9            Financial projections




Contents
                                                                          ...
Introduction
    9.1. This chapter sets out financial projections for Manchester, and gives details of the assumptions
upo...
Passenger numbers: methodological approaches to passenger forecasting

Manchester’s approach
    9.7. Manchester’s approac...
9.12. Manchester then produces forecasts for the intervening years by interpolating between the
short-term forecast (to 20...
same period in 2000/01 and projected this change forward for the whole of 2002/03, after making an
adjustment for the unus...
FIGURE 9.1

                                              Historic passenger growth figures vs predictions

              ...
FIGURE 9.2

                                                Manchester and CAA passenger forecasts
                       ...
over the next quinquennium. Were regulated charges to fall by a greater extent, this might be expected to
result in higher...
TABLE 9.3 Forecast cargo tonnage

            Q3        Q4
           2002/     2003/    2004/    2005/    2006/      2007...
the CAA, Manchester deducts actual (as opposed to projected) depreciation on the grounds that this is
consistent with the ...
Rolling forward the RAB
    9.44. Manchester rolls forward the RAB over Q4 using Manchester’s latest projected capex figur...
Other revenues
   9.50. In order to calculate Manchester’s revenue requirement for activities related to regulated air-
po...
— 2002/03 RAB calculated by rolling forward the 1997 MMC figure for actual capex (net of dis-
        posals) and actual d...
9.54. Table 9.8 summarizes the regulatory outputs of the base case. Manchester must set its regulated
charges so that the ...
outputs of MAG rather than the outputs applicable to the activities within the scope of regulation. Also
Manchester was al...
9.59. Table 9.9 reflects a forecast increase in turnover from £245.5 million to £263.2 million in real
(2001/02) prices fr...
FIGURE 9.3

                Comparison of price cap paths implied by base case scenario
                          and base...
TABLE 9.13 Financial projections: dual-till scenario: balance sheet (historical cost, 2001/02 prices)

                   ...
TABLE 9.15 Impacts of alternative model assumptions, 2000/01 prices
                                                      ...
— The option to claw back from Manchester an amount equivalent to the NPV associated with
      capital underspend during ...
ratio of at least 1.00, a ratio of net debt to EBITDA of no more than 4.25, and a ratio of net debt to net
debt plus owner...
9.77. Table 9.16 shows that the CC’s base case presents Manchester with the potential for both
higher and lower return on ...
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9 Financial projections

  1. 1. 9 Financial projections Contents Page Introduction............................................................................................................................................. 194 Building blocks for the revenue requirement.......................................................................................... 194 Passenger numbers: methodological approaches to passenger forecasting............................................. 195 Manchester’s approach ....................................................................................................................... 195 The CAA’s approach .......................................................................................................................... 196 Constraints on future growth .................................................................................................................. 197 Passenger forecasts ................................................................................................................................. 197 Historic passenger numbers ................................................................................................................ 197 Current projections.............................................................................................................................. 198 Impact of changes to regulated charges on passenger numbers .......................................................... 199 Impact of marketing support expenditure on passenger numbers ....................................................... 200 Cargo forecasts ................................................................................................................................... 200 Operating costs ................................................................................................................................... 201 Calculating the regulatory asset base ...................................................................................................... 201 Till definition and the RAB ................................................................................................................ 202 Working capital adjustment ................................................................................................................ 202 Rolling forward the RAB........................................................................................................................ 203 Impact of construction prices indices.................................................................................................. 203 The cost of capital................................................................................................................................... 203 Other revenues ........................................................................................................................................ 204 Model runs .............................................................................................................................................. 204 The CC base case ................................................................................................................................ 204 Impacts of alternative key assumptions .............................................................................................. 208 Model sensitivities .................................................................................................................................. 213 193
  2. 2. Introduction 9.1. This chapter sets out financial projections for Manchester, and gives details of the assumptions upon which they are based. The chapter outlines how the revenue requirement is derived, and how the price cap (maximum average revenue yield) and X factors are calculated. The impact of these regulatory decisions on Manchester’s financial projections is then examined, including a discussion of alternative scenarios and sensitivity analysis considering key factors that might lead to Manchester making greater or lower returns. 9.2. Financial projections have been produced using the CAA’s regulatory financial model. The financial model allows the user to examine the impact of alternative regulatory assumptions on the com- pany’s forecast profit and loss account, balance sheet and cash flows, and key financial indicators. The CAA model has been adapted to allow us to consider those financial indicators which are of key impor- tance to Manchester. A reconciliation exercise has also been carried out to ensure that the outputs of the CAA model are consistent with those of Manchester’s own financial model, when the models are run with identical inputs and other assumptions. The key calculations in each model have been checked for logical integrity by independent parties.1 9.3. Financial projections presented in this chapter assume that revenue yield will equal the maxi- mum allowable yield under the price cap. It is possible that actual yield may differ, were Manchester to decide not to seek to recover the maximum allowable yield in every year, or if out-turns prove to be different to projections. Building blocks for the revenue requirement 9.4. The financial model calculates Manchester’s total revenue requirement by adding together its operating costs, an allowance for depreciation, and the return it requires on its capital assets (the cost of capital multiplied by the RAB, or regulatory capital value (RCV). Revenues from sources other than regulated airport charges are then deducted from this total to provide a forecast of the total amount of revenue that Manchester will need from its regulated airport charges in order to cover its costs (including capital costs). The figures for operating costs, revenues, the RAB (and its depreciation) and capital expenditure will all vary depending on whether a single or dual till has been adopted. 9.5. The resulting revenue requirement figure is then divided by passenger numbers to give the maximum average revenue yield per passenger that would be consistent with Manchester earning enough to cover these costs, but no more. From this, X factors can be derived, and financial projections pro- duced. X is the number that represents the percentage change in the maximum revenue yield per passen- ger from one year of the quinquennium to the next, after adjusting for inflation, as measured by the RPI.2 9.6. The following items are therefore of key importance in establishing Manchester’s revenue requirement from regulated charges over the coming regulatory period: — passenger numbers; — operating costs, including efficiency gains (see Chapter 6); — the RAB (also known as the RCV) and its roll-forward, including capital expenditure (see Chapter 8) and an allowance for depreciation (see Chapter 4); — the cost of capital (see Chapter 4); and — other (non-regulated) revenues (see Chapter 7). Apart from those items discussed elsewhere in this report, each of these issues is examined in turn below. 1 Ernst and Young have audited the CAA model and Deloitte and Touche the MA model. 2 For example, an X factor of 3 per cent, combined with an RPI of 2 per cent, would lead to a requirement that the maximum average revenue yield per passenger in the year in question fall by 2 per cent minus 3 per cent—ie a net fall of 1 per cent. 194
  3. 3. Passenger numbers: methodological approaches to passenger forecasting Manchester’s approach 9.7. Manchester’s approach to passenger forecasting is based on combined long- and short-term forecasts. Manchester’s long-term passenger forecasts are derived using the Air Traffic Forecasting Using Logit (ARTFUL) model, which provides a forecast for the year 2015. 9.8. ARTFUL takes as its forecasting base the DfT’s (formerly the DTLR) 1997 mid-point air traffic forecasts for the UK as a whole at 2015. It then allocates this forecast traffic between airports by model- ling the airport choices that each potential passenger can make, by trading off surface access time, ser- vice frequency, and fare levels.1 The model forecasts each main category of passenger separately, and these are then aggregated to provide the total forecast. The rationale of this approach is that different passenger types—for example, business versus leisure, or scheduled versus charter—will trade off the access time, fare levels and frequency factors differently.2 The model’s assumptions as to how passen- gers trade off these three factors are based on CAA origin/destination surveys (using revealed preference techniques) and CAA data. 9.9. As demand increases at an airport based on these allocations, new routes are assumed to be added. The model takes account of capacity constraints at Heathrow and Gatwick, by assuming that once capacity is reached, traffic will spill over to other UK airports. The impact of low-cost carriers on growth is modelled by assuming lower fare levels at airports where low-cost carriers are most likely to develop/expand hubs, and by increasing demand to popular low-cost carrier destinations (such as southern Europe). 9.10. The key assumptions underlying Manchester’s central passenger forecasts are as follows: — no additional runway capacity at Heathrow or Gatwick before 2015 (Heathrow’s Terminal 5 is assumed to go ahead); — increasing road congestion, particularly in the London area, which increases access times to London airports; — low-cost carriers stimulate the market by 4 per cent above the 1997 DfT central forecast (over- all); — Liverpool, Luton and Stansted develop fully as low-cost hubs; — some reduction in domestic flights to Heathrow from regional airports; — increased charges at Heathrow in Q4; and — pressure in airline alliances to divert some traffic away from London to other European airports (including UK regional airports). These key assumptions are varied in a series of sensitivity tests. 9.11. Manchester produces short-term forecasts, covering the next three years, by surveying each of the major airlines at Manchester Airport, and asking their views on what their levels of demand are likely to be. Manchester noted that whilst this approach might fail to identify extra services or routes not yet planned by the major airlines, any as yet unidentified service withdrawals would also be excluded, so that Manchester expected the combined impact of these two effects to be neutral. Manchester also assumed that other airlines at Manchester would generate similar growth rates in the short term to the major airlines. 1 For charter traffic, access time alone is used as the criterion for allocation. 2 For example, a business traveller is likely to be less concerned with price and more concerned with flight frequency, whilst the opposite is likely to apply for a leisure passenger. 195
  4. 4. 9.12. Manchester then produces forecasts for the intervening years by interpolating between the short-term forecast (to 2005) and the long-term forecast (2015). Interpolation is done on an individual traffic type basis (domestic London/non-London, international scheduled to European hubs/non- hubs/North America/Rest of World, short-haul charter and long-haul charter). Currently, simple linear interpolation is used. The CAA’s approach 9.13. The CAA’s long-term passenger forecasts take the DfT 2000 unconstrained passenger forecasts as their base. The CAA then uses the Second Passenger Allocation Model (SPAM), which allocates the DfT passenger forecasts between airports. Like Manchester’s ARTFUL model, SPAM uses passenger decision-making criteria to allocate demand between the airports, based on the cost to passengers of choosing between airports.1 SPAM is calibrated against observed passenger behaviour to check its accuracy. 9.14. Following the demand shocks associated with 11 September, the CAA made downwards adjustments to the SPAM model figures in the early years of the forecast. The latest projections from the CAA model this effect by assuming two negative impacts: an economic impact and a perception impact. The economic impact was estimated by measuring the difference between GDP forecasts (to Q1 of 2004, published by Consensus Forecasts) immediately before 11 September, and those in June 2002 for both the UK and USA (the UK figures were used to proxy impacts on traffic originating in the UK, and US figures were used to proxy impacts on traffic from the rest of the world). The observed difference was multiplied by a GDP multiplier of between 1.8 and 2.1 depending on the traffic segment, to produce the estimated downward impact on passenger growth. The GDP multipliers were derived by examining his- toric changes in traffic in comparison with GDP changes. 9.15. The CAA estimated a perception effect made up of two components: a short-term confidence- to-fly effect and a longer-term substitution effect associated with customers switching from traditional to no-frills carriers. The CAA modelled the confidence-to-fly effect by drawing on observations of passen- ger traffic recovery following the Gulf War in 1991, plus additional information that has become avail- able on the recovery from 11 September to date. Following the Gulf War, the CAA observed passenger demand for the UK as a whole to have been restored to its previous growth trends within 9 to 12 months. The CAA examined trends in passenger numbers for the period September 2001 to May 2002 and, based on this information, judged that the recovery at Manchester Airport was likely to take longer than in the Gulf War case. To estimate the duration and profile of the confidence-to-fly effect, the CAA therefore measured the percentage drop in traffic for each main traffic category between September 2001 and May 2002 (net of the economic impact described above).2 Judgement was used to divide this drop into effects that were likely to be transitional confidence-to-fly effects, and those that were likely to be substitution effects, lasting up to 15 years. It was assumed that the recovery period for the confidence-to-fly factor would be about two years and that subsequently growth rates would broadly return to previously expected levels. The CAA also assumed that 50 per cent of the demand drop-off would be restored by late 2003 but the remaining demand reduction would persist due to the long-lasting nature of the substi- tution effects. Thus the growth after 2003 would be from a lower base, not only because of these effects but also because GDP is now forecast to be lower than before. This causes the absolute level of demand to remain below pre-September 2001 forecast levels for the duration of the forecast. No specific allow- ance has been made for the effect of any further conflicts following 11 September, such as the impact of any further conflict in Iraq. 9.16. As a check on its methodology, the CAA prepared an alternative estimate for 2002/03 based on Manchester’s traffic in 2000/01, a year which the CAA considered to be more typical than 2001/02. The CAA compared the monthly traffic at Manchester Airport in the April to July period of 2002/03 with the 1 In SPAM’s case the cost includes both the time and money costs of travelling to the airport, air time as a proxy for the cost of the air journey, and parameters representing the frequency costs of a direct journey and of the additional inconvenience of making a connecting journey. 2 Passenger categories were EC Scheduled, Other Scheduled, Chartered and Domestic. 196
  5. 5. same period in 2000/01 and projected this change forward for the whole of 2002/03, after making an adjustment for the unusually heavy domestic traffic during the winter of 2000/01. The CAA reported that the forecast produced using this method gave similar results to those derived using the methodology out- lined above. Constraints on future growth 9.17. Potential constraints on future growth at Manchester Airport could arise from two main sources: runway capacity and terminal capacity. Manchester has reported to us that runway capacity was fully subscribed for 2 hours a day during the 2001 summer peak. The maximum number of runway movements has been increased for summer 2002 (from 57 to 59 per hour) so that summer peak hours demand is currently close to, but slightly below, this capacity constraint. As passenger demand continues to grow over the next five years, it is therefore expected that Manchester will be faced with some runway capacity constraints. However, Manchester anticipated that these constraints would apply for only a couple of hours a day during the summer peak, so they were not expected to have any significant impact on passenger projections for the year as a whole. Constraints would also be reduced to the extent that Manchester’s off-peak pricing policies and practices would result in flight schedules being moved away from peak hours. 9.18. Manchester has also provided us with details of likely constraints to terminal capacity. It esti- mated current terminal capacity to be 23 million passengers a year, whilst it forecast passenger numbers to rise to 24.1 million passengers a year by 2007/08. The capacity enhancement measures identified in the capital programme are intended to meet this increase in volume,1 so that passenger growth is not expected to be constrained by terminal capacity over the next quinquennium. However, we note that were Manchester to achieve passenger growth higher than that predicted by the CAA, this might lead to some terminal capacity constraints towards the end of Q4, unless further expenditures on terminal enhancements were to be carried out. Passenger forecasts Historic passenger numbers 9.19. Table 9.1 and Figure 9.1 illustrate recent passenger growth trends at Manchester Airport, and contrast them with the trends projected at the 1992 and 1997 reviews.2 TABLE 9.1 Historic passenger growth figures vs forecasts million 1992/ 1993/ 1994/ 1995/ 1996/ 1997/ 1998/ 1999/ 2000/ 2001/ 2002/ 93 94 95 96 97 98 99 00 01 02 03 Out-turn 12.5 13.6 14.4 14.8 14.6 15.9 17.4 17.5 18.6 19.0 18.3 % growth per year - 8.8 5.9 2.8 –1.4 8.9 9.4 0.6 6.3 2.2 –3.7 Manchester forecast 11.1 11.9 13.0 13.9 14.8 15.8 16.2 16.9 17.8 19.4 20.8 % growth per year - 7.2 9.2 6.9 6.5 6.8 2.5 4.3 5.3 9.0 7.2 Difference in passengers 1.4 1.7 1.4 0.9 –0.2 0.1 1.2 0.6 0.8 –0.4 –2.5 Source: Manchester Airport and 1997 MMC report. Note: 2002/03 figures are forecast. 1 Manchester’s 2002 forecasts expect terminal capacity to increase to 24.5 million passengers a year by the beginning of 2007/08, and to 26.0 million passengers a year by the beginning of 2008/09. 2 At the last review, the MMC adopted MA’s passenger projections. 197
  6. 6. FIGURE 9.1 Historic passenger growth figures vs predictions 25.0 20.0 Passengers (million) 15.0 Manchester forecast 10.0 Out-turn 5.0 0.0 3 4 5 6 7 8 9 0 1 2 3 /9 /9 /9 /9 /9 /9 /9 /0 /0 /0 /0 92 93 94 95 96 97 98 99 00 01 02 19 19 19 19 19 19 19 19 20 20 20 Year Source: Manchester and 1997 MMC report. 9.20. Total passenger numbers have grown at an average of 3.0 per cent a year over the last five-year review period, and 4.0 per cent a year for the ten-year period 1992/93 to 2002/03,1 but growth rates have varied significantly from year to year. Figure 9.1 also shows that Manchester has historically slightly under predicted growth on average, compared with out-turn in the early years of the past two quin- quennia. Current projections 9.21. Both the CAA and Manchester have provided us with their own passenger forecasts for the next ten years. These differ somewhat, as Table 9.2 and Figure 9.2 show. TABLE 9.2 Total passenger forecasts million 2002/ 2003/ 2004/ 2005/ 2006/ 2007/ 2008/ 2009/ 2010/ 2011/ 2012/ Forecast data 03 04 05 06 07 08 09 10 11 12 13 CAA Sept 2002 18.5 20.0 21.3 22.9 24.2 25.4 26.9 28.3 29.8 31.2 32.7 % growth per year - 8.1 6.5 7.5 5.7 5.0 5.9 5.2 5.2 4.8 4.8 Manchester Sept 2002 18.3 19.1 20.2 21.2 22.6 24.1 25.7 27.3 29.1 31.0 33.2 % growth per year - 4.9 5.4 5.3 6.6 6.5 6.5 6.5 6.5 6.5 7.0 Difference in passengers 0.2 0.9 1.1 1.7 1.6 1.3 1.2 1.0 0.7 0.2 –0.5 Source: Manchester and the CAA. 9.22. The difference between the two sets of projections is illustrated in Figure 9.2. 1 Or 4.8 per cent for 1992/93 to 2001/02 which removes the effects of 11 September. 198
  7. 7. FIGURE 9.2 Manchester and CAA passenger forecasts 35.0 Total passengers (million) 30.0 CAA September 2002 25.0 Manchester September 2002 20.0 15.0 20 3 20 4 20 5 20 6 20 7 20 8 20 9 20 0 20 1 20 2 3 0 /0 /0 /0 /0 /0 /0 /1 /1 /1 /1 2/ 03 04 05 06 07 08 09 10 11 12 0 20 Year Source: Manchester and the CAA. 9.23. As Figure 9.2 illustrates, Manchester forecasts lower levels of passengers at the start of the next quinquennium than the CAA, and significantly slower growth during the period 2003/04 to 2005/06, causing the gap between the two sets of forecasts to be widest in 2005/06 at 1.7 million passengers. From 2006/07 onwards, Manchester’s forecasts gradually converge with the CAA’s, due to faster assumed annual growth rates (on average). However, during the coming quinquennium, the gap remains quite substantial at around 1.3 million a year less on average. 9.24. When Tables 9.1 and 9.2 are compared, it can be seen that Manchester’s forecasts for 2002/03 to 2006/07 give average growth broadly in line with trend growth seen in the past quinquennia, but do not forecast any sharp ‘bounce-back’ from the demand reductions immediately following 11 September. Manchester’s forecast growth trend then increases to 6.5 per cent a year plus for 2007/08 to 2012/13. This contrasts with the CAA’s forecasts, which show higher growth in the initial years (2003/04 to 2005/06) as demand recovers from 11 September, and then a slower trend growth to 2012/13. 9.25. The key reason for the gap observed is Manchester’s and the CAA’s differing assumptions as to how quickly demand is likely to recover from the drop observed following the events of 11 September. Prior to the demand shocks following 11 September, Manchester and the CAA had pro- duced forecasts which were significantly closer, with an average difference of only 0.2 million passen- gers a year for the period 2003/04 to 2007/08. 9.26. The CAA’s approach to modelling short-term recovery from 11 September draws at least partly on factors relating to UK demand as a whole (with some adjustments for outcomes at Manchester Airport since 11 September), while Manchester’s bottom-up approach aggregates the plans of the major airlines over the next three years. While the CAA assumes a combination of bounce-back of demand towards its pre-11 September trends, plus some more permanent effects, Manchester assumed that demand would remain significantly lower during Q4, which Manchester told us was partly due to the implementation of BA’s ‘Future Size and Shape’ policy, which included reductions in domestic services to and from Manchester and reductions in aircraft sizes and therefore capacity. Impact of changes to regulated charges on passenger numbers 9.27. Both Manchester’s and the CAA’s forecasting methodologies assume that passenger numbers are affected by the costs that passengers face, one of which is the air fare. For example, implicit within Manchester’s forecasts is the assumption that regulated charges will fall by 5 per cent a year in real terms 199
  8. 8. over the next quinquennium. Were regulated charges to fall by a greater extent, this might be expected to result in higher passenger numbers than Manchester currently predicts (other things being equal). How- ever, the extent to which this would apply depends primarily on two factors. The first is the extent to which airlines pass the extra reductions in regulated charges on to passengers in the form of lower air fares. This depends, for example, on the level of competition the airline in question faces for each service it operates to and from Manchester Airport. In particular, where the airline operates in a competitive market at an uncongested airport, it might be expected that the airline would pass a large proportion of the reduction in regulated charges on to the passenger. However, Manchester told us that it would expect such cost pass-through to be very limited (see paragraphs 11.27(g) and 11.41). 9.28. The second factor affecting the impact of changes to regulated charges upon passenger numbers is passengers price elasticity of demand with respect to air fare levels. NERA produced a paper for us reviewing the economic literature that examines price elasticity of demand for air fares.1 This review has identified a negative relationship between air fares and passenger numbers (that is, if fares fall, passenger numbers would be expected to rise). However, the level of this elasticity varies consider- ably between studies, between long-run and short-run effects, and between types of passengers (for example, leisure travellers tend to be more price responsive than business passengers). The NERA review reported a range of price elasticities of demand of –0.3 to –1.7 depending on passenger type and the period examined. 9.29. For the reasons described above, we might expect to see a rise in passenger numbers if regulated charges fall by a greater extent than that assumed when forecasts were made. We might also expect to see some airlines switching some services to operate out of Manchester instead of other air- ports. However, the uncertainties described above mean that it is difficult to estimate the likely impact of this effect accurately. We would also expect the effects to be relatively small, given the relatively low elasticities identified in the NERA report (particularly in the short run) and given that airport charges typically make up only a relatively small proportion of airline costs and air fares. Manchester also told us that it would expect such effects to be small. Impact of marketing support expenditure on passenger numbers 9.30. A further factor that might be expected to impact on passenger numbers in the next quinquen- nium is the level of marketing support expenditure. Manchester told us that the level of marketing sup- port has a strong impact on passenger forecasts, and that its current forecasts as described in this chapter are based on the assumption that Manchester is allowed to spend the total amount it has allocated to sales and development and additional marketing support over the next five years. In its submissions to us, Manchester has had some difficulty in quantifying the exact relationship between marketing support and passenger numbers in simple passenger yield per pound spent terms. Taking this factor into account, along with the fact that the CAA’s passenger projections are significantly higher than Manchester’s, our base case financial projections set out later in this chapter do not make any reductions to Manchester’s passenger forecasts to reflect our decision to reduce allowed sales and development expenditure to £6 million a year in real terms (at 2002/03 prices). 9.31. In sum, when the elasticity effects described above are combined with any impacts associated with reducing Manchester’s Sales and Development/Additional Marketing Support fund, we would expect passenger projections to lie somewhere between the CAA estimates and the Manchester esti- mates. Cargo forecasts 9.32. Table 9.3 sets out Manchester’s forecast cargo tonnage for the period 2003 to 2013. Manchester bases its cargo forecast on Boeing’s long-range growth forecast for world air cargo, adjusted in the short term where further information is available on specific sources of new business or business withdrawals. 1 The Price Elasticity of Demand for Air Transport: A Note for the Competition Commission, NERA, August 2002. 200
  9. 9. TABLE 9.3 Forecast cargo tonnage Q3 Q4 2002/ 2003/ 2004/ 2005/ 2006/ 2007/ 2008/ 2009/ 2010/ 2011/ 2012/ 03 04 05 06 07 08 09 10 11 12 13 Forecast cargo tonnage 129,000 138,000 146,280 156,057 164,360 174,222 185,501 195,386 206,914 219,122 232,050 Source: Manchester. Operating costs 9.33. Operating costs and the scope for efficiencies in this area are discussed in Chapter 6. Financial projections scenarios run by the CC, including alternative opex assumptions, are discussed later in this chapter. Calculating the regulatory asset base 9.34. A key factor in the price cap calculation for Manchester is the RAB (also known as the RCV). The RAB is forecast by first establishing its base level at the start of Q4. This base is then rolled forward over the quinquennium by adding forecast additions (net of any disposals) and deducting depreciation. 9.35. The base (2002/03) RAB is calculated by taking the RAB at the start of the last review (1997), adding capital expenditure made during Q3 (net of any disposals), deducting an allowance for deprecia- tion, and making any adjustments considered necessary to reflect special factors that have occurred dur- ing Q3. This calculation is described further in paragraphs 4.50 and 4.51. 9.36. The CAA has calculated the 2002/03 RAB by taking the 1997 MMC RAB figure of £506 million (1996/97 prices), and rolling this forward for actual capex undertaken net of disposals. The CAA then deducted an allowance for depreciation from this figure to arrive at the 2002/03 RAB. The CAA made a deduction for projected depreciation as opposed to actual depreciation on the grounds that customers paid prices during the last quinquennium based on this projected depreciation figure. The CAA argued that this treatment reduced the incentive for the company to game the regulator by over- estimating depreciation. It also removed any difficulties associated with changes in accounting policies and asset book lives that might have taken place during the last quinquennium. However, we note that the CAA’s proposed treatment involves some inconsistency between the resulting treatment of capex and depreciation. The financial projections set out in this chapter calculate the 2002/03 RAB using actual depreciation. 9.37. In its recommendations to us, the CAA did not make any further adjustments to the 2002/03 RAB. (Final capex figures for 2001/02, and most recent projected figures for 2002/03, were not available in March 2002, so the CAA figures were based on the most recent projections available at that time.) TABLE 9.4 Changes to MA’s capex programme since March 2002 £’000, 2001/02 prices 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Total expenditure at March 2002 67,519 90,985 88,679 103,466 101,092 97,446 Total expenditure at September 2002 60,024 80,507 50,896 108,640 103,131 55,978 Source: Manchester. Note: Figures are before CC capex adjustments and CPI adjustments. 9.38. Manchester’s projections also take the 1997 RAB as identified in the MMC report as their starting point, and roll this figure forward for actual capex undertaken net of disposals. However, unlike 201
  10. 10. the CAA, Manchester deducts actual (as opposed to projected) depreciation on the grounds that this is consistent with the treatment of capex (ie adjusting the RAB for actual capex as opposed to projected capex). 9.39. In Q3, Manchester underspent on capex by £43.2 million (in 2001/02 prices) compared with capex predicted at the last review. In its March recommendations, the CAA took account of capex spent by Manchester, but did not make any adjustments to Manchester’s 2002/03 RAB to claw back the cost of capital allowance associated with this capex underspend. In theory, a regulator might choose to claw back the benefits associated with capex underspend (which take the form of a higher price cap being allowed than would otherwise have been the case), so as to discourage any deliberate gaming of capex projections. In this case, our calculations suggest that due to underspending on capex, Manchester’s net present value (NPV) of revenues was £4.2 million (in 2001/02 prices) higher during Q3 than would have been the case had capex forecasts matched out-turns. However, Manchester’s capex underspend arose primarily in response to the severe demand shocks associated with 11 September, where Manchester took the decision that it would not be commercially sensible to continue to spend on capital expansion pro- jects at the same levels in the face of collapsing passenger demand. Also Manchester has spent a sub- stantial amount on leasing equipment for T3, which was not included in the operating expenditure projections for Q3. Manchester claimed that had this equipment been bought rather than leased, it would have qualified as capital expenditure and thus have largely offset the underspend. For these reasons, clawback of capex underspend has not been included in our base case scenario described later in this chapter. Till definition and the RAB 9.40. In its March 2002 recommendations, the CAA included only MA assets in the RAB (see para- graphs 4.2 and 4.3 for an explanation of Manchester’s recent restructuring). However, we have extended the till definition to include the assets, costs and revenues associated with MAAS, MAV motor transport, MAD and the GTI office block (paragraphs 4.2 to 4.4 explain what these entities encompass, and para- graph 2.71 sets out the rationale for our decision to include these entitities within the till). Whilst the inclusion of the GTI office block increases the RAB over what it would otherwise be, MAAS, MAV motor transport and MAD have negligible capital assets, so that their inclusion has no effect on the 2002/03 RAB. Working capital adjustment 9.41. In its March 2002 recommendations, the CAA’s financial projections adjusted for working capital by deducting a forecast average of £35 million a year (in 2001/02 prices) from the RAB. This approach is consistent with that taken at the last review. However, Manchester put it to us that corpora- tion tax, which had been included in the £35 million figure, should be removed from the working capital adjustment. The CAA told us that it would also consider this approach, and we have adopted it in our base case. The CC’s financial projections have been adjusted to reflect this decision, the impact of which is to increase the 2002/03 RAB by £11.7 million in 2001/02 prices. 9.42. In effect, regulatory models assume that tax liabilities arise on accounting profits and are paid immediately. In reality, substantial timing differences arise because of tax lags and the fact that there is a difference between costs recorded in the accounts and costs that are allowable deduction for tax purposes (for example, depreciation is not a tax-allowable expense as set rates of capital allowances are used for the purposes of taxation).1 There are two ways of adjusting for this in regulatory models. One is to deduct the present value of future tax liabilities from the RAB; the other is to adjust the cost of capital for the tax lag effect. As all our calculations of profit are made on a pre-tax basis using a pre-tax cost of capital, we adopt the latter approach here. 9.43. Table 4.13 illustrates the calculation of the 2002/03 RAB, assuming that actual depreciation is deducted. Figures shown here assume a single till (so non-aeronautical assets are included) but the same principles would apply in calculation of a dual-till RAB. 1 A further confounding effect is that tax liabilities arise in nominal terms whereas most regulatory models are applied in real terms. 202
  11. 11. Rolling forward the RAB 9.44. Manchester rolls forward the RAB over Q4 using Manchester’s latest projected capex figures, net of disposals. Details of Manchester’s forecast capex additions can be found in Chapter 8. Manchester forecasts depreciation assuming the same asset lives as those used by the MMC at the last review. How- ever, since then, Manchester has undertaken an asset relifing exercise, which has led to some assets being depreciated over longer asset lives for statutory accounts purposes. 9.45. In its March 2002 recommendations, the CAA assumed asset lives that corresponded to the average asset lives figures set out by Manchester in its statutory accounts. These asset lives are longer than those assumed by Manchester for runway assets and building assets. The difference is particularly large in the case of runway asset lives, where the CAA adopted the figure quoted in the statutory accounts of 75 years, which compares with the 25-year life assumed by Manchester (which was also used at the last review). However, Manchester and the CAA have since agreed to adopt the same, shorter, asset lives as used at the last review and we have also adopted this assumption in our base case. In present value terms the effect of this change is neutral, but it affects the timing of when charges are levied. 9.46. In its final recommendations to us, the CAA also rolled forward the RAB using Manchester’s own projected capex figures (net of disposals). Since the CAA’s March 2002 recommendations, Manchester has updated its capital programme, so that latest figures are now different from those assumed by the CAA at that time. Impact of construction prices indices 9.47. The real cost of carrying out capital investment will depend to a large extent upon movements of construction prices relative to prices generally (as measured by the RPI). Manchester has assumed that construction prices will rise faster than the RPI during Q4, by, on average, an extra 1 per cent (ie RPI + 1 per cent a year). The CAA also took account of construction prices in its financial projections, assuming in its March 2002 recommendations that construction prices would rise by RPI + 1 per cent a year until 2004/05 after which they would rise by RPI. 9.48. Table 9.5 illustrates the rolling forward of the RAB (in 2001/02 prices) using Manchester’s capex figures, increasing the opening RAB for the changes to the working capital adjustment as described in paragraph 9.41, and assuming construction prices indices for new capital expenditure that rise at RPI + 1 per year throughout Q4. TABLE 9.5 Rolling forward the RAB £’000, 2001/02 prices Years ending 31 March Q3 Q4 2003 2004 2005 2006 2007 2008 Opening value 686,994 702,974 728,632 724,595 752,920 783,061 Additions (disposals) 60,024 79,305 51,145 84,386 88,539 66,227 Depreciation –44,043 –53,648 –55,181 –56,061 –58,397 –59,776 Closing RAB 702,974 728,632 724,595 752,920 783,061 789,512 Source: MA; CC modelling output. The cost of capital 9.49. The cost of capital is discussed in detail in Chapter 4. The CC ran a series of model scenarios including an evaluation of the impact of alternative cost of capital assumptions. This is presented in paragraph 9.69. 203
  12. 12. Other revenues 9.50. In order to calculate Manchester’s revenue requirement for activities related to regulated air- port charges (runway services, passenger facilities etc—see paragraphs 7.32 to 7.36), it is necessary to know how much revenue Manchester expects to earn from other sources over the next five years (ie from commercial activities and unregulated charges). Table 9.6 summarizes Manchester’s projected revenues from these other revenue sources, assuming a single till and with all figures in 2001/02 prices. These revenues and the related activities at Manchester are discussed further in Chapter 7 (where the price base used, generally out-turn prices, differs in some instances from that adopted in Table 9.6). TABLE 9.6 Projected revenues from commercial activities and unregulated charges £ million, 2001/02 prices Years ending 31 March Q3 Q4 Revenue category* 2003 2004 2005 2006 2007 2008 Duty- and tax-free 16,279 18,305 20,499 22,943 24,486 26,132 Catering 4,161 4,678 5,239 5,864 6,258 6,679 Other retail† 20,610 23,063 25,718 28,669 30,578 32,614 Car parks‡ 27,471 29,141 30,999 31,699 32,595 33,506 Property§ 18,821 19,414 18,745 19,117 19,552 19,780 Utilities and recharged costs¶ 6,484 6,266 6,299 6,447 6,596 6,749 Other operational¤ 5,411 5,371 5,376 5,400 5,441 5,486 Other# 26,632 27,121 27,741 28,461 29,327 30,293 AAA and HBS 0 1,867 1,888 1,908 1,928 1,954 Total 125,869 135,227 142,503 150,507 156,760 163,193 Source: Manchester. *As used for modelling purposes. †Includes some tax-free retailing revenues. Retailing activities in general are considered in paragraphs 7.76 to 7.94. ‡Revenues from all on-site car parks operated by Manchester, including staff car parks; see paragraphs 7.95 to 7.115. §Includes office rental revenues from the GTI in 2004, but not other years, as MA told us that it intended to sell the office building in 2005. RAB figures have been adjusted accordingly. ¶Mainly revenues from the provision of utilities and telecommunication services. ¤Includes revenues from charges to cargo-only aircraft using the airport. #Revenues from unregulated charges, including those relating to use of the baggage system, check-in desks, aircraft refuelling facilities etc; see paragraphs 7.55 to 7.73. Note: Totals may not sum because of rounding. Model runs 9.51. This section provides details of the main model scenarios run by the CC, including sensitivity tests aimed at assessing the impact of alternative model assumptions. The CC base case 9.52. The CC’s modelling work has involved production of a base case around which alternative scenarios have been run. The key assumptions of the base case are as follows: — Single till, with the till definition including MAAS, MAV motor transport and MAD (MAAS, MAV motor transport and MAD are described in Chapter 4).1 The office block above the GTI has also been included within the regulatory calculation.2 1 As explained in paragraph 2.71, MAAS, MAV motor transport and MAD’s activities have been included in the till to the extent that they meet three criteria: (a) they relate to activities at Manchester Airport; (b) they would have formed part of the till in the past; and (c) the services in question are not being provided in competition with other independent suppliers. As explained in paragraph 2.72, RHS has been included in the financial model calculations because of difficulties in splitting RHS data from MAAS data, but MA forecast RHS to break even over Q4, so the impact on the price cap is zero. 2 See, for example, paragraph 2.74. 204
  13. 13. — 2002/03 RAB calculated by rolling forward the 1997 MMC figure for actual capex (net of dis- posals) and actual depreciation. The RAB has been increased by £11.7 million in 2001/02 prices to reflect taking corporation tax out of the working capital adjustment. — Forecast RAB for 2003/04 to 2007/08 calculated assuming Manchester’s forecast capex levels. Capital expenditure associated with the Metrolink connection is also included. Claims payments associated with R2 construction (noise claims and construction claims) have been assumed to be £50 million in 2001/02 prices, included in capital expenditure in five equal annual payments. These adjustments are explained in more detail in Chapter 8. Depreciation on all additions is calculated assuming the same asset lives as at the last review. It is assumed that construction prices for new investment (as measured by the construction price index, (CPI)) increase by RPI + 1 per cent a year throughout Q4. — A 7.5 per cent cost of capital. — Manchester’s central passenger forecasts for 2002/03 to 2007/08. — Manchester’s operating cost projections, except for two adjustments. First, the real increase in staff costs during Q4 has been limited to a 1 per cent real increase per year, as opposed to the 2 per cent suggested by Manchester. As a result, opex is reduced by £625,000 a year, cumula- tive, over each year of Q4, giving a total adjustment in 2001/02 prices of £9.37 million. Secondly, forecast additional marketing support, which has been excluded, and sales and devel- opment expenditure has been limited to £6 million a year in 2002/03 prices. — Manchester’s assumptions on revenue from sources other than regulated charges. 9.53. Table 9.7 summarizes the CC base case scenario and compares it with Manchester’s own pre- ferred scenario and the assumptions of the CAA in its recommendations to us (as updated by subsequent discussions). TABLE 9.7 Summary of model assumptions: CC, Manchester and CAA (2001/02 prices) CC Manchester CAA Till definition Single Dual Dual MAAS, MAV transp, MAD MAAS, MAV transp, MAD and MAAS, MAV transp, MAD and and GTI office block included GTI office block excluded GTI office block excluded 2002/03 (base) RAB MMC 97 as base + Q3 net MMC 97 as base + Q3 net MMC 97 as base + Q3 net additions – Q3 actual additions – Q3 actual additions – Q3 projected depreciation depreciation depreciation 2003–08 RAB 2002/03 base + net additions 2002/03 base + net additions 2002/03 base + net additions – depreciation assuming – depreciation assuming asset – depreciation assuming asset asset lives as at 1997 review. lives as at 1997 review. lives as at 1997 review. CPI assumed at RPI + 1% on CPI assumed at RPI + 1% on CPI assumed at RPI + 1% on new investment. new investment. new investment. Runway claims allowance Runway claims allowance Runway claims allowance £50m £79.5m £79.5m Cost of capital 7.5% 8.6% 7.5% Passenger forecasts Manchester Manchester CAA Opex Manchester but (a) sales and Manchester Manchester* development/additional marketing support limited to £6m a year; (b) staff cost increases limited to 1 per cent real a year Other revenues Manchester Manchester Manchester* Source: CC, Manchester and the CAA. *Adjusted for the CAA’s alternative passenger numbers assumptions. 205
  14. 14. 9.54. Table 9.8 summarizes the regulatory outputs of the base case. Manchester must set its regulated charges so that the resulting revenue yield per passenger in the year in question does not exceed the figure for that year (here shown in 2001/02 prices). The rate of return is the accounting rate of return on the RAB, consistent with a cost of capital of 7.5 per cent. TABLE 9.8 Key regulatory outputs: base case (2001/02 prices) Years ending 31 March 2003 2004 2005 2006 2007 2008 Passengers (m) 18.3 19.1 20.2 21.2 22.6 24.1 Revenue yield per passenger (£/passenger) 6.55 5.90 5.44 4.98 4.55 4.15 Annual X factor (%) - –8.9 –8.9 –8.9 –8.9 –8.9 Allowed opex (£m) - 147.3 142.9 142.6 145.1 148.0 Other revenue offset (£m) - –135.2 –142.5 –150.5 –156.8 –163.2 Eligible capex (£m) - 79.3 51.1 84.4 88.5 66.2 Allowed depreciation (£m) - 53.6 55.2 56.1 58.4 59.8 RAB at the end of the year (£m) 691.3 728.6 724.6 752.9 783.1 789.5 Adjustment to 2002/03 RAB (£m) 11.7 - - - - - Regulatory return (£m) - 51.9 52.8 53.5 55.4 56.8 Rate of return (%) - 7.23 7.23 7.23 7.23 7.23 Source: CC modelling output. 9.55. As Table 9.8 shows, the CC base case assumes that maximum revenue yields per passenger will fall from £6.55 at the end of Q3 (2002/03) to £4.15 at the end of Q4 (in 2001/02 prices). This amounts to an average X of –8.9 per cent.1 Because the X factor is adjusted for the previous year’s September to September RPI in the RPI–X formula, the X factor of –8.9 per cent does not correspond exactly to the percentage change in the revenue yield per passenger in real terms from year to year in Q4.2 The –8.9 per cent is the figure that is applied to the RPI–X formula to drive the price cap. (Actual maximum revenue yields may differ from those in Table 9.8 if the relationship between September to September inflation and financial year inflation differs from our assumptions.3) Note that the X of –8.9 per cent includes the impacts of (a) removing AAA security costs and HBS labour costs from the regulated charge, as requested by Manchester; and (b) the impact of limiting claims payments associated with R2 construction to £50 million, with any further costs being passed through. Without these two adjustments, the X factor would be –7.8 per cent. This compares with the CAA’s assumption at March 2002 that charges would stay broadly the same in real terms over Q4, falling from £6.74 to £6.64 in 2001/02 prices between 2002/03 and 2007/08, equivalent to an average annual X of –0.2.4 9.56. Manchester’s own financial projections are based on the assumption of an X of 5, which would see Manchester’s charges falling from £6.55 to £5.10 from 2002/03 to 2007/08 in 2001/02 prices.5 9.57. Tables 9.9 and 9.10 summarize financial projections derived using the CC base case assump- tions in real (2001/02) terms. Appendix 9.2 provides these projections in nominal terms, plus some key performance indicators which are also referred to in the text below. When considering financial ratios in the base case and all other scenarios shown in this chapter, the £95 million of unsecured debt associated with the purchase of the regional airports in the Manchester group belonging to MA has been removed as this debt is not associated with activities within the scope of regulation. 9.58. Manchester expressed concern that scenarios that we put to it would cause some breaches in its banking covenants. However, Manchester’s calculations of financial ratios were done using financial 1 Where X is the percentage change in the maximum allowed revenue yield per passenger from year to year. Note that where X implies a prices fall in real terms, it is shown here with a negative sign in front to make this clear—ie in this case the X factor is shown as –8.9 per cent which is equivalent to applying a formula of RPI–8.9 per cent. 2 For example, the change in the maximum average revenue yield from 2002/03 to 2003/04 (£6.55 to £5.90) is –9.9 per cent, not –8.9 per cent. 3 See also the note on inflation in Appendix 9.1. 4 The revised maximum revenue yield figure for 2002/03 presented in Table 9.8 includes amendments to take account of updated Manchester figures on a number of key inputs that were not available to the CAA when it made its recommendations. 5 As stated in the CAA’s March 2002 recommendations, this price profile would mean Manchester did not price up to the cap under the CAA’s dual-till scenario. 206
  15. 15. outputs of MAG rather than the outputs applicable to the activities within the scope of regulation. Also Manchester was already breaching one DfT ratio, namely the ratio of net profit to turnover.1 TABLE 9.9 Financial projections from the CC base case assumptions: profit and loss and key performance indicators (2001/02 prices) £’000 Years ending 31 March Q3 Q4 2003 2004 2005 2006 2007 2008 Profit and loss (historical cost) Total turnover 245,498 248,195 252,298 256,167 259,640 263,193 Of which: Regulated airport charges 119,629 112,968 109,795 105,660 102,880 100,000 Other revenue 125,869 135,227 142,503 150,507 156,760 163,193 Operating expenditure –165,829 –147,331 –142,930 –142,623 –145,073 –148,006 Depreciation –47,457 –46,429 –46,849 –45,769 –45,149 –46,755 Operating profits 32,212 54,435 62,519 67,775 69,418 68,432 Interest –24,206 –23,919 –23,945 –22,959 –22,967 –23,052 Profit before tax 8,006 30,516 38,574 44,816 46,450 45,380 Tax –5,478 –9,252 –10,999 –10,316 –8,680 –8,621 Profit after tax 2,528 21,265 27,575 34,500 37,771 36,758 per cent Performance indicators Return on net operating assets 12.0 21.1 22.3 23.9 24.6 22.8 Operating margin 13.1 21.9 24.8 26.5 26.7 26.0 Percentage change in turnover - 1.1 1.7 1.5 1.4 1.4 Percentage change in operating profit - 69.0 14.8 8.4 2.4 –1.4 Percentage change in profit before tax - 281.2 26.4 16.2 3.6 –2.3 Percentage change in profit after tax - 741.0 29.7 25.1 9.5 –2.7 £ Operating costs per passenger –9.09 –7.70 –7.09 –6.72 –6.41 –6.14 Operating profit per passenger 1.76 2.84 3.10 3.19 3.07 2.84 Source: CC modelling output. TABLE 9.10 Financial projections from the CC base case assumptions: balance sheet (historical cost, 2001/02 prices) £’000 Years ending 31 March Q3 Q4 2003 2004 2005 2006 2007 2008 Tangible fixed assets 839,702 852,098 835,611 854,643 878,819 878,532 Fixed asset investments 115,146 112,337 109,598 107,029 104,623 102,270 Total fixed assets 954,848 964,435 945,209 961,672 983,441 980,802 Stocks 1,694 1,688 1,690 1,689 1,689 1,689 Debtors 27,567 27,852 28,286 28,695 29,062 29,438 Cash 41,013 40,879 40,944 40,893 40,899 40,896 Current assets 70,274 70,420 70,920 71,277 71,650 72,023 Creditors due within one year –36,836 –38,476 –36,450 –44,342 –39,692 –38,336 Total assets less current liabilities 988,287 996,379 979,679 988,607 1,015,399 1,014,490 Creditors due after one year –274,795 –285,736 –267,525 –269,506 –286,999 –278,549 Provisions –4,404 –4,416 –4,467 –4,288 –4,206 –4,137 Net assets 709,087 706,227 707,688 714,813 724,194 731,804 Source: CC modelling output. 1 See paragraph 4.32 where Manchester is required to maintain a minimum ratio of 6 per cent, whereas the ratio achieved in the financial year 2001/02 was less than 2 per cent. 207
  16. 16. 9.59. Table 9.9 reflects a forecast increase in turnover from £245.5 million to £263.2 million in real (2001/02) prices from the last year of Q3 to the last year of Q4. During the same period, revenue for regulated airport charges falls in real terms, reflecting the fall in maximum allowed revenue yield per passenger, while revenue from other sources rises, reflecting, at least in part, passenger growth. 9.60. Operating costs are forecast to fall in real terms between 2002/03 and 2007/08 by a total of £17.8 million, or 11 per cent. When passenger growth is taken into account by examining operating costs per passenger, the percentage reduction increases to just over 32 per cent. 9.61. Q4 shows a sharp increase in both operating profits and profits before/after tax compared with the last year of Q3. When operating cost per passenger is examined, it can be seen that while operating profits per passenger grow in the early years of the quinquennium, they return to 2003/04 levels by 2007/08. 9.62. Table 1 in Appendix 9.2 projects performance against Manchester’s key financial indicators. The forecasts shown here allow Manchester to meet its borrowing requirements of an EBITDA cover of at least 2.75, an acid test ratio of at least 1.00, a net debt to EBITDA ratio of a maximum of 4.25, and a maximum ratio of net debt to net debt plus owner’s equity of 50 per cent. Manchester’s ability to meet these key financial ratios under alternative scenarios is discussed in further detail in paragraph 9.75. Impacts of alternative key assumptions 9.63. The CC has examined the impacts on maximum regulated charges levels of key alternative scenarios. In particular, running the ‘base case’ scenario, but changing the single-till assumption to a dual-till assumption (with X smoothed over ten years), and retaining the other base case assumptions gives the following results. TABLE 9.11 Key regulatory outputs: dual-till assumption, 2001/02 prices Years ending 31 March 2003 2004 2005 2006 2007 2008 Passengers (m) 18.3 19.1 20.2 21.2 22.6 24.1 Revenue yield per passenger (£/passenger) 6.55 6.58 6.75 6.86 6.98 7.09 Annual X factor (%) - 1.6 1.6 1.6 1.6 1.6 Allowed opex (£m) - 116.4 112.6 112.3 113.8 116.2 Other revenue offset (£m) - –35.2 –35.6 –36.3 –37.3 –38.2 Eligible capex (£m) - 58.5 33.4 64.2 75.1 50.9 Allowed depreciation (£m) - 45.8 46.5 46.7 48.2 49.3 RAB at the end of the year (£m) 601.7 626.2 613.0 630.5 657.4 659.0 Adjustment to 2002/03 RAB (£m) 11.7 - - - - - Regulatory return (£m) - 46.5 49.6 52.1 55.6 57.9 Rate of return (%) - 7.23 7.23 7.23 7.23 7.23 Source: CC modelling output. 208
  17. 17. FIGURE 9.3 Comparison of price cap paths implied by base case scenario and base case plus dual-till scenario 8.00 7.00 6.00 Single till 5.00 £ Dual till 4.00 3.00 2.00 2003 2004 2005 2006 2007 2008 Year Source: CC modelling outputs. 9.64. As Table 9.11 and Figure 9.3 illustrate, applying a dual-till assumption would lead to a signifi- cantly higher charges cap compared with the base case. On the dual-till basis, revenue yield per passen- ger rises to £7.09 by 2007/08 (in 2001/02 prices) compared with a fall to £4.15 in the base case. As a result, the average X in the dual-till scenario is 1.6 per cent (ie RPI + 1.6) per cent, compared with –8.9 per cent in the base case. Were X to be smoothed over five years rather than ten, the price cap profile under the dual-till scenario would increase more sharply. TABLE 9.12 Financial projections: dual-till scenario: profit and loss and key performance indicators (2001/02 prices) £’000 Years ending 31 March Q3 Q4 2003 2004 2005 2006 2007 2008 Profit and loss (historical cost) Total turnover 245,498 261,129 278,549 296,214 314,678 334,067 Of which: Regulated airport charges 119,629 125,902 136,045 145,706 157,918 170,873 Other revenue 125,869 135,227 142,503 150,507 156,760 163,193 Operating expenditure –165,829 –147,331 –142,930 –142,623 –145,073 –148,006 Depreciation –47,457 –46,429 –46,849 –45,769 –45,149 –46,755 Operating profits 32,212 67,370 88,770 107,822 124,456 139,305 Interest –24,206 –23,584 –22,633 –20,148 –17,857 –14,908 Profit before tax 8,006 43,786 66,137 87,674 106,599 124,398 Tax –5,478 –13,233 –19,268 –23,174 –26,724 –32,327 Profit after tax 2,528 30,554 46,869 64,501 79,875 92,071 per cent Performance indicators Return on net operating assets 12.0 24.3 26.2 26.9 25.9 23.0 Operating margin 13.1 25.8 31.9 36.4 39.6 41.7 Percentage change in turnover - 6.4 6.7 6.3 6.2 6.2 Percentage change in operating profit - 109.1 31.8 21.5 15.4 11.9 Percentage change in profit before tax - 446.9 51.0 32.6 21.6 16.7 Percentage change in profit after tax - 1,108.4 53.4 37.6 23.8 15.3 £ Operating costs per passenger –9.09 –7.70 –7.09 –6.72 –6.41 –6.14 Operating profit per passenger 1.76 3.52 4.40 5.08 5.50 5.78 Source: CC modelling output. 209
  18. 18. TABLE 9.13 Financial projections: dual-till scenario: balance sheet (historical cost, 2001/02 prices) £’000 Years ending 31 March Q3 Q4 2003 2004 2005 2006 2007 2008 Tangible fixed assets 839,702 852,098 835,611 854,643 878,819 878,532 Fixed asset investments 115,146 112,337 109,598 107,029 104,623 102,270 Total fixed assets 954,848 964,435 945,209 961,672 983,441 980,802 Stocks 1,694 1,688 1,690 1,689 1,689 1,689 Debtors 27,567 29,220 31,061 32,929 34,882 36,932 Cash 41,013 40,879 40,944 40,893 40,899 40,896 Current assets 70,274 71,787 73,696 75,511 77,469 79,517 Creditors due within one year –36,836 –40,421 –40,405 –50,386 –48,014 –49,072 Total assets less current liabilities 988,287 995,802 978,500 986,798 1,012,896 1,011,246 Creditors due after one year –274,795 –275,870 –237,989 –210,004 –185,997 –123,708 Provisions –4,404 –4,416 –4,467 –4,288 –4,206 –4,137 Net assets 709,087 715,515 736,044 772,505 822,693 883,401 Source: CC modelling outputs. 9.65. It is important to note that the dual-till scenarios set out above provide only approximations of financial projections under a dual-till regime. This is because estimates have had to be made as to how assets should be allocated between the two tills. While Manchester and the CAA undertook an asset allocation exercise for the dual-till scenarios presented by the CAA in its March recommendations, Manchester has since updated its capital programme. Further adjustments to the allocation of assets between the tills would therefore be needed to reflect this capital plan.1 The dual-till results shown here reflect our inclusion of the GTI (excluding the office block) and Metrolink in the aeronautical till. 9.66. We have also examined the impact on the price cap if each of Manchester’s own assumptions, as set out in Table 9.7, were adopted. Our results (in Table 9.14) show that this would imply the follow- ing maximum allowed revenue yield and X factors, although we note Manchester’s stated intention to reduce charges by RPI–5 per cent during Q4, so that the charges cap shown here would not, in fact, ‘bite’. TABLE 9.14 Implied price cap under Manchester’s modelling assumptions (2001/02 prices) Years ending 31 March 2003 2004 2005 2006 2007 2008 Revenue yield per passenger 6.55 6.61 6.82 6.97 7.12 7.27 Annual X factor (%) 2.2 2.2 2.2 2.2 2.2 Source: CC modelling outputs. 9.67. Table 9.15 provides a summary of the impacts of other key alternative scenarios. The scenarios included here concentrate on the important issues which have been the focus of major disagreements in terms of the arguments put to us by alternative parties. These issues are: — Exclusion of MAAS, MAD and MAV motor transport in the till, reflecting Manchester’s argu- ments on this issue. Paragraph 2.71 sets out the details of these arguments. — Increasing the cost of capital to 8.6 per cent, the figure put to us by Manchester. This point is dealt with in more detail in Chapter 4. 1 The results shown here are based on the CAA’s latest estimated allocations. The CAA is currently updating these allocations. 210
  19. 19. TABLE 9.15 Impacts of alternative model assumptions, 2000/01 prices Passenger MAAS, MAD, MAV All sales and devt forecasts reduced Metrolink motor transport Cost of Clawback of marketing support by 0.25 million pa capex NATS costs ‘Base case’ excluded from till capital 8.6% £4.2m included cumulative removed removed Scenario 2003–08 2003–08 2003–08 2003–08 2003–08 2003–08 2003–08 2003–08 Average revenue yield (£) 5.01 5.02 5.38 5.00 5.33 5.25 4.87 4.66 Difference from base case (£) - 0.01 0.37 –0.01 0.32 0.24 –0.14 –0.35 Average X per year (%) –8.9 –8.9 –6.7 –9.1 –6.9 –7.4 –9.9 –11.4 211 Rate of return on RAB (%) 7.23 7.23 8.25 7.23 7.23 7.23 7.23 7.23 EBITDA cover (average) 4.74 4.77 5.27 4.72 4.74 4.74 4.90 4.76 Acid test (average) 1.81 1.82 1.78 1.82 1.79 1.83 1.84 1.84 Net debt to EBITDA (average) 2.02 2.01 1.78 2.04 2.03 2.03 1.87 2.00 Net debt to net debt plus owner’s equity (%) 24 24 22 24 24 24 22 23 Source: CC. Note: Capex is assumed to remain constant in the reduced passenger numbers scenario.
  20. 20. — The option to claw back from Manchester an amount equivalent to the NPV associated with capital underspend during Q3 by adjusting the 2002/03 RAB downwards by a corresponding amount. We have estimated this NPV to be £4.2 million in 2001/02 prices. This point is dis- cussed further in paragraphs 2.114 and 2.115. — Including the full amount of sales and development and additional marketing support expendi- ture that was identified by Manchester in allowed opex. The current base case allows only £6 million in real terms in 2002/03 prices. See paragraphs 2.132 to 2.147 for further details of this issue. — Adjusting Manchester’s passenger forecasts downwards on the grounds that the reduction in allowed sales and development/additional marketing support expenditure will have a negative impact on passenger growth during Q4. MA estimated this impact to be a reduction in the order of 0.25 million passengers a year in Q4 (cumulative) compared with its central forecast. (See paragraph 9.30.) — Removing the capital expenditure associated with Metrolink. It was put to us that this expendi- ture should be removed (see paragraph 8.66). — Removing NATS costs from the regulatory calculation. This point is discussed further in para- graphs 2.103 to 2.105. In each case, all assumptions are the same as the base case except for the particular changes noted (for example, all scenarios in Table 9.15 assume a single till). 9.68. As Table 9.15 illustrates, the addition of Manchester’s subsidiaries (here referring to MAAS, MAV motor transport, and MAD) into the regulatory till has no tangible impact on average maximum allowed revenue yield per passenger and the X factor, reflecting the fact that when considered together, Manchester forecast MAAS, MAV motor transport and MAD to break even over Q4 as a whole. 9.69. The fourth column shows the impact of increasing the cost of capital to Manchester’s proposed figure of 8.6 per cent. This significantly increases prices, adding 37p to the average revenue yield per passenger figure over Q4. 9.70. The fifth column shows that were the 2002/03 RAB to be reduced to ‘claw back’ £4.2 million NPV of capital underspend to Manchester during Q4, prices would fall only slightly to an average of £5.00. 9.71. The sixth column of Table 9.15 shows that were all sales and development and additional marketing support expenditure proposed by Manchester to be included in the price-cap calculation, this would increase charges by around 32p on average over Q4. If, as a result of this expenditure being excluded from allowed opex, passenger numbers were lower by the amount suggested by Manchester, then the seventh column shows that average Q4 charges would need to rise by 24p. 9.72. If Manchester’s capital expenditure associated with Metrolink should be removed from the price-cap calculation, column eight of Table 9.15 shows the reduction in charges that this would imply: a fall, on average, of 14p. 9.73. The final scenario presented in Table 9.15 illustrates the impact of removing NATS costs from the regulatory till as Manchester proposed should happen from the start of Q4. In this case, charges would fall to an average of £4.66 per passenger over Q4. However, if NATS costs were removed from the regulatory till, then a direct charge would be levied on airlines (either by the airport or by NATS). 9.74. In addition to the scenarios shown in Table 9.15, we examined the impact of rolling forward the RAB to 2002/03 for depreciation as projected at the last review, as opposed to rolling it forward using actual depreciation. We found the impact to be very small, implying a change in the average maximum revenue yield per passenger over Q4 of around 1p. 9.75. The lower half of Table 9.15 shows the average financial ratios against four indicators that are of key importance to Manchester. Financial ratios are examined for the activities included within the regulatory till rather than for MAG as a whole. These are EBITDA cover of at least 2.75, an acid test 212
  21. 21. ratio of at least 1.00, a ratio of net debt to EBITDA of no more than 4.25, and a ratio of net debt to net debt plus owner’s equity of no more than 50 per cent. A comparison of these averages against the critical levels reveals that none are breached on average over Q4. We also confirm that none of these critical levels are breached in our projections on an individual year basis during Q4. Model sensitivities 9.76. As part of our consideration of what the most appropriate regulatory assumptions are, we have considered what would happen were outcomes to be different from those projected. Table 9.16 provides details of key scenarios assuming different out-turns of key variables as described, while assuming a price cap set according to the CC base case. In each case, the maximum average revenue yield per passenger and X will be the same as in the base case, but due to the differing out-turns, the rate of return on the RAB actually achieved will be either higher or lower than the 7.23 per cent accounting return that is consistent with a cost of capital assumption on 7.5 per cent. Similarly, the NPV of Manchester’s profits will also be affected. As Table 9.16 illustrates, we have also considered the impact of these model sensitivities on the financial ratios that Manchester has identified as of key importance to Manchester’s creditors. TABLE 9.16 Model sensitivities: impact of outcomes differing from regulatory projections* (2000/01 prices) 2 1 Opex targets 3 Passenger growth exceeded by Retail targets ‘Base case’ at CAA levels† £2.7 million‡ exceeded by 5%t§ 2003–08 2003–08 2003–08 2003–08 Scenario upsides Rate of return on RAB (%) 7.23 8.44 7.60 7.68 NPV of total turnover (£) 1,033 1,095 1,033 1,044 NPV of total opex (£) –587 –614 –576 –587 NPV of operating profits (£) 259 295 269 270 EBITDA cover (average) 4.74 5.40 4.93 4.94 Acid test (average) 1.81 1.76 1.81 1.80 Net debt to EBITDA (average) 2.02 1.71 1.93 1.92 Net debt to net debt plus owner’s equity (%) 24 22 23 23 4 Passenger growth 5 6 reduced by a severe Opex targets Retail revenues as ‘Base case’ demand shock†¶ missed by 2% per MMC 1997¤ 2003–08 2003–08 2003–08 2003–08 Scenario downsides Rate of return on RAB (%) 7.23 5.16 6.82 6.46 NPV of total turnover (£) 1,033 935 1,033 1,013 NPV of total opex (£) –587 –545 –599 –587 NPV of operating profits (£) 259 203 247 239 EBITDA cover (average) 4.74 3.88 4.55 4.43 Acid test (average) 1.81 1.92 1.82 1.84 Net debt to EBITDA (average) 2.03 2.63 2.14 2.21 Net debt to net debt plus owner’s equity (%) 24 27 24 25 Source: CC. *For each of the scenarios presented in this table, that allowed maximum average revenue yield will be the same as in the base case, as this table assumes that prices are set according to base case assumptions, but that out-turns are different to those assumptions. †Capex programme has not been adjusted for out-turn differences in passenger numbers. ‡Based on assumption that MA improves its absence rates to the benchmark average thereby saving £2.7 million a year. §5 per cent increase to duty-free, catering, and other shop revenues (excludes car parks). ¶Assumes passenger numbers hit at the beginning of Q4 by similar percentage reductions to those observed at MA following 11 September with similar recovery profiles as those forecast by MA from 11 September. A smaller impact would be observed if the demand shock took place later in Q4. ¤Formula used by MMC in 1997 to forecast retail revenues: RPI+2%+100* passenger growth. 213
  22. 22. 9.77. Table 9.16 shows that the CC’s base case presents Manchester with the potential for both higher and lower return on the RAB and operating profits. For example, sensitivity 1 shows that were Manchester to achieve passenger growth at levels forecast by the CAA, this would imply a return on the RAB of 8.44 per cent as opposed to 7.23 per cent on average over Q4. We have also considered the potential upside to Manchester in the form of increased passenger numbers associated with the fact that in our base case, charges fall by a much greater extent than the fall assumed in Manchester’s passenger forecast. Whilst we expect that such a fall in landing charges could have tangible effects on passenger forecasts, we would expect it to represent a smaller upside to Manchester’s passenger forecasts than the increase in passenger numbers implied by sensitivity 1. 9.78. However, we have also considered the possibility that Manchester may fail to meet its current passenger growth targets, resulting in lower returns for the company. For example, in sensitivity 4, we have modelled the potential effects resulting from a severe demand shock (such as a second Gulf War), based on the assumption that this event would trigger a similar downturn in passenger numbers to that observed following 11 September. Table 9.16 shows that this sensitivity would imply significantly lower returns for Manchester over Q4. We note that it would be open to the CAA to revisit the regulatory review in the event of a severe demand shock. 9.79. When examining Manchester’s opex projections, we have considered the extent to which Manchester might be able to achieve higher opex savings. Sensitivity 2 shows one potential outcome, based on the assumption that Manchester was able to reduce its current absence rates to the average observed in benchmark industries, thereby reducing operating costs by £2.7 million in each year of Q4 (non-cumulative) in 2001/02 prices. Sensitivity 5 considers the possibility that Manchester fails to achieve its opex targets, and that opex levels are 2 per cent higher than forecast in Q4. 9.80. A further area where Manchester might experience out-turns different from those projected is in its commercial revenues. Sensitivities 3 and 6 explore some of the possible variations. Sensitivity 3 shows the impact on Manchester’s rate of return if it were able to achieve retail incomes per passenger of 5 per cent above target, while sensitivity 6, which was put to us by Manchester, shows the reduction in returns that would result were Manchester to fail to meet its current retail revenue targets, but was instead able to achieve the same level of retail growth predicted by the MMC for Q3 at the last review (100 per cent passenger growth, plus RPI + 2 per cent). 9.81. When considered individually, the downsides illustrated above produce a rate of return on the RAB of no lower than 5.16 per cent. If scenarios 5 and 6 were to occur simultaneously, the average return on the RAB during Q4 would fall to 6.05 per cent. 9.82. Table 9.16 also shows average values during Q4 for each of Manchester’s key financial ratios. These show that, on average, Manchester’s financial performance targets as set by its principal lenders are all met (the critical levels for each of these targets are set out in paragraph 9.75.1 Although not presented in Table 9.16, we have also examined the variations in these financial ratios over each year of Q4. These projections show that Manchester is forecast to meet its financial ratio targets in every year of the quinquennium under each of the sensitivities shown, although profits would be affected. Were sensitivities 5 and 6 both to occur simultaneously, these key financial ratios would still not be breached in our forecasts. 1 Debt associated with the purchase of other group airports which is allocated to MA in Manchester’s accounts is not included in these calculations, as the other group airports are not part of the regulated business being considered here. Also the financial performance targets that Manchester typically faces are set for the group as a whole rather than just for the parts of the business being considered in this regulatory review. 214

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