The private financing of airport infrastructure expansions

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1 The private financing of airport infrastructure expansions Economic and financial challenges Aviation Insight Series, Singapore Aviation Academy 15 July 2015 Greg Houston Partner, HoustonKemp Australia

2 Introduction

3 A number of economic and financial challenges arise when major capacity upgrades must be planned, financed and built on a foundation of voluntary commercial agreements with airlines. Today s discussion considers: Some examples of major, planned airport capacity expansions The implications of sharp increases in the total cost of aeronautical services, when passenger demand continues to grow in modest increments The desirability of long-term contracts to support such investments when airlines and passengers plan on much shorter time horizons The implications of capital markets requirements for financing such expansions 3

4 Examples of planned airport expansions An illustration of the significance of planned investments in the industry

5 Air traffic growth during the past few decades has absorbed excess capacity at many airports Global air travel is expected to double over the next 15 years, and Asia- Pacific is expected to lead exceed all other regions with annual traffic growth over the next 20 years of 5.7% 5

years The single-runway airport is expected to be in operation by the mid-2020s and serve 5 million passengers per annum The

6 Sydney: development of existing airport and new second airport Sydney Airport development Second airport at Badgery Creek New ground transport network, hotel and redevelopments to improve access and convenience Construction to be staged over 20 years The single-runway airport is expected to be in operation by the mid-2020s and serve 5 million passengers per annum The cost is expected to be $2.7 billion Sydney Airport has the first right of refusal for development and operation of the airport 6

a current asset base of 718 million Construction is expected to be completed before 2020 The new runway will be 3km

7 Perth s additional runway Melbourne Airport s third runway The new runway will be 2.7km long, 34m wide and parallel to the existing main runway The cost is expected to be $500-$600 million, compared to a current asset base of 718 million Construction is expected to be completed before 2020 The new runway will be 3km long, 60m wide The cost is expected to be $500 million, compared to a current asset base of 1.35 billion Construction is expected to take place over

airfield infrastructure, etc The cost is expected to be $1.35 billion over 8 years - this compares to the 2013-14 asset base of $1.

8 Brisbane s third runway Heathrow Airport: new runway and terminal The new runway will be 3.3km long, 60m wide and located 2km west of and parallel to the existing runway There will be more than 12km of taxiways, navigational aids, airfield infrastructure, etc The cost is expected to be $1.35 billion over 8 years - this compares to the asset base of $1.73 billion The new runway will be 3.5km long and around 2 miles north of the existing runways The cost is estimated to be between 15.6 and 18.6 billion, compared with a regulatory asset base of 14.9 billion in December

Changi: Terminal 5 and third runway Both to be located on reclaimed site of 1,080 hectares Expected cost of clearing the land and strengthening the soil alone is over S$1 billion Runway to be 4km

9 Changi: Terminal 5 and third runway Both to be located on reclaimed site of 1,080 hectares Expected cost of clearing the land and strengthening the soil alone is over S$1 billion Runway to be 4km long, to handle larger passenger craft Terminal 5 planned to be able to handle 50 million passenger movements per annum, initially, compared to current handling capacity of 66 mppa Expected to be completed mid 2020s 9

10 Aeronautical capacity costs and user charges The implications for user charges of sharp increases in the cost of aeronautical capacity

11 Airport capacity increases must ultimately be paid for through aeronautical charges unless there are to be government subsidies for air travellers Airport capacity increases are lumpy in nature, and often represent a significant increase in the asset/cost base, especially for airports with largely depreciated assets There are generally long lead times between expenditure commencing and the date at which new facilities become available for use Both equity and debt investors must expect to earn a reasonable rate of return through aeronautical charges, or financing will not be forthcoming The implications for the future path of prices may be inconsistent with efficient use of the asset, and objectives such as the smoothing of prices over time 11

12 The framework for aligning infrastructure costs with annual revenues/prices is widely accepted Opex + Depreciation + Return on capital Assets Starting Asset Base + Capex - Depreciation - X WACC Non-Aero profits (single till) Revenue allowance Aeronautical Charges Revenue allowance Throughput projections 12

13 Application of the accepted pricing framework to step changes in capacity can give rise to substantial jumps in prices. Passenger numbers Capacity pre-expansion Aeronautical Charges (cost-based, assets in cost base upon commissioning) Sharp increase as new infrastructure comes on-line Capacity Passenger numbers Charges fall as capital is shared over increasing passenger base Airport expansion commissioned Time Airport expansion commissioned Time 13

14 Increasing prices upon commissioning of new capacity can send inverse signals in relation to the use of scarce/surplus capacity Aeronautical Charges ($) Price path to encourage efficient asset use Price path using simple cast-based approach Airport expansion commissioned Time 14

15 Pre-funding offers a number of advantages when compared with raising prices only once an asset is commissioned improves price signals Charges eases cash flow constraints and improves financeability provides a smoother price path but, is generally resisted by airlines Revenues With pre-funding Without pre-funding Commission date Time 15

16 Deferring depreciation, or other cash flows, once upgraded capacity is in place, also improves signals for efficient usage and smooths prices improves price signals Charges but pushes out recovery may increase project risk Revenues Straight-line depreciation Adjusted depreciation Commissioning date Time 16

17 Role of commercial agreements The desirability of long term commitments to support investment by airports

18 Australia s major airports are privately-owned and exempt from formal price control. Between 1997 and 2003, the Australian Government sold long term leases over the 22 Federal Airports Corporation- operated airports to the private sector (50 year leases with 49 year renewal options) In the period to 30 June 2002, aeronautical charges were regulated by means of: CPI-indexed price caps, applying under business as usual circumstances, and provision for ACCC amendment to those price caps for necessary new investment or NNI but, the underlying basis for the initial business as usual price caps was never specified Formal price controls on aeronautical services were removed as of 30 June 2002, but the four largest airports remain subject to a monitoring regime administered by the ACCC: prices, costs, profits, financial accounts and aeronautical service performance are reported annually and disclosed by the ACCC ACCC publishes an annual price monitoring report, drawing attention to economic performance of airports 18

19 Commercial agreements between airports and major airlines have replaced formal price controls Since 2002, individual airports and airlines (or groups of airlines) have increasingly entered into a series of multi-year pricing agreements Such pricing agreements have taken the place of formal regulatory arrangements and provide assurance: to airport operators, as to how their investments will be remunerated to airport users in relation to prices and service levels However, major infrastructure upgrades new runways and/or terminals represent substantial new investment involving risks of a nature and scale disproportionate to those that have gone before Such expansions by privately-owned airports operating under commercial agreements are without precedent The nature and extent of complexities introduced into the negotiation process are substantial, particularly in relation to the timing of capital expenditure recovery, and so long term price paths the management and sharing of multiple forms of risk 19

20 In other, unregulated infrastructure sectors the financing of large-scale investments in capacity is addressed through long-term commercial agreements, with fixed payment obligations Large civil engineering projects are all about risk: how to price it, how to manage it, who should bear it. - Iain Osborne, CAA, Airlines are reluctant to enter into agreements that involve commitments to pay for capacity they cannot be sure of utilising open-ended commitments to underwrite construction cost or other risks The aviation industry has a history of game-changing transformations the emergence of low-cost carriers in 1990s the increasing prevalence of global airline alliances, and regional hubs advances in aircraft technology, eg, Airbus and Boeing and is subject to intrinsic uncertainties Unexpected events natural disasters, medical crises etc 20

21 Private capital market requirements The implications of private capital markets requirements for financing expansion

22 Investors will only commit funding to an airport expansion project under a reasonable expectation of earning a return commensurate with the risk Demand risk Regulatory risk Political risk Project Risk Construction risk Cost risk Risk and uncertainty affect financing through: Credit ratings on debt Capital structure Cost of capital Investors appetite Financial risk The actual or perceived risk of capacity expansion will influence the market s appetite for the project and the cost at which a project may be financed CAA

23 Rapid evolution in the detail and sophistication of agreements underpinning Australian airport infrastructure upgrades is under way Large civil engineering projects are all about risk: how to price it, how to manage it, who should bear it. - Iain Osborne, CAA, Agreements must/are evolving from terms that, principally, specified the price to be paid over a relatively short (~5 year) fixed term period toward those that also specify the framework or basis on which future prices will be determined Such frameworks are addressing the economic and financial principles for determining future asset values, rate of return the arrangements by which major risks (demand, construction cost) will be shared between the parties The basis upon which each of the critical cost/pricing parameters will be updated as today s forecasts becomes tomorrow s observable outcomes, and anticipated market conditions change Nature and extent of the detail that needs to be addressed has many of the features of a wellspecific framework for economic regulation since the threat of re-regulation of airports remains, the question of how regulators have approached such issues becomes a frequent point of reference The fundamental issues are in any case the same, but the difference is that the parties are able to tailor their approach to reflect particular circumstances 23

24 Relevance of Australia s learnings to other airports Despite some significant differences in operating environments, there are still valuable insights

25 Whereas Australia s airports are generally origin-destination locations, many airports in this part of the world focus on developing hub status This increases the degree of competition airports face potentially limiting their ability (profitably) to increase landing charges Not all airports in the region may be required to earn a reasonable WACC on their assets given government subsidies which can intensify the price pressure on competing airports Airlines may be particularly unwilling to accept aeronautical charges that incorporate pre-funding The regulatory arrangements vary, with many airports subject to heavierhanded regimes than exist in Australia Critical that the regulatory regime supports new investments in airport infrastructure, given the importance of this sector to other parts of the economy However, competitive pressures from other airports may limit the extent to which airports can rely on achieving full cost prices in the near term 25

26 Concluding comments

27 Without the expectation of a reasonable return on assets, no privately funded investment in new airport infrastructure will be forthcoming Aeronautical prices are the principal source of revenue for recovering the costs of new infrastructure projects over the life of the asset - there are many options for the cost recovery for major infrastructure investments, for example: the use of pre-funding, and/or the timing at which new expenditure is included into the cost base and therefore prices straight-line versus tailored depreciation schedules Pre-funding reduces risk to the operator and investors but is often opposed by airlines Once assets are in place, sculpting depreciation to match future demand can help align prices but comes with increased risk to the airport operator The appropriate mechanisms will depend on the: commercial circumstances of the airport the airport s negotiation strategy the legal and regulatory considerations the financial preferences and capabilities of the airport 27

28 Level 40, 161 Castlereagh Street Sydney NSW 2000 Phone:

Airservices Australia Long Term Pricing Agreement. Discussion Paper April Submission by Australia Pacific Airport Corporation (APAC)

Airservices Australia Long Term Pricing Agreement Discussion Paper April 2015 Submission by Australia Pacific Airport Corporation (APAC) Airservices Australia Long Term Pricing Agreement Discussion Paper