Aviation Investment

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

Doramas Jorge-Calderón

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781351713412
• Edition: 2
• Topic: Commerce
• Subtopic: Industrie des transports

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. This practice-oriented book presents methods through realistic case studies. It covers both economic appraisal, or cost-benefit analysis, measuring the value of projects to society, and financial appraisal, valuing projects as cash generators.

This substantially expanded second edition covers in greater detail the treatment of environmental emissions, paying particular attention to climate change. It addresses the treatment of Market-Based Mechanisms (MBMs), including cap and trade systems like ETS and offset systems like CORSIA, and compares them to environmental taxes. It also addresses the adjustments needed to measure the foreign exchange generating value of projects, relevant in the presence of trade barriers. The new edition includes two new project types. One is airport relocations, perhaps the most complex type of airport projects, where the economic case is often more nuanced than may be apparent. The second is the re-introduction of supersonic travel.

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.

1 Introduction

1.1 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. Also, time can be considered a resource, implying that the first reason should be included in the second one. But time is such an important driver of value that it is usually considered separately.

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. Indeed, the financial appraisal is a subset of the economic appraisal, constituting a partial look at the flows associated with a project. Second, the economic benefits of an investment takes a broader perspective at the sources of value, offering 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 1.2 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. Examples of the resulting waste include newly built airports that remain virtually empty after opening and which end up constituting a sink of regional resources, the exact opposite of the original intention.

• 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. An example was the Concorde supersonic aircraft.

• 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. The history of the airline industry is full of examples of defunct airlines that had expanded too fast in the quest for market share.

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.

1.2 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.

The financial return of a project is a subset of the wider economic returns of the project. Under very specific circumstances the financial return equals 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 and services, 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, property rights are not always well defined, and substitutes may be imperfect, giving certain operators a degree of market power. These three distortions are addressed in turn in the following paragraphs.

Firstly, 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.

Secondly, 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 to 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 defi...