rate for selecting any project. NPV and IRR have been used together as appraisal tools and given good results. As far as the Thames Airport project is concerned, after looking at the financial forecasts and in particular the hugely negative NPV it is my assumption that the IRR is lower than Cost of Capital therefore is a bad investment.

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7. NPV This appraisal technique takes into account the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project. This methods reliability in capital budgeting is based on accounting for time value of money with the use discounted cash inflows. The Net Present Value (NPV) of this project is negative taking into account that subtracting costs from the airport value when cost is higher than the airport value renders a negative figure. From a finance standpoint a based on this NPV value an investor would be unlikely to embark on the investment. This then implies that the collective investment in a new airport in addition to related infrastructure is improbable as a commercial investment. However it may still be possible to finance the project in the new airport infrastructure of around 20 billion alone, but only through injection of substantial levels of public subsidy and investment for the surface access and compensation, which would comprise around 6075% of the total investment cost.4

http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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Cash flow Model

8. PAYBACK PERIOD This appraisal technique is one of the simplest and takes into account the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. According to the House of Commons, The ambitious and wide-ranging set of developments intended to fix Britains creaking infrastructure would cost in the region of 50 billion (20 billion for the airport and 30 billion for the other infrastructure improvements), though the authors claimed that if implemented the plan could generate 150 billion - 35bn from the airport, 35bn from road and rail; 2bn from environmental management and 75bn from growth in the Thames Hub area.5 The main issue with a lot of contention is the time frame needed to recoup the funding and begin experiencing profitability here. Giving the planning and construction timetables its hig hly unlikely a new airport could be operational within 25 years. Given the pressing needs of the UK economy to meet the current demand for international travel, inaction over this period would be highly detrimental to recovery and growth.6

5 6

http://www.parliament.uk/briefing-papers/SN04920.pdf http://eandt.theiet.org/magazine/2013/03/debate.cfm

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PART B 3. PURCHASING AND SUPPLY Purchasing and supply can be defined as the acquisition or rendering of goods, services or works. It is complimentary that the goods, services or works are appropriate and that they are availed at the best possible cost, quality, quantity, time, and location. It important to note that Corporations and public bodies often define processes intended to uphold fair and open competition for their business while reducing contact to racketeering and conspiracy. Due to the magnitude of this project the essential success criterion is the well-timed, precise to excellence and gainful delivery of supplies, systems and amenities. There are many stakeholders, contractors and suppliers involved in this kind of project, not forgetting consulting firms. Due to this procurement methodologies and processes are fundamental to ensuring that project resources are delivered as requisite. Procurement Cycle

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The Procurement Process

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The city of London in 2009 proposed to have the following structure for procurement.

As far as Strategy goes I looked at the Just in time strategy used mostly in Japan and despite it being comprehensive I was not convinced it would serve this project well. As will be seen below I have a diagram with a strategy proposed in New South Wales that I believe would be suitable to the Thames project.

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http://www.hpw.qld.gov.au/SiteCollectionDocuments/CWMFProcurementStrategy.pdf

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4. COMMERCIAL ISSUES AND RELATED RISKS IN THE TENDERING AND CONTRACT PHASES 2.1 IDENTIFYING NEED AND PLANNING PURCHASE Potential Risk Understatement of the need Probable Effect of risk Purchase of unsuitable product or service Money wasted Need not satisfied Overstatement of the need Greater expense Poor competition Misinterpretation needs of Analyse need accurately Use functional requirements and performance Action required to Counter Effects Analyse need accurately

user Totally unacceptable Improve consultation with users purchase or not most suitable Obtain clear statement of work and product or service definition of need Time lost Increased costs Possible downtime

Insufficient funding

Delay in making the purchase Additional costs for re-tender

Obtain appropriate approvals before undertaking process Improve planning Improve forecasting, consultation with users planning and

Impractical timeframe

Inadequate responses from tenderers Reduced competition Delivery schedule not met

Improve communication with potential tenderers Implement best practice guidelines and practices policies,

Probity issues

Increased procurement costs Misuse of resources

Maintain ethical environment Most suitable product not obtained Improve training of personnel Unethical conduct Put suitable controls and reviews in place Consider using a probity adviser Improve communication with potential tenderers

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2.2 SELECTING TENDERER Potential Risk Probable Effect of risk Selecting an inappropriate Failure to fulfil the contract supplier Action required to Counter Effects Provide staff with appropriate tender evaluation, financial and technical skills training and commercial expertise Improve evaluation procedures Improve evaluation criteria and clearly identify them to tenderers in tender documents Reject unacceptable offers Perform financial, technical and company evaluations before awarding contract Procurement Review Committee to review tender and selection process prior to awarding contract Selecting product inappropriate Failure to meet the clients need Ensure users are involved evaluation/selection process in the

Improve technical evaluation procedures and train staff as appropriate Procurement Review Committee to review tender and selection process prior to awarding contract

2.3 CONTRACT MANAGEMENT Potential Risk Probable Effect of risk Variations in price and foreign Cost overruns exchange Unwillingness of the supplier Delays in delivery to accept the contract Need to restart procurement Action required to Counter Effects Agree on prices and the basis of prices Agree on a formula for calculating variations Seek legal redress if non-acceptance causes loss Negotiate but retain integrity of the contract Failure of either party to fulfil the conditions of the contract Contract disputes Failure to satisfy needs Delays in delivery Downtime Legal action Ensure good contract administration and performance management Hold regular inspections / meetings and ensure progress reports Ensure all staff know responsibilities and conditions Ensure good record keeping and

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Potential Risk Inadequately the contract

Probable Effect of risk administering Cost increases Failure of contract Full benefits not achieved Delivery product of

Action required to Counter Effects documentation Maintain up-to-date agency procedures and practices

Ensure all staff are suitably trained and experienced in contract planning and unsatisfactory management

Contract/supply disputes Commencement of work by Potential liability to pay for Confirm verbal acceptance of contract the supplier before contract is unauthorised work with written advice exchanged or letter of Possibility of legal action for Accept all contracts in writing acceptance issued perceived breach of contract Ensure approvals are received before allowing work to start Unauthorised scope of work increase in Unanticipated cost increases Contract disputes Ensure all contract amendments are issued in writing Record all discussions and negotiations Confirm instructions in writing Loss of intellectual property Loss of opportunity commercial Ensure suitable clauses are included in the contract

Unwarranted reliance on supplier for product support Failure to meet liabilities of Legal action third parties (eg. royalties or Damage to the agencys third party property professional reputation insurance) Check that all obligations are covered in the contract Agree on responsibilities Implement appropriate safety standards and programs Include appropriate instructions in specification packaging

Loss or damage to goods in transit

Delays in delivery Downtime Liability disputes

Agree on insurance cover for supplier to provide Accept delivery only after inspection Know when title of goods is transferred to buyer

Fraud

Misuse of resources Legal action Disruption to procurement activities

Maintain an ethical environment Follow and procedures maintain fraud control

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Potential Risk Key personnel not available

Probable Effect of risk Progress on project disrupted Less expertise

Action required to Counter Effects Include requirement in specification and ensure compliance in post-tender negotiation Know the market Accept risk and manage possible delay

Acknowledgment: This checklist is an adaptation of information derived by consultation with a checklist developed by NSW Department of Public Works and Services.8

http://www.nswprocurement.com.au/psc/Tendering-Manual/Appendix-3A.aspx

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CONCLUSIONS Based on the appraisal techniques used it is evident that the project leaves a lot of financial uncertainties. Based on this reason I do not believe it is a wise investment. The NPV and IRR are a big factor in this realization as they do not project long term financial viability. It is important to also note that due to the nature of the project size not all areas have been forecast by the office of Mayor Boris Johnson. It can be then concluded that there is a lot of optimism bias with little fact to back up. As far as the contract and tender phases as outlined in the document, it is very important that these areas be managed closely as improprieties will prove costly not only financially but time wise and politically as well as this is highly controversial project. RECOMMENDATIONS 1. Government regulation to reduce tax improving returns 2. Attract investment from development banks that seek returns other than the financial 3. Issuing government guaranteed or backed debt to raise financing changes to the cost structure to reduce cash outflows 4. Having supplier credit as it is a good way to improve project performance because one does not pay suppliers immediately freeing up cash for other uses 5. Having strict contract and tender practices that are closely monitored and evaluated 6. Having strict in house and outsourced audit systems to reduce improprieties

Word Count (2488)

REFERENCES

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1. http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary_air port.aspx 2. http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hubairport.pdf?ext=.pdf 3. 4. http://www.parliament.uk/briefing-papers/SN04920.pdf http://eandt.theiet.org/magazine/2013/03/debate.cfm

5. http://www.gowerpublishing.com/isbn/9781409425151, http://www.gowerpublishing.com/pdf/SamplePages/Managing-Project-Supply-ChainsAuthor.pdf 6. http://www.nswprocurement.com.au/psc/Tendering-Manual/Appendix-3A.aspx 7. http://www.hpw.qld.gov.au/SiteCollectionDocuments/CWMFProcurementStrategy.pdf 8. Baily, P., Farmer, D., Croker, B., Jessop, D., Jones D. (2008) Procurement Principles and Management,10th Edn. London, FT Prentice Hall (Financial Times). Recommended By The Chartered Institute Of Purchasing And Supply 7. http://www.cips.org/Documents/Resources/Knowledge%20Now/What%20is%20purchasing% 20and%20supply%20management.pdf 8. http://www.cityoflondon.gov.uk/business/tenders-andprocurement/Documents/Procurement%20strategy.pdf 9. http://archive.treasury.gov.uk/pub/html/docs/cup/cup39.pdf All references accessed between Thursday, January 24 2013 and Friday March 22 2013

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BIBLIOGRAPHY OF SOURCES CONSULTED BUT NOT DIRECTLY REFERRED TO WITHIN THE WORK 1. http://www.parliament.uk/documents/commonscommittees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf 2. http://www.parliament.uk/documents/commonscommittees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf 3. http://www.publications.parliament.uk/pa/cm201213/cmselect/cmtran/writev/aviation/m 103.pdf 4. http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary _airport.aspx 5. http://www.ciltuk.org.uk/Portals/0/Documents/ProSectors/Aviation/CILT_response_to_DfT _aviation_policy.pdf 6. http://www.parliament.uk/documents/commonscommittees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf 7. www.parliament.uk/briefing-papers/SN04920.pdf 8. http://www.bbc.co.uk/news/uk-politics-16606212 9. http://www.purchasing.tas.gov.au/buyingforgovernment/getpage.jsp?uid=07CC4222E4F10F 00CA256C8D007F9FC6 10. http://www.bbc.co.uk/news/uk-england-kent-15473914 11. http://media.aerosociety.com/aerospace-insight/2012/09/07/londons-thames-airportplans-deja-vu-all-over-again/7288/ 12. http://www.bbc.co.uk/news/uk-england-london-15817520 13. http://www.bbc.co.uk/news/uk-england-london-20317321 14. http://www.archdaily.com/339271/foster-partners-to-submit-thames-hub-airportproposal-to-airport-commission/ 15. http://thamesestuaryairport.com/pdf/THAMES%20ESTUARY%20AIRPORT%20for%20web. pdf

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16. http://thamesestuaryairport.com/masterplan.html 17. http://www.dailymail.co.uk/news/article-2088376/New-London-airport-Thames-Estuaryfavoured-Government-says-Boris-Johnson.html 18. www.fosterandpartners.com/core/pdf/news/?id=494 19. http://www.telegraph.co.uk/finance/newsbysector/epic/bba/9022146/New-ThamesEstuary-airport-could-be-built-in-six-years.html 20. http://www.fosterandpartners.com/news/thames-hub-team-welcomes-consideration-ofthames-estuary-airport-and-re-states-its-vision/ 21. http://www.tfl.gov.uk/assets/downloads/corporate/a-new-airport-for-london-part1.pdf 22. http://www.london.gov.uk/sites/default/files/Anewairportforlondon_part2.pdf

All sources accessed between Thursday, January 24 2013 and Friday March 22 2013

THE END

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