Aviation Investment

Economic Appraisal for Airports, Air Traffic Management, Airlines and Aeronautics

Doramas Jorge-Calderon

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317176701
• Edition: 1
• Topic: Business
• Subtopic: Transportation Industry
• Index: Business

Aviation Investment uniquely addresses investment appraisal methods across the key industries that make up the aviation sector, including the airports, air traffic management, airline and aircraft manufacturing - or aeronautic - industries. It is a practice-oriented book where methods are presented through realistic case studies. The emphasis is on economic appraisal, or cost-benefit analysis, in order to determine the viability of projects not only for private investors but for society as a whole. Financial (cash flow) appraisal is illustrated alongside economic appraisal, as the latter builds on the former, but also to show how economic appraisal enhances standard financial appraisal to determine the long-term sustainability of any investment. Aviation is a capital-intensive sector that is growing rapidly, with world traffic expected to double over the next 15 years or so. A great deal of economic appraisal of investment projects takes place already, as aviation is subject to government intervention through economic regulation and financial support, and as both investors and policy makers seek to understand issues such as how environmental legislation may impact the viability of investments. Both economic growth and welfare go hand in hand with sound investment decisions, particularly regarding sectors such as aviation where investments are large and almost invariably debt-financed. Aviation Investment offers all aviation sub-sectors a single-source reference, bringing together the theoretical background of the economic appraisal literature and aviation investment in practice. It is written in a style that is accessible to non-academic professionals, using formulae only where strictly necessary to enable practical applications, and benefits from the substantial practical experience of the author.

Chapter 1
Introduction

1 Reasons to Invest in Aviation

There are three main reasons to invest in aviation and these are common to all modes of transport. They are:

1. Reducing the time it takes to transport a person or freight from one place to another (including time-saving by reducing congestion and increasing on-time departure).

2. Reducing the cost, in terms of resources used, of moving a person or freight from one place to another.

3. Improving the safety of a journey by reducing the risks inherent in physical transportation.

Comfort and quality of service are additional sources of value in transport, but are rarely in themselves a reason to invest. Instead, they tend to accompany some combination of the three main reasons.

Private sector operators develop their competitive strategies by focusing primarily on the first two reasons, and value the returns on their investment through a financial appraisal. The third reason is mostly relevant for promoters in countries with very poor transport conditions. Public sector investors also base their investment decisions on the very same criteria, although they widen the scope of benefits and costs beyond monetised private flows to include non-monetised private flows, as well as flows to third parties including, ultimately, society at large. Such an exercise constitutes an economic or socio-economic investment appraisal.

The private and public perspectives on investment – the financial and the economic, respectively – are mutually complementary in two respects. First, private financial benefits and costs offer a first approximation to economic benefits and costs. This constitutes a partial look at the flows associated with a project. Second, the economic benefits of an investment offer the private sector investor clues about untapped sources of revenue; and economic costs signal potential risks arising from market distortions and badly defined property rights. These issues are explored in section 2 of this chapter.

However, the distinction between financial and economic returns is often saddled with confusion, opening the doors to abuse. For example, the projected positive financial profitability of an investment may be touted as proof of the soundness of a project. However, what is advertised as a financially viable investment may in fact not reflect social value or a competitive advantage at all, but rather transfers from other stakeholders. After all, operators and investors may try to influence public policies in order to protect their competitive positions by erecting barriers to competition and, more generally, distorting markets, in extreme cases turning a financially non-viable project into a viable one. In such situations an economic appraisal would show that the proposed investment would be wasteful, despite the positive financial return. A second example is when politicians, for electoral reasons, may want to justify devoting public money to financially loss-making investments with arguments about all sorts of wider benefits to the local economy. On closer examination, a proper economic appraisal may show that many of the alleged wider economic benefits are invalid.

Besides the three fundamental reasons to invest in transport – including time and cost savings and safety improvements, as mentioned above – investment appraisal analysts are continuously confronted with myriad other reasons put forward to justify investments. Some of these reasons are ultimately invalid, but come mixed with elements of the three valid reasons set out above, making it hard to distil the extent to which an investment creates value, and the extent to which it constitutes waste and abuse. Arguments put forward may include the following:

• This investment will open up our region and lead to new economic activity and industry. This is a valid rationale insofar as it is reflected in the three fundamental reasons. Unfortunately, it tends to open the gates to all sorts of claims to benefits that are in fact mostly invalid.

• This is the latest technology. The fact that a project introduces the latest technology does not make it necessarily a good investment. There may be a case for keeping the technology alive, but that does not imply its deployment.

• And this technology will improve safety. In aviation, the safety argument has been used over the years all too often as an excuse to preserve market power (with the accompanying economic rents) and to justify transfers. Safety does not justify any expenditure, regardless of the cost. Expenditure on safety has to be set against the value of the expected safety improvement, and investments argued for on safety grounds in circumstances where operations already meet international safety standards tend to have other motivations.

• It will create jobs and the multiplier effect will generate more economic activity in the area. Many of the jobs ‘created’ may be crowded out from other activities. Moreover, loss-making investments also ‘create’ jobs and unleash multiplier effects. Contrary to frequent popular discourse, jobs and multipliers are not in themselves a sound reason to invest.

• We will bring more tourists. Whether this is a good reason or not will depend on the cost of bringing those tourists, and the added benefits the tourists generate.

• We need to increase market share. Many businesses have gone bust making wasteful investments in their chase for market share rather than profit.

There are also more clearly invalid reasons for investing that are easier to spot in advance:

• We must operate that route because an airline like ours has to be seen flying that route. Such routes are usually found on the route maps of nationalised airlines.

• Our neighbours have it, so we must have it. Very often politicians will push to supply locally what a nearby region or city already has, independently of whether there is a case to have it in the neighbouring location but not in the proposing politician’s constituency (or, indeed, in neither of them).

• Visitors must be impressed when they arrive in our country. The funds used to impress the visitors come at the expense of other items that society may demand more urgently.

And even:

• Passengers get the feeling of an amusement park attraction when they see this project. It may well be that the promoter is subject to rate of return regulation, and the motive of the project at hand is to inflate the regulatory asset base of the promoter. In such cases, financing the project with debt can boost the return on equity of the promoter.

To conclude, sound financial returns and arguments with popular appeal are no guarantee that the investment will be worthwhile. The ultimate case is based on saving time, reducing costs and improving safety in ways that ensure that the benefits outweigh the costs. A project with a positive financial return and a negative economic return is likely to be fully dependent on political patronage.

2 Financial and Economic Returns

The financial appraisal of an investment project involves estimating revenues and costs, including financing costs. Such an estimate constitutes the backbone of any standard business plan. In this regard, there is nothing exceptional in the mechanics of conducting the financial appraisal of an investment in the aviation sector, or in transport in general, relative to a project in any other sector. To simplify, the financial appraisal as presented in this book ignores considerations regarding the capital structure of a project. The focus is on whether the financial resources invested in a project as a whole generate a sufficient cash return to the promoter. Projects can be thought of as being 100 per cent financed with equity capital.

Under very specific circumstances the financial return of a project also measures the economic return. When markets are competitive, are free from distortions such as taxes, subsidies or price regulations, when there are close substitutes for all goods, when an investment project is too small relative to the size of the economy to significantly alter prices, and property rights are well defined, prices reflect the benefits of an additional unit of output produced and costs reflect the resource cost of producing that unit. Private sector investors, in following expected revenues and costs in making investment decisions, will make investments that are in line with maximising not only private profit but also social welfare. That is, the investor will inadvertently be part of the proverbial ‘invisible hand’ whereby the pursuit of private interest leads to an allocation of resources that is socially desirable.

In such circumstances, the financial appraisal of a private sector investment analyst would be sufficient to decide whether the investment should be made from the point of view of society at large, without any need for a public sector economist to carry out any other viability test. However, in reality, prices are often distorted, substitutes may be imperfect, giving certain operators a degree of market power, and property rights are not always well defined. These issues are addressed in turn in the following paragraphs.

Prices may not reflect full resource cost because of the presence of taxes, subsidies, or regulations such as minimum wages or price caps in markets for inputs or outputs. A tax on an input, for example, means that the promoter will pay for the resource cost (the opportunity cost) of the input, plus a transfer (the tax) to the government. The price the promoter pays for the input overestimates the cost of the input to society, and therefore, as far as society is concerned, this price cannot be taken as the basis for making a sound allocation of scarce resources since the taxed input would tend to be consumed less than would be socially desirable. A subsidy on an input would have the opposite effect. Similarly, price regulation, such as price ceilings or floors, may imply that the price does not reflect the scarcity of the input. Prices may instead reflect a market outcome that over- or under-supplies the good.

When property rights are not well defined, a market transaction involving a buyer and a seller may interfere with the rights of a third party that does not voluntarily take part in the transaction. These impacts to third parties are called ‘externalities’, in the sense that they are external to the parties that voluntarily agree a transaction. In the case of aviation the main examples of potential externalities concern the environment, including emissions of greenhouse gases, air-polluting particles and noise. When the property rights of third parties are well defined, the parties involved in the transaction will also have to pay, via taxes or direct compensation, to the third parties affected by the transaction.

It should be noted that effects on third parties may not only be negative. Projects can have positive external effects, such as knowledge spillover effects from investments in aviation research and development (R&D). There can also be beneficiary price effects, as when a project is large enough to affect the price of one of its inputs in the presence of cost economies in the production of that input. The higher demand for of the input brought about by the project would lower the price of the input, yielding productivity gains to other firms, which are unrelated to the project but also use that input.

Finally, when the products supplied by competitors are not close substitutes, consumers can experience a cost in switching from one producer to another. In such situations, if supply is lumpy (i.e. there are indivisibilities) competitive markets may not work well to address supply shortages, giving incumbents an element of pricing power that can be abused. An example may be an airport (supply is lumpy: capacity cannot be doubled at short notice) that is a monopolist in a city, and users have as an alternative another airport two hours’ drive away (constituting a switching cost). The monopolist airport could adjust prices in order to try to convert all of the cost of switching into extra revenues (extracting rents through market power).

In recognition of this monopoly power, the prices offered by the airport (aeronautical charges) are often regulated by the government, leaving such switching costs un-monetised. The switching costs represent a resource use (time to drive to the alternative airport and operating cost of the vehicle to reach that other airport), so much so that the airport user would be willing to pay in order to avoid it. Such willingness to pay, however, remains unregistered by the revenues or costs of the project, and therefore ignored in a financial appraisal. Whereas they are un-monetised, the switching costs measure consumer willingness to pay – over and above existing prices (aeronautical charges) – to continue using the airport, before switching to a competing service. Switching costs constitute, therefore, a measure of the competitive advantage of the airport, that is, how much customers value the distinctive characteristics of the service offered by the operator (in this case consisting largely of location, or proximity) over and above those of its competitors and, therefore, how much extra they would be willing to pay to the airport before switching to the next best competitor.

An economic appraisal aims at quantifying the three distortions mentioned above, and incorporates them in the calculation of project returns. It attempts to work through price distortions, inefficient property rights and unobserved willingness to pay, in order to register the actual resources used by the project and the actual benefits produced by it. It is, in other words, an attempt to estimate the net benefit of the investment to society (where value to society is largely reflected by the use of the facility) when the presence of market imperfections leaves the estimate of financial return incapable of answering that question. Fortunately, the tools of economic appraisal are very apt for application to transport projects, including aviation. The standard technique for economic appraisal is cost-benefit analysis (CBA).

The literature on CBA is well developed, often extending to application to transport projects.¹ Table 1.1 below summarises the main differences between financial and economic appraisals. While it is merely a summary table, it gives a flavour of where to pay attention in order to avoid frequent so...