Davies Commission
exposes pre-funding dilemma Jul/Aug 2015

It is now several weeks since the Davies Commission issued its final report on new runway capacity for the South East of England. Given the enormous amount written about the report, you might think that there is not a great deal more to say. In fact, the spin generated by the reactions to the report means that it is sometimes difficult to see the forest for the trees. It is time to try to identify the key issues and how they might play out over the coming months and years, and one major issue in particular.

The starting point is the fact that the UK is rapidly running out of airport capacity in the South East of England, especially for hub operations on which Howard Davies was asked to focus. Davies found that for aircraft movements Heathrow has been full since 2010 and that Gatwick will be full by 2020, London City by 2024, Luton by 2030 and Stansted by 2041. (It may be worth reminding ourselves that the last Labour Government's Airports White Paper outlined proposals for two new runways, one at Stansted to be opened by 2012 and one at Heathrow to follow in 2020.)

This underlying problem of capacity shortage has been recognised for many years, and studies of what to do about it have almost become a growth industry in the UK.

In terms of scale and thoroughness, the Roskill Commission, which reported in 1970, is usually regarded as the first major analysis undertaken, but it was by no means the first, nor of course the last.

Not one of the many studies got anywhere in terms of implementation of their recommendations for increased runway capacity, overwhelmingly because of the lack of political commitment. To say that after all the hard work the aviation industry has been frustrated is something of an understatement.

In his book “Great Planning Disasters” (1980), Peter Hall commented that: “After the biggest inquiry, by the Roskill Commission,… someone unkindly said that the documentation, suitably pulped and compressed, could provide all the material needed for the runways.” Heaven knows how many airports could have been built with all the subsequent reports, submissions and responses.

It might be thought, therefore, that by 2012 yet another study was the last thing needed. But politicians faced with an awkward policy commitment and an approaching election didn't see it like that.

Hence the Davies Commission, an exercise set up with the resources to at least match those of Roskill, but with the added, and politically useful, objective of delaying any final decision until after the 2015 General Election.

Davies' final report in July this year came to a unanimous (unlike Roskill) and unequivocal set of decisions, in particular that there is a need for one, and eventually two, additional runways in the South East of England, and that the first one should be built at Heathrow rather than Gatwick.

Over a sixty-year period, the Commission estimated, the benefits to the UK could be as high as £214bn, with GDP expected to be up to 1% higher by 2050 than it would be without this additional airport capacity.The consultation generated some 63,000 responses and by any measure was thorough and comprehensive, which is not to say, of course, that its conclusions attracted universal support.

Whatever the Commission had decided, there would always have been some opposition. Having fought what many regarded as a very negative campaign against Heathrow, it would be extremely surprising if Gatwick were now to concede defeat.

Similarly, the Mayor of London, Boris Johnson, has spent political capital on supporting a new hub airport to the East of London and is clearly unwilling to give up, even in the face of enormous opposition from the aviation industry and others, including Howard Davies himself.

Finally, the environmental lobby will inevitably continue to oppose airport expansion anywhere, irrespective of the economic benefits and commitments to reduce the environmental impact of additional capacity.

It is important to recognise, however, that the political environment today is very different from what it was just five or six years ago when David Cameron made his ill-judged commitment not to build any new runways in the South East.

Aviation is no longer widely regarded as the toxic industry it once was. The economic downturn helped to focus attention on the importance of growth and employment and the role aviation plays in generating prosperity. Companies in both manufacturing and services, once unwilling to be seen supporting the expansion of air transport, are now openly and willingly campaigning for more runways. The Labour Party (at least under its current leadership) has committed to support Davies' recommendations, and it seems a majority of the Conservative Party is similarly leaning in that direction.

The old debate about expanding Heathrow or regional airports has been laid to rest and shown to be a false choice; growth at Heathrow not only does not prevent growth at Manchester, Edinburgh or Newcastle, it positively helps it.

None of this means that the battle has been won. Noisy, and perhaps even violent, opposition is likely and the Government will still be faced with a difficult political decision.

This should not come as a surprise to anyone given the history of UK airport planning since the Second World War. Even the briefest of studies of that history highlights two clear and recurring themes, both of which have emerged again in recent years.

Two recurring themes

The first, and perhaps less expected, is that despite the seriousness of the subject matter and the amounts of money involved, airport expansion has attracted some crazy ideas.

There are plenty of examples, but a particularly “innovative” one emerged in 1967, when Sir Donald Gibson, Director General of Research and Development at the Ministry of Public Buildings and Works, and one might assume a serious senior civil servant not prone to smoking certain substances, proposed that a new airport made of expanded polystyrene should be constructed to float on mud flats in the Thames Estuary. Passengers could travel to the new airport, he argued, by hovercraft.

The more recent suggestions for a Thames Estuary airport, while lacking Sir Donald's more visionary innovation, might nevertheless be placed into the same category of the totally unworkable.

The second recurring theme in post-war UK airport planning is more serious and at the end of the day far more damaging.

The absence of political will to take what are admittedly difficult decisions has been seen time and again. More specifically, what we have had is a cycle whereby a political party sees electoral gain in opposing airport expansion, is elected and soon realises the error of its previous judgement, sets up a review of some form to dig itself out of the hole it has found itself in, concludes that more capacity is after all needed, only to be replaced by another party which has identified opposition to more runways as a vote winner.

The pattern isn't perfect over the decades, but it is sufficiently clear to act as a guide.

The current Conservative Government and its Coalition predecessor are, of course, a good example. Labour's commitment to two new South East runways was overturned by David Cameron in the hope of winning marginal seats near Heathrow. Instead of a long-term strategy for aviation, we had a political slogan: Better not Bigger.

The result was inevitable, although it took some time to emerge. The increased focus on economic growth, employment and trade led to growing doubts about the sustainability of a “no more runways” policy, resulting in a lengthy review by the Davies Commission and eventually, after the General Election, to a potential political U-turn. As the saying goes, it's déjà-vu all over again.

Where now?

So where do we go from here? On balance the signs for a positive decision on a third runway for Heathrow are actually quite positive, but you would be foolish to bet your house on it.

The Davies Commission, combined with strong business support and reduced environmental opposition (the proposal to ban night flights if a third runway is built could be crucial here), have certainly made it easier for the Government.

On the other hand, we have been here before and history suggests that at the end of the day the politicians will lack the commitment (or bravery) to support expansion. For a politician, as former Secretary of State for Transport Lord Adonis has recently noted, doing nothing is often the easiest way out.

But let's assume that on the last day of Parliament before the 2015 Christmas recess the current Secretary of State for Transport announces that, subject to a raft of safeguards and conditions, the Government will support a third Heathrow runway. Inevitably that would not be the end of the saga; it would barely be the beginning of the end.

The Government should be able ensure that the necessary Parliamentary legislation is passed relatively smoothly, especially if the Labour Party maintains its support, despite strong opposition from some of its own MPs, not least Boris Johnson.

There will almost certainly be noisy and aggressive protests and legal challenges, but it is probably reasonable to assume that one of the reasons for the Government's delay in announcing its conclusion is that it is determined to make such a decision as challenge-proof as possible, just as Howard Davies did with respect to his report.

Capital raising not a problem

However, the position taken by certain airlines highlights one major issue which has to be addressed, but to which at present there is no obvious solution acceptable to all stakeholders. Raising the capital for a third Heathrow runway should not be a major problem, despite the size of the investment involved. This was not only the conclusion of the Airports Commission, but also of the regulator, the Civil Aviation Authority.

In his Beesley Lecture in October last year, the CAA's former Group Director for Regulatory Policy noted unequivocally, for example, that “runway expansion should be achievable with private capital, with or without a regulatory under-pinning.”

Such a conclusion is hardly surprising. Heathrow is after all a monopoly where demand for access far exceeds supply. A new runway will fill up quickly, to some extent at Gatwick's expense, which at least partly explains the Surrey airport's opposition to Heathrow's expansion. Finance will probably be needed from the public purse for improved road access etc, but most will be raised privately. The overall picture is clear; the devil is in the detail.

One of the most interesting and surprising developments to emerge in the course of the Davies Commission's consultations was the decision by easyJet to support Heathrow rather than Gatwick expansion. It seems a reasonable conclusion that this decision played a significant role in the Commission's eventual choice.

easyJet is Gatwick's largest customer by some way, and Gatwick is easyJet's largest base. The airline currently has no presence at Heathrow and has declined to bid for free slots available for UK domestic and possibly Irish services as a result of IAG's acquisition of bmi and Aer Lingus.

It has stated that the number of slots available is too small for a viable operation, but such an argument is hardly credible given the scale of its operations at many other airports where it similarly faces a major legacy competitor. It is far more likely that easyJet is only too well aware of the fact that entering the Heathrow market now would put it at a major disadvantage later when/if slots for a new runway are allocated.

And this highlights the critical regulatory problem which the Government, the regulator and the whole industry will have to face eventually, but which so far has attracted only limited public attention.

If easyJet's decision to support Heathrow was a surprise, so surely was the announcement by Willie Walsh that IAG was not in favour of a third runway there.

Over several years the IAG Chief Executive had maintained that a new runway would never be built because the political will to overturn decades of inaction did not exist. But that wasn't the same as actively opposing construction. (Ironically, BA itself had continued to lobby for a third Heathrow runway until quite recently.)

Walsh now argues that the costs of expanding Heathrow are “outrageous” and can't be financed. “I think the issues that need to be addressed are so very, very significant, not just the politics…. I think there is a major issue to address in terms of the cost of the infrastructure, and I fail to see how the airport will be able to finance it given the impact that it would have on the operating costs for Heathrow.”

Not surprisingly, Gatwick Airport seized on IAG's opposition to argue that the Davies Commission report was “unravelling fast”, ignoring the rather obvious point that Willie Walsh would almost certainly have been even more opposed to a new Gatwick runway for exactly the same reasons.Talk of the ability or inability to finance airport expansion really serves only to obfuscate the argument.

As already noted, a monopoly such as Heathrow with an operation where demand for airline access far exceeds the supply of slots, and will in all probability continue to do so even with a third runway, is unlikely to experience difficulties in persuading investors and banks to provide the finance. After all, under the current RAB-based regulatory system, generally the more investment at the airport, the higher the profits for Heathrow Ltd.

The only potential problem is that the regulator, the CAA, may not allow the airport to pass on all the additional costs to its captive customers, and as explained below, at present that seems unlikely. The CAA itself, like the Airports Commission, certainly sees no problem in raising the finance.

Slot Allocation regulation and the issue of pre-funding

To understand why easyJet and IAG have taken such different positions on a third Heathrow runway it is necessary to turn to the European Regulation on Slot Allocation at congested airports, and perhaps not surprisingly, the EU element greatly adds to the complexity involved.

This Regulation specifies (in general terms — the actual conditions are far more complicated) that at least 50% of any new slots which become available — as distinct from those which are sold/exchanged between airlines — must be offered to new entrant carriers. This is normally not a significant issue with only a small number of slots (or in the case of Heathrow, none) becoming available each season.

A whole runway's worth of slots, however, accompanied by high demand, is a totally different matter.

The next and closely associated problem is how airlines pay for the additional airport facilities.

The traditional approach, at least in the UK, has involved a high degree of pre-funding. In other words, the airlines currently using a regulated airport pay higher fees while the new capacity is being built. By the time it comes online, a significant proportion of its funding will have been met.

This approach has never been popular with airlines, who view it as favouring the airport owner, but they have tended to acquiesce as pre-funding has not resulted in significant competitive distortion among carriers.

For example, BA gained from the construction of Terminal 5 at Heathrow, which was paid for by all airlines serving the airport, but the other carriers subsequently gained, or will do so, from the construction of the new Terminals 1 and 2 and the refurbishment of Terminal 4, to the costs of which BA contributed.

It doesn't take a genius to see that this cosy arrangement breaks down if at least half of any new facilities, in this case a new runway, is required by law to be offered to new entrant airlines, defined as carriers with no more than a very limited current presence at Heathrow, who will not have contributed to the pre-funding. The incumbent airlines will be hit twice in such a situation: they will face increased competition from carriers which they have effectively had to cross-subsidise.

Not surprisingly, such blatant market distortion has found few supporters among Heathrow's current airline customers.

Whether to approve pre-funding or not will almost certainly be a decision for the airport regulator, the CAA, which has already consulted on the subject. It has given every indication of favouring such an approach, combined with increased commercial agreements between the airport and its airline customers.

In his address to the RunwaysUK conference in London in July, for example, the CAA's Chief Executive, Andrew Haines, commented : “We are certainly open to the idea of allowing pre-funding.” He quite rightly pointed out that the arguments pro and anti pre-funding are complex and by no means all one-sided. However, “allowing airports to increase charges to start paying for expansion before a new runway is open could be beneficial to users and investors:

• it reduces the amount of finance required and brings forward the point where investment is paid back, and so reduces the risk and hence the cost of that risk; and
• by spreading cost over a longer period, it reduces the size of the price uplift when the runway opens.”

The CAA's Iain Osborne went even further in his Beesley Lecture in arguing that “pre-funding is, one way or another, a natural aspect of market operation,” a statement with which far from everyone would agree.

Such arguments are not likely to impress the current airline customers of Heathrow, but they do help to explain the positions taken by easyJet and IAG to the Davies Commission recommendations.

easyJet clearly expects to be a major beneficiary of a third Heathrow runway, gaining a large number of slots because of its new entrant status. At Gatwick, on the other hand, it is already the largest airline and would potentially have had to contribute substantially towards the cost of building new runway capacity, much of which might have gone to new competitors and little of which is really needed, at least in the short/medium term, by easyJet itself.

It is interesting, however, that the airline has firmly opposed pre-funding at Heathrow, despite the fact that it would benefit from it. It claims that such an approach would be “unfair”, but a cynic might suspect it is more concerned about setting future precedents for other airports where easyJet is an incumbent.

Reading IAG's position

IAG's position is more difficult to read. It already has over 50% of Heathrow's slots. The acquisition of bmi's portfolio combined with the extra flexibility provided by the addition of Aer Lingus' slots, despite the fact that most of the latter will have to continue to be used on Irish routes for the foreseeable future, probably means that it can meet its long-haul expansion plans for some years to come.

Why, therefore, would it want more competition at its main base? BA fought for a long time to keep most of the US carriers out of Heathrow, to its obvious benefit; all it is doing now, the argument goes, is repeating the exercise to protect Fortress Heathrow, despite the negative impact this might have on the extent of its short-haul network out of the airport, especially with respect to UK domestic feeder services. That is a perfectly logical approach from IAG's commercial perspective.

However, it is equally possible that the stance adopted by Willie Walsh, who to be fair has not been associated with regulatory protectionism, is just an opening shot in the approaching battle on how new runway capacity should be financed. If this is the case, IAG is lucky to have easyJet as a co-lobbyist.

BA/IAG has long since lost its role as a cosy partner of the Government in developing UK aviation policy. Today easyJet is considerably more influential in the corridors of Whitehall. Of course, none of this will be at all relevant unless the Government decides to approve a third Heathrow runway, and that is far from a done deal.

New entrant solution

There is one possible solution to the slot allocation/new entrant conundrum.

It is likely that those who drafted the 50% new entrant rule were really focused on airports where capacity expanded gradually, in relatively small chunks. The rule is not nearly as effective where there is a one-off substantial increase in slot availability and high demand for all the new slots.So the obvious answer is to reform the Regulation.

Economists might argue that a far better approach, for example, might be to auction the new slots and use the money thereby raised to pay for at least part of the new runway. New entrant airlines would not then have a free ride.

Most Heathrow slots acquired by incumbent carriers in recent years have been paid for, often involving substantial sums, including BA's acquisition of bmi's portfolio. Such an approach, while not a total solution, would appear to be fairer to all concerned and remove much of the risk of market distortion inherent in pre-funding.

Admittedly most slots currently used by Heathrow's airlines were not paid for, but they were obtained at a time when the airport still had unused capacity, and therefore are not distorting of competition. The airlines involved simply have what economists would call a first mover advantage.

This is not a new idea. Indeed, Heathrow Airport itself suggested something similar in a submission to the Davies Commission: “There are alternatives that Heathrow is keen to explore with our airline customers. It may be possible to replace a proportion of the existing airport charges with a direct purchase of landing rights by airlines, with proceeds going either to the Government (and in turn used as a contribution towards the funding of the capacity expansion), or directly to the airport itself. This would need to be consistent with European rules on allocation of airport slots.” (May 2014).

The Airports Commission itself noted that if the EU Slot Regulation could be modified to recognise an incumbent airline's potential contribution relative to a new entrant, this might be helpful in raising finance for the new capacity.

However, if the Commission was thinking here of differential charging, rather than avoiding pre-funding altogether, there is an added EU complication in the form of the Airports Charges Regulation, which requires all airport charges to be non-discriminatory.

Thus, it is evident that some form of reform of the EU Slot Regulation would be a way out of the problems associated with the funding of new UK airport capacity. Such an approach would have a number of benefits, but unfortunately one major drawback: it would require agreement by the 28 Members of the European Union, and the chances of that happening any time soon make getting government approval for additional runways in the South East of England seem like child's play.