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					CAA’s initial price control proposals for Heathrow,
Gatwick and Stansted airports
December 2006


Supporting paper VII
Review of BAA’s revenue and cost allocation process

Report
Contents

Glossary ...................................................................................................................1


1       Executive Summary .......................................................................................3


2       Introduction and scope of work ..................................................................19


3       BAA’s allocation process ............................................................................30


4       LECG review of BAA’s allocation process ................................................43


5       CAS and PLC costs ......................................................................................50


6       IT leases.........................................................................................................64


7       Other charges ...............................................................................................77


8       Mark-up..........................................................................................................82


9       Capping .........................................................................................................99


10      Cost driver analysis ...................................................................................105
Glossary

The following abbreviations are used in this report:


ABC             Activity Based Costing

AMA             Acquire and Maintain Assets

Andersen        Arthur Andersen

AOS             Airport Operating Systems

BAA             BAA plc

                BAA Business Support Centre Ltd or the Business Support
BSC
                Centre (as appropriate to the context)

CAA             Civil Aviation Authority

CAS             Central Airport Services

CC              Competition Commission

DEE             Deliver Excellent Experience

EPMU            Equal proportional mark up

                Gatwick Airport Ltd or Gatwick Airport (as appropriate to the
GAL
                context)

GPIT            Group IT costs

                Heathrow Airport Ltd or Heathrow Airport (as appropriate to the
HAL
                context)

                Heathrow Express Ltd or the Heathrow Express (as the
HEX
                appropriate to the context)

HMRC            HM Revenue and Customs

ITT             Invitation to Tender

LECG            LECG Ltd

NATS            National Air Traffic Services

NIC             Employers National Insurance Contribution

OFA             Oracle Financial Analyser
Ofgas      Office of Gas Supply

Ofgem      Office of Gas and Electricity Supply

Oftel      Office of Telecommunications

           Water Services Regulation Authority, formerly the Office of
Ofwat
           Water Services

           Office of Rail Regulation (formerly the Office of the Rail
ORR
           Regulator)

PAX        Passengers

           A grouping of head office and corporate service departments
PLC
           within BAA plc.

Postcomm   Postal Services Commission

Q4         The fourth quinquennial price control period (2003-2008)

Q5         The fifth quinquennial price control period (2008-2013)

RAB        Regulated Asset Base

RCV        Regulatory Capital Value

RMS        Resource Management System

SMIS       Senior Management Incentive Scheme

           Stansted Airport Limited or Stansted Airport (as appropriate to
STAL
           the context)

T5         Terminal 5 at Heathrow Airport

UEL        Useful Economic Life

VOIP       Voice Over Internet Protocol

WACC       Weighted Average Cost of Capital

WDF        Worldwide Duty Free
                                                                                       December 2006




1     Executive Summary

      Introduction
1.1   The Civil Aviation Authority (“CAA”) is performing a review of the costs, efficiency
      and business plans of BAA plc’s (“BAA”) Heathrow (“HAL”), Gatwick (“GAL”) and
      Stansted (“STAL”) airports (together, “the Airports”), before setting the fifth
      quinquennial (“Q5”) price control, which will apply from 1 April 2008 to 31 March
      2013.


1.2   The CAA stated in its December 2005 policy paper1 that it intends to conduct the
      price control review based on the separate regulation of each airport. Therefore,
      the price control applicable to each of the designated airports will reflect the costs,
      assets and market conditions faced by each airport. The CAA has also indicated
      that the price controls will be set under the single till approach, whereby the
      aeronautical revenue requirement, which drives the level of charges, is calculated
      after deducting certain commercial revenues.


1.3   As part of its price control review process, and in the context of the policy positions
      outlined above, the CAA engaged LECG to undertake a review of BAA’s cost
      allocation process. This report presents the work we have undertaken and our
      conclusions.

      Scope
1.4   The scope of LECG’s work comprised: (i) a review of BAA’s revenue and cost
      allocation policies, with a particular focus on the objectivity with which BAA
      allocates costs and revenues between each of its price controlled airports and the
      rest of its business; and (ii) a review of the cost drivers and any other factors
      applied by BAA to allocate costs and revenues, judged against both recognised
      commercial best practice and against the CAA’s statutory duties governing its
      price control regulation.


1.5   Additionally, the CAA requested LECG to provide advice on whether the cost
      allocation processes used by BAA are appropriate for price control purposes. In
      particular, the CAA sought advice on: (i) the efficiency and effectiveness with
      which BAA records costs and revenues between each of its price controlled
      airports and the rest of its business; and (ii) an evaluation of BAA’s cost allocation
      systems, judged against both recognised commercial best practice and against
      the CAA’s statutory duties governing its price control regulation.


      1
              “Airports review – policy issues, Consultation paper”, CAA, December 2005.




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1.6   The CAA and LECG agreed that references to “revenue” in terms of the scope of
      work should be interpreted as meaning inter-company revenue. Accordingly, the
      allocation of third party revenue should not form part of the review.


1.7   Our primary focus has been to review the processes used by BAA to allocate
      centrally incurred costs, referred to as Central Airport Service (“CAS”) and Group
      (“PLC”) costs, to the Airports and to BAA’s other businesses. In reaching our
      conclusions, we have also examined BAA’s approach to the allocation of certain
      other costs that are charged directly between businesses within the BAA group. In
      performing our work, we have considered the validity of BAA’s cost allocation
      drivers.

      Approach
1.8   LECG’s approach to assessing BAA’s cost allocation process can be summarised
      as follows.

      Figure 1:           LECG approach
       •   Review BAA documented cost allocation process
       •   Discuss process with key BAA management
       •   Review of the accounting system and data hierarchy           BAA’s allocation process
       •   Check consistency with regulatory precedent and CAA’s
           preferred approach

       • Build model for testing allocation process
       • Review the mechanics of the allocation process to
         identify inconsistencies and errors                        LECG review of allocation process
       • Transparency of the process

       • Review the different types of CAS and PLC costs
         allocated to the Airports and other businesses
       • Understand the nature of the different cost activities            CAS and PLC costs
       • Review how costs are calculated for each CAS and PLC
         department

       • Understand the process for calculating IT lease charges
       • Review the calculations
       • Review how costs are calculated to the Airports and                    IT leases
         other businesses
       • Consistency with RAV

       • Review other charges directly allocated to the Airports
       • Understand the nature of the different cost activities
       • Understand the process for how these charges are
         allocated                                                           Other charges
       • Consistency of application of processes across all BAA’s
         businesses

       • Review the appropriateness of applying a mark-up on
         allocated costs
       • Perform benchmarking analysis                                          Mark-up
       • Consistency of application with other regulated sectors
       • Reasonableness assessment of the level of the mark-up

       •   Understand the process of capping costs
       •   Review the basis for capping charges
       •   Review BAA supporting analysis for capping                           Capping
       •   Review the appropriateness for applying caps

       • Review the appropriateness of revenue and cost drivers
         for CAS and PLC costs
       • Compare the cost drivers used with commercial best               Cost driver analysis
         practice
       • Review alternative cost allocation drivers


      Source: LECG




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       Limitations
1.9    In performing our work and producing this report, LECG has reviewed the internal
       consistency of data supplied to us by BAA. However, nothing in this report should
       be taken to imply that we have conducted any procedures or investigations in an
       attempt to verify or confirm, by means of reviewing source documentation or
       processes, the accuracy of the data underlying BAA’s cost accounting systems or
       other supplementary information. Our work does not constitute an audit.


1.10   LECG has written this report solely for the use of the CAA. We are aware that the
       CAA may rely in part on our findings, as set out in this report, in its determination
       of the price controls applicable to the Airports. We are also aware that the findings
       of this report that will be provided to BAA before publication, may form part of the
       CAA’s submission to the Competition Commission and may be made available
       publicly by the CAA.

       Information
1.11   As is normal when performing reviews of this nature, LECG has relied extensively
       on information provided by the CAA and, in particular, on information provided by
       BAA. The information we received from BAA comprised documents containing
       background information and explanations on particular topics as well as a large
       number of spreadsheets containing financial and operating data, as well as BAA’s
       calculations of the costs to be allocated and the results of its allocation process.


1.12   We acknowledge that the combined impact of the price control review and the
       associated requests for information from CAA, LECG and the CAA’s other
       consultants, as well as the recent takeover of BAA plc may have created a very
       significant workload for those at BAA with whom we dealt. We are grateful for all
       of their input and assistance.


1.13   Notwithstanding the comments above, we believe that the information received
       was deficient in a number of areas. In particular, a significant number of the
       documents we received in support of BAA’s approach and by way of explanation
       appeared to have been prepared specifically for LECG.            Normally, we would
       expect to be provided with existing documentation such as accounting procedures
       manuals and contemporaneous documents supporting decisions, particularly on
       the development and operation of the cost allocation process. We believe that as
       a function of     the lack       of   documentation,   particularly contemporaneous
       documentation, and/or the way in which certain calculations are performed, BAA’s
       allocation process lacks transparency in a number of areas.




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1.14   Based on our experience, and our understanding of the requirements and practice
       in other regulated companies and sectors, we believe that quality of BAA’s
       documentation, its processes and its application of quality assurance procedures
       falls short of best practice. If the CAA wishes to apply the concept of separate
       regulation and monitor its implementation effectively and efficiently, we believe
       that this requires improved documentation, information systems, processes and
       controls on the part of BAA, in relation to cost allocation.

       BAA’s approach
1.15   Within the BAA group, the central CAS and PLC departments provide a range of
       support functions and services to the Airports and other businesses. Where these
       departments incur costs that are attributable directly to a particular business, a
       direct charge is made.       Similarly, where costs are incurred in relation to the
       provision of goods or services from one company to another in the normal course
       of business, these costs are also charged directly to each company. Where a
       direct relationship cannot be identified, which applies to many of the support
       services provided by BAA centrally, the relevant costs are allocated by BAA, in
       accordance with its allocation methodology.


1.16   BAA’s objectives when developing and applying its cost allocation process are
       driven primarily by financial reporting requirements, and the need to produce
       information for HM Revenue and Customs (“HMRC”).                   What is acceptable or
       appropriate for these purposes is not necessarily appropriate for price control
       purposes.


1.17   BAA appears to adopt a rigorous, bottom-up approach to projecting future costs
       (though we have not been asked to review this process) and to identify which
       costs can be directly allocated. In contrast, its approach to allocating costs for
       which no causal link can be established is generally less analytical, and is
       described by BAA as being “based on pragmatic, simple and cost effective
       principles and methods which do not require the use of specialist systems”2. BAA
       then relies on management review and the use of ex-post adjustments to address
       situations in which the allocation of costs implied by its calculations appears
       unreasonable.

1.18   An issue with a high-level process, such as that adopted by BAA, is that it is
       difficult to assess whether an alternative more detailed approach would result in
       significantly different allocations of costs. Whilst BAA’s management argue that
       they use their experience to adjust costs through “capping” to ensure an equitable

       2
               BAA/Q5/171 – “BAA Central Cost Re-charges Principles”, BAA, June 2006.




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       allocation of costs, it must be recognised that this approach is not necessarily
       accurate and is extremely judgmental. Consequently, the lack of documentary
       evidence and analysis supporting BAA’s methodology raises concerns as to the
       appropriateness of the allocation process in the context of this study.


1.19   To test the accuracy of BAA’s allocation process, LECG constructed a
       spreadsheet model that replicates BAA’s cost allocation methodology and
       calculations. We compared the output generated from our model with the output
       from BAA’s own cost allocation process, investigated the cause of any differences,
       with assistance from BAA, and used this a basis for forming our conclusions on
       the appropriateness of BAA’s cost allocation methodology.


1.20   Our review and analysis identified a number of inconsistencies and errors in BAA’s
       calculations, the aggregate impact of which is not material. The majority of these
       relate to small mistakes in the development or use of BAA’s cost allocation
       spreadsheets, particularly those related to the calculation of IT lease costs. These
       were not detected by BAA’s internal review procedures.


1.21   Based on our analysis we conclude that, but for the errors detected, BAA’s
       allocation process appears to produce accurate calculations that are consistent
       with its approach and assumptions. Consequently, we believe that it can be relied
       upon to produce materially correct cost allocations.


1.22   The errors and inconsistencies we have identified are easily rectified. We suggest
       that the CAA actively encourages BAA to effect such changes and that the CAA
       adopts the revised figures for the purposes of setting the next price control. We
       use the corrected figures in this report when considering the impact of using
       alternative allocation drivers.

       BAA’s allocated and recharged costs
1.23   The table below summarises departments and cost categories that fall under CAS,
       the basis on which their costs are allocated under BAA’s approach, and the
       amounts to be allocated in 2008/093.




       3
                We show information here for 2008/09 as it is the first year of the Q5 price control period,
       and the costs in this year form the basis for BAA’s projections of costs for the remainder of Q5. The
       departments included within CAS and PLC in this year are more numerous than in 2005/06.




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       Table 1:        2008/09 CAS departments, allocation drivers and costs

       Department                                        Allocation Driver           % of total cost

       IT leases                                              Specific                     34.8%

       Group IT                                               Specific                     45.5%

       Acquire & Maintain Assets (“AMA”)                      CAPEX                          5.2%

       Group Health & Safety                                    PAX                          0.7%

       Group Security                                           PAX                          1.4%

       Research                                                 PAX                          2.6%

       Airport planning                                         PAX                          1.7%

       Airline Relations Team                                   PAX                          0.6%

       Corporate Responsibility & Environment                   PAX                          0.7%

       Rail Strategy                                            HEX                          0.0%

       Managing and Divisional Directors                        PAX                          1.0%

       Group Marketing                                          PAX                          1.7%

       Olympic 2012                                  South East airports’ PAX                0.3%

       UK Airports retail                                Net retail income                  (0.4%)

       Chief Fire Officer                                       PAX                          0.3%

       Group Services Director                            Operating Profit                   0.7%

       Airport Operations                                 Operating Profit                   0.4%

       Group Retail                                      Net retail income                   1.6%

       DEE AOE from 2008/9                                      DEE                          0.5%

       Common costs                                       Corporate Office                   0.8%

       Total                                                                              100.0%

       Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls “. A summary of CAS costs
       is provided in Section 5 of this report. Note: This table may contain rounding differences.


1.24   IT related costs (IT leases and Group IT) account for nearly 80% of the CAS costs
       allocated under BAA’s approach. Accordingly, in our work we have focussed on
       determining the appropriateness with which BAA identifies and allocates IT costs.


1.25   The table below summarises departments and cost categories that fall under PLC,
       the basis on which their costs are allocated under BAA’s approach, and the
       amounts to be allocated in 2008/09.




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       Table 2:         2008/09 PLC departments, allocation drivers and costs

           Department                              Allocation Driver                % of total cost

           Board                                    Corporate Office                          8.2%

           Finance (including insurance)             Operating Profit                       26.6%

           Business Assurance                        Operating Profit                         5.0%

           Human Resources                           Operating Profit                       17.7%

           Property                                  Operating Profit                         6.6%

                                                 50% Operating Profit,
           Corporate Affairs                                                                13.2%
                                                 50% Corporate Office

           Economics & Regulation                    Operating Profit                         4.6%

           Legal                                     Operating Profit                         3.2%

           Company Secretary                        Corporate Office                          6.7%

           SMIS & NIC                               Corporate Office                          8.2%

           Travelex                                   Not Allocated                           0.0%

           Total                                                                           100.0%

       Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls “. Source: BAA/Q5185-14
       “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls “. A summary of CAS costs is provided in Section 5
       of this report. Note: This table may contain rounding differences.


1.26   In the tables above, those costs identified as having ‘Corporate Office’ as the
       allocation driver are not allocated to the Airports or other businesses. The costs
       are borne centrally by BAA plc. Further details on BAA’s approach can be found
       in Sections 3 and 4 of this report.


1.27   In addition to CAS and PLC costs, a number of costs are directly charged to the
       Airports from central BAA departments and other group businesses. These costs
       and our conclusions can be summarised as follows:

       •        Corporate Office costs include certain retail, IT property and other costs for
                which a direct causal link between the user and the level of cost incurred
                can be identified, and hence the costs are charged directly.                      This is
                consistent with best practice;

       •        HEX costs relate to the operation of the Heathrow Express. These are
                charged directly to Heathrow Airport. This basis of allocation is appropriate;
                and

       •        Business Support Centre (“BSC”) costs relate to the accounting and other
                support services provided by BAA’s shared service centre. BSC costs are



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             allocated to other businesses within BAA based on detailed analysis and
             drivers that BAA believes reflect the use made of the services provided.
             Based on our limited review, this approach appears reasonable.

1.28   Further details on BAA’s Other Charges can be found in Section 7of this report.

       IT leases
1.29   IT lease costs are one of the largest categories of CAS and PLC costs. They
       represent the mechanism by which BAA seeks to charge each of the Airports and
       BAA’s other businesses an appropriate annual amount for their use of common IT
       software and systems that are owned by HAL. These costs differ from the other
       recharged and allocated costs considered in this report as follows:

       •     IT lease costs are an allocation of costs from one of the regulated
             businesses to other businesses within the BAA group rather than being the
             allocation of costs from a corporate office department or a ringfenced
             subsidiary;

       •     the level of the costs is generated internally within BAA in a series of
             complex spreadsheets rather than being the result of a series of
             transactions recorded within BAA’s accounting system; and

       •     the allocation of costs from HAL to the other businesses results, in
             accounting terms, in the generation of income.        When considering the
             appropriateness of BAA’s IT costs and the resulting allocations it is
             necessary to take into account the treatment of the IT lease income under
             the single till mechanism.

1.30   The lease mechanism adopted by BAA to calculate and allocate costs associated
       with use of shared assets also differs from that what might be expected under the
       ‘normal’ regulatory approach (i.e. using an RCV approach). In general, our finding
       is that it may be equally valid to use a lease approach. However, it is important to
       ensure, from a regulatory perspective, that the lease mechanism adopted gives
       rise to equivalent cost allocations (at least in NPV terms) as would occur under the
       ‘normal’ regulatory approach.


1.31   BAA’s annual lease cost, for each IT asset, is based on an annuity calculation.
       The calculation assesses the amount to be paid annually, such that the NPV of the
       lease annuity over the life of the asset is equal to the original investment cost of
       the asset. The lease cost for each IT asset is allocated to each of the Airports and
       to each of BAA’s other businesses, based on usage of the particular system.




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1.32   The effect of the operation of the single till is to ensure that any difference
       between the NPV of total costs under BAA’s and the RCV approach are adjusted
       for in the calculation of HAL’s aeronautical revenue requirement. As a result, the
       total net costs across the group under BAA’s approach will be the same as under
       the RCV approach.       Importantly, however, the operation of the single till may
       distort the allocation of IT lease costs.


1.33   Given the current assumptions used by BAA and the CAA and the current IT asset
       mix, the difference in the allocation of IT lease costs under the BAA and RCV
       approaches is not material. Accordingly, we conclude that currently no adjustment
       is required to the level or allocation of IT lease costs for price control purposes.


1.34   However, should BAA make any changes to the assumptions on which it
       calculates the IT lease costs, or, perhaps more importantly, should the CAA
       determine that different cost of capital assumptions are appropriate for setting the
       Q5 price control, we believe that our conclusion on the appropriateness of BAA’s
       calculation and allocation of IT lease costs will need to be revisited.


1.35   More details of the issues associated with IT lease costs, our analysis of BAA’s
       calculation and allocation of IT lease costs and our conclusions are contained in
       Section 6 of this report.

       Mark-ups
1.36   BAA’s policy is to mark-up most CAS and PLC department costs before they are
       allocated. The mark-up applied is 7.5%. The key exception to this policy is IT
       lease costs, to which, from the start of the current financial year (i.e. 2006/07),
       BAA no longer applies a mark-up in recognition that the lease calculation already
       allows for a return.


1.37   A mark-up of 7.5% is also applied to BSC costs while the HEX costs are subject to
       a management fee of 10%. BAA does not apply a mark-up to certain direct costs
       or to those costs that will be capitalised in the books of the recipient company.
       The effective mark-up on CAS and PLC costs, after taking into account the impact
       of the categories of cost to which no mark-up is applied, is 4.8%.


1.38   A key policy issue that the CAA will need to address is whether to allow or exclude
       mark-ups when determining the efficient level of allowable operating costs for
       price control purposes. As is explained in more detail in Section 8 of this report,
       reaching a conclusion will require the CAA to address some complex regulatory
       and economic issues, including whether CAA wishes as a matter of policy to
       reward BAA for out performance of efficiency incentives.




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1.39   Arguments can be made in support of either allowing or excluding mark-ups, and
       any assessment will need to take account of the assumptions made at previous
       price controls. While the CAA is not bound by regulatory precedent4, we note that
       such precedent supports strongly the exclusion of mark-ups.                         The standards
       prevailing in the UK water, energy and postal sectors would support the exclusion
       of mark-ups.


1.40   We do not believe that the reasoning put forward by BAA in support of including
       mark-ups, which is based in large part on financial reporting and taxation
       requirements, are of particular relevance for price control purposes.


1.41   In view of the complexity of this area we believe that it is a topic on which the CAA
       may wish to seek consultation


1.42   Under an assumption that it is appropriate to allow a mark-up, we believe that
       additional analysis is required in order to conclude definitively on the
       appropriateness of the 7.5% mark-up applied by BAA. However, given that the
       overall effective mark-up for CAS and PLC department costs is 4.8% over the
       relevant period, a margin of 7.5% on those costs where a mark-up is charged,
       may at least appear reasonable on the grounds of materiality.

       Capping
1.43   Capping is the term used within BAA to refer to the process by which BAA’s
       management exercises its judgement to adjust (or ‘cap’) the allocation of PLC and
       CAS costs to particular businesses.                BAA makes these adjustments when it
       believes that the results of its cost allocation process result in levels of charge in
       some businesses that are unreasonable, inequitable or otherwise inappropriate.
       BAA sees this step as being a necessary and integral part of its overall cost
       allocation process.


1.44   BAA has identified circumstances or reasons why adjustments may be required,
       which include:

       •      the failure of the allocation process to take into account adequately the level
              of costs that the recipient business might reasonably have expected to pay
              for services received had it been a standalone entity able to take
              independent procurement decisions;



       4
                 Consistency is one of the five key principles originally devised by the Better Regulation Task
       Force in 1997, and subsequently endorsed by Government and adopted by the European Commission.




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       •     how the drivers used by BAA fail to reflect the ways in which different
             airports contribute to CAS and PLC costs through their operational
             complexity; and

       •     the possibility that the level of business activity and the position of the
             business in its development cycle may mean that certain airports may be
             unable to absorb the level of costs that BAA’s allocation mechanism
             suggests should be recharged to them.

1.45   In the past BAA has applied two caps.         The first involves a reduction in the
       allocation of corporate costs to certain non-regulated airports, with these costs
       being absorbed by BAA. The second cap is applied to BAA’s regulated airports in
       the South East of England. This has involved capping the level of costs allocated
       to Stansted and the reallocation of costs in excess of this cap to Heathrow and
       Gatwick.


1.46   In recent years, the impact of the cap on the costs allocated to Stansted has fallen
       and this is forecast to continue. In 2008/09, the first year of Q5, BAA anticipates
       that Stansted will be paying 64.6% of the basic allocation as compared with 43.8%
       in 2002/03. BAA is forecasting that from 2008/09 onwards no capping adjustment
       will be applied to the costs allocated to Stansted. BAA has explained that this
       does not represent any change to its policy or approach, but is the result of its
       process of review and exercise of management judgment taking into account
       anticipated developments.


1.47   LECG has some concerns about the management review and capping process
       adopted by BAA, and about its appropriateness for the purposes of setting price
       controls. These concerns relate entirely to the lack of objectivity and transparency
       in the process. In particular:

       •     as in other areas, BAA does not have an accounting manual or similar
             documents which record and explain the process for management review
             and the factors that should be taken into account when considering the need
             for, or the scale of, any capping adjustment;

       •     BAA does not have any contemporaneous records or analysis supporting
             the derivation of the capping adjustments;

       •     the process adopted by BAA does not consider the appropriateness of the
             level of the allocated charge for a particular service or category of cost; and




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       •     BAA has not identified any measurable or otherwise objectively identifiable
             criteria for determining why no capping adjustment is required from 2009/10
             onwards.

1.48   We believe that whether to accept the capping adjustments applied and/or
       proposed by BAA for the purposes of setting the price control is ultimately a policy
       decision for CAA. However, we do not believe that BAA has produced adequate
       evidence based justification for any of its capping adjustments (including those
       that it has applied in the past, those that it is forecasting will be applied in the
       future and when it believes that no capping adjustment will be required). As such,
       we cannot conclude that it is not appropriate for any or all of BAA’s capping
       adjustments (including the forecast zero values) to be included in the cost base of
       any of BAA’s airports for the purposes of setting the Q5 price control.


1.49   On this basis we have excluded the impact of BAA’s capping adjustments from all
       of our calculations and consider the impact of using alternative drivers on the level
       of costs before application of BAA’s capping adjustments. This does not affect the
       figures submitted by BAA for 2009/10 and beyond.           This is because BAA is
       forecasting that 2008/09 is the last year in which a capping adjustment will be
       appropriate.


1.50   Further details of the issues associated with capping, our analysis of BAA’s
       calculation and our conclusions are contained in Section 8 of this report.

       Alternative basis of allocation
1.51   BAA’s approach to the selection of allocation drivers is consistent with its simple
       and pragmatic approach. BAA has considered in detail the basis on which IT
       costs should be allocated, with the remainder of the CAS and PLC department
       costs allocated based on a limited number of high-level drivers.


1.52   Where possible, BAA allocates costs on a causally linked driver, consistent with
       best practice. In situations in which BAA is unable to identify such a link, BAA
       allocates costs based on a default driver. For the CAS department costs the
       default driver is passenger numbers (“PAX”), while for PLC department costs it is
       operating profit. The basis on which BAA selected the allocation drivers appears
       not to have been well documented, and we have not had access to any
       contemporaneous documentation that supports the choice of allocation drivers.


1.53   As is explained in detail in Section 10, our review identified that it is BAA’s normal
       practice to update driver values annually but that BAA does not update the values
       used to allocate the IT lease costs. This presents a risk that the allocation of costs




                                                                                    CAA|   14
                                                                                           December 2006




       does not vary with changes in the pattern of usage over time. In the absence of
       evidence from BAA demonstrating the appropriateness of freezing the allocation of
       IT lease costs at the values used, we believe that it would be appropriate to
       update these drivers annually. We have updated the driver values to calculate a
       revised base case against which to compare the impact of other driver changes.


1.54   Based on the information provided by BAA we have been unable to perform a
       detailed, bottom-up, assessment of the most appropriate drivers to be applied at
       the level of individual budget (cost) centres. We focussed most of our efforts on
       considering the appropriateness of the default drivers that are applied to costs
       where no causally linked drivers can be identified - referred to in this report as the
       common costs5. We have also reviewed the causally linked drivers selected by
       BAA.


1.55   When reaching our conclusions on the appropriateness of the basis on which BAA
       allocates costs, we have taken into account our overall experience of cost
       allocation issues and knowledge of the approaches adopted in other regulated
       sectors as well as the explanations and information provided by BAA. It is widely
       accepted regulatory practice to allocate common costs based on the equi-
       proportional mark-up principal (“EPMU”). Under this approach, common costs are
       allocated in proportion to directly and indirectly attributable operating costs.


1.56   As part of our review, we modelled the impact of adopting alternative allocation
       drivers under a number of different scenarios.                   The scenarios we modelled
       included making changes to the drivers selected by BAA where we believe they
       are inappropriate and assessing the sensitivity of the allocation process by
       applying alternative, potentially equally valid, allocation drivers.                Details of the
       scenarios tested are set out in Section 10.


1.57   Of all of the scenarios we considered, the one that we believe the CAA should
       adopt, as the basis for determining the efficient level of allowable operating costs
       in Q5, is Scenario 7 (refer to Section 10 for a full summary of the various
       scenarios). The table below summarises the differences between the approach to
       allocation under this scenario and the approach adopted by BAA.




       5
                  The common costs to which we refer here are NOT the same as the ‘Common Costs’ listed
       in Table 1 and described in more detail in Section 5 of this report. The ‘Common Costs’ are a category
       of cost identified by BAA, which are not allocated to the Airports and other businesses. The ‘common
       costs’ to which we refer in this paragraph and extensively in Section 10 of this report are those CAS
       and PLC department costs to which BAA has applied a default driver.




                                                                                                 CAA|     15
                                                                                       December 2006




       Table 3         LECG suggested changes to allocation

           Cost category                          BAA drivers                     LECG drivers


           AMA                                Capital expenditure           Operating costs (EPMU)

                                                                               Average number of
           HR                                   Operating profit
                                                                                  employees

           CAS costs                            Operating profit            Operating costs (EPMU)


           PLC costs                            Operating profit            Operating costs (EPMU)

       Source: LECG analysis. For CAS and PLC our change relates to where the default driver is operating
       costs. Other CAS and PLC costs, which use different drivers, such as PAX, have not been changed in
       our preferred scenario.


1.58   The reasoning for selecting this scenario is explained further in Section 10.
       However, the primary arguments for supporting our approach can be summarised
       as follows:

       •     it excludes BAA’s unsupported capping adjustments;

       •     it corrects for the errors identified in BAA’s calculations;

       •     it includes the impact of updating annually the allocation drivers applied to IT
             lease costs;

       •     it changes the basis for allocation of AMA costs to a driver which we believe is
             more causally linked than the one selected by BAA;

       •     it replaces the default driver used by BAA to allocate HR costs with an
             allocation driver which we believe to be causally linked; and

       •     it avoids the circularity associated with using operating profit as a default
             driver to allocate CAS and PLC costs by adopting the EPMU approach in line
             with regulatory best practice.

1.59   Where CAS costs are allocated by BAA using the PAX default driver, we also
       considered the appropriateness of the EPMU approach. To the extent that PAX
       has been applied as a default driver, this would be consistent with regulatory
       precedent and LECG’s proposed treatment of PLC department costs.                          These
       departments would appear to contain some costs that are common in nature and
       some that are linked directly to airport operations. The EPMU approach would be
       appropriate for the former while PAX is potentially more appropriate for the latter.




                                                                                              CAA|    16
                                                                                              December 2006




       However, we did not have access to sufficiently detailed information to separate
       the CAS department costs in this way, and therefore do not propose a change to
       BAA’s allocation of these costs for the purposes of the Q5 price control.


1.60   LECG also considered recommending a scenario under which IT costs are all
       allocated based on PAX, consistent with the default driver applied to IT lease
       costs. Notwithstanding the lack of documentary evidence provided by BAA to
       support the basis on which it allocates IT costs, particularly Group IT costs, we
       recognise that BAA has sought to allocate IT costs at a detailed level based on
       usage. Consequently, we do not recommend that a change be made for purposes
       of setting the Q5 price control.

       Summary of allocation adjustments
1.61   In the tables below, we show the impact of our recommended changes relating to
       the allocation of CAS and PLC department costs for the years 2005/06 and
       2008/09. We present information for these years because the former is the base
       year for the CAA’s analysis of costs. The latter is the first year of the Q5 price
       control period.

       Table 4:         Summary of adjustments and suggested changes 2005/06

       £m                                 HAL           GAL          STAL          Other              Total

       BAA as submitted                    78.1          26.8           7.1        ||||||||        ||||||||||

       Remove capping                       (4.0)         (1.0)         5.0             ||                ||

       BAA pre capping                     74.0          25.8          12.1        ||||||||        ||||||||||

       Correct errors                       (2.7)         (1.3)         1.3        ||||||||         ||||||||

       BAA’s adjusted submission           71.3          24.5          13.4        ||||||||        ||||||||||

       Impact of changing drivers           (6.3)         (0.1)         0.6         ||||||                ||

       LECG allocation                     65.0          24.4          14.0        |||||||         |||||||||

       Change                              (13.1)         (2.4)         6.9             4.9              (3.6)

       Source: LECG analysis. Note: This table may contain rounding differences.




                                                                                                  CAA|          17
                                                                                               December 2006




       Table 5:         Summary of adjustments and suggested changes 2008/09

       £m                                   HAL          GAL            STAL        Other              Total

       BAA as submitted                 ||||||||||     ||||||||        ||||||||     ||||||||        ||||||||||

       Remove capping                         (4.2)        (1.3)            5.5           -                 -

       BAA pre capping                   ||||||||      ||||||||        ||||||||     ||||||||        ||||||||||

       Correct errors                         (3.0)        (1.5)            3.9          1.3               0.7

       BAA’s adjusted submission         ||||||||      ||||||||        ||||||||     ||||||||        ||||||||||

       Impact of changing drivers             (2.3)        (0.5)           (1.8)         4.5                -

       LECG allocation                    |||||||      |||||||         |||||||      |||||||         |||||||||

       Change                                 (9.5)        (3.3)            7.6          5.8               0.6

       Source: LECG analysis. Note: This table may contain rounding differences..


1.62   LECG’s proposed adjustments and changes to allocations result in material
       changes to the allocation of costs. The combined impact of all of the changes is a
       significant reduction in the level of costs allocated to HAL and an increase in the
       allocation to the unregulated businesses.                  There is a small reduction in the
       allocation to GAL and an increase in the allocation to STAL. The latter is driven
       primarily by removing the capping adjustment, and hence the scale of the increase
       at STAL is much lower from 2009/10 onwards.




                                                                                                   CAA|          18
                                                                            December 2006




2     Introduction and scope of work

      Introduction
2.1   The CAA is performing a review of the costs, efficiency and business plans of
      HAL, GAL and STAL (“the Airports”), before setting the fifth quinquennial price
      control, which will apply from 1 April 2008 to 31 March 2013.        As part of this
      process, the CAA engaged LECG to undertake a review of BAA’s cost allocation
      process.


2.2   In this section, we provide context to the work we have been asked to perform.
      We summarise our terms of reference, and provide an overview of LECG. We
      summarise our approach and the information we have relied upon.             We also
      summarise certain limitations to the work we have undertaken.


2.3   Our primary focus has been to review the processes used by BAA to allocate
      centrally incurred costs, referred to as CAS and PLC costs, to the Airports and to
      BAA’s other businesses. In reaching our conclusions, we have also examined
      BAA’s approach to the allocation of certain other costs, which are allocated (or
      charged) from other businesses within the BAA group to the Airports.               In
      performing our work, we have considered the validity of BAA’s cost allocation
      drivers.


2.4   This report presents the work we have undertaken and our conclusions.

      Regulatory background
2.5   The CAA was established by Parliament in 1972 as an independent specialist
      aviation regulator and provider of air traffic services. Following the separation of
      National Air Traffic Services (“NATS”) from the CAA in 2001, the CAA became the
      UK’s independent aviation regulator, with all civil aviation regulatory functions
      integrated within a single specialist body.


2.6   The CAA has powers under the Airports Act 1986 and the Airports (Northern
      Ireland) Order 1994 for the economic regulation of airports in the UK. Any airport
      with an annual turnover of at least £1 million requires a "permission to levy airport
      charges" from the CAA. The exceptions are airports managed by the Secretary of
      State, or owned or managed by the CAA. The CAA can investigate the conduct of
      such airports and if it finds that the airport operator is unreasonably discriminating
      between users, unfairly exploiting its bargaining position or engaging in predatory
      pricing it can impose conditions to remedy the situation.




                                                                                  CAA|   19
                                                                                           December 2006




       Scope of the regulated business

2.7    Under the Airports Act 1986, the CAA sets price caps on airport charges every five
       years at airports designated by the Secretary of State, which has designated four
       airports: HAL, GAL, Manchester and STAL.                     Airport charges include runway
       charges, charges per passenger for the use of a terminal and aircraft parking
       charges.


2.8    The CAA refers the Airports to the Competition Commission (“CC”), which
       recommends a price cap and decides whether they have been acting against the
       public interest over the previous five years. The CAA has to impose conditions if
       the CC finds that an airport has been acting against the public interest, but the
       CAA takes the final decision on the price cap.


2.9    In undertaking our work, we have had regard to the scope of regulation and the
       regulatory process. Accordingly, our work has focused on the impact of BAA’s
       process on the allocation of costs to each of BAA’s designated airports.                            In
       general, we have regarded all of the other businesses within the BAA group as if
       they were a single business 6 .             Our work has also been undertaken in the
       knowledge that it may be subject to scrutiny by the CC, as well as by BAA and
       other interested parties.

       CAA’s statutory duties

2.10   In meeting its regulatory functions and setting price caps, the CAA must have
       regard to its statutory duties 7 . In so doing, the CAA is obliged to impose the
       minimum necessary level of restrictions and to take account of the UK’s
       international obligations under the Chicago Convention and various bilateral air
       service agreements. When reviewing BAA’s cost allocation processes and when
       reaching our conclusions, we have considered these statutory duties.

       CAA’s approach to the Q5 price control

2.11   The CAA states in its December 2005 policy paper that it intends to conduct the
       price control review based on the separate regulation of each airport. Therefore,
       the price control applicable to each of the designated airports will reflect the costs,
       assets and market conditions faced by each airport8. The CAA has also indicated
       that the price controls will be set under the single till approach, under which the

       6
                  In the text of this report, the other activities and businesses are generally referred to
       collectively as “the other businesses” or “BAA’s other businesses”. In certain tables and calculations,
       this is abbreviated to “Other”.
       7
                   These duties include the requirement to further the reasonable interests of airport users,
       promote the efficient, economic and profitable operations of airports, and encourage investment in new
       facilities at airports in time to satisfy anticipated future demand.
       8
                 “Airports review – policy issues, Consultation paper”, CAA, December 2005.




                                                                                                  CAA|     20
                                                                                   December 2006




       aeronautical revenue requirement, which drives the level of charges, is calculated
       after deducting certain commercial revenues. When performing our work we have
       had regard to these policy positions.

       Terms of reference
2.12   LECG’s terms of reference are set out in the CAA’s Invitation to Tender, no 1134
       (“ITT”). In paragraph 3 of the ITT, the CAA summarises our terms of reference as
       follows:


                “To implement this approach of separate regulation of airports will
                require the CAA to reach a view on how BAA allocated costs and
                revenues between its various subsidiaries and business lines.               In
                particular, the CAA will need evidence on how BAA:

             •     determines the level of inter-company transfers between its designated
                   airports and other businesses in the group; and

             •     allocates central recharges for centralised airport services and for
                   corporate     costs   between     the   designated      and    non-designated
                   businesses and, within the designated businesses, to each designated
                   airport”9.

2.13   Paragraphs 6 to 8 of the ITT set out the required scope of work in the following
       terms:


                The CAA is seeking proposals for the provision of expert advice on the
                degree to which BAA’s approach to cost and revenue allocation can be
                objectively justified and is consistent with good industry practice.
                However, the consultants should also have regard to the CAA’s
                statutory duties when advising on the approach to cost and revenue
                allocation [Paragraph 6]:


                In particular, the CAA is seeking advice in the following areas
                [Paragraph 7]:

             •     a review of BAA’s revenue and cost allocation policies, focussing in
                   particular on the objectivity with which BAA allocates costs and
                   revenues between each of its price-controlled airports and the rest of its
                   business;

       9
                ”The Requirement – Tender no. 1134, Advice to CAA on revenue and cost allocation for
       BAA’s designated airports”, CAA, April 2006.




                                                                                         CAA|    21
                                                                                           December 2006




              •    a review of the costs drivers and any other factors applied by BAA to
                   allocate costs and revenues from centralised airport services and group
                   costs to the three individual price-regulated airports, judged against both
                   recognised commercial best practice and against the CAA’s statutory
                   duties governing its price control regulation.

              The CAA is also seeking advice on whether the cost allocation
              processes are efficiently and effectively implemented and thus provide
              an appropriate basis on which the CAA can rely during the forthcoming
              price control review. In particular, the CAA is seeking advice in the
              following areas [Paragraph 8]:

              •    a review of BAA’s cost allocation processes, focussing in particular on
                   the efficiency and effectiveness with which BAA records costs and
                   revenues between each of its price-controlled airports and the rest of its
                   business;

              •    an evaluation of BAA’s cost allocation systems, judged against both
                   recognised commercial best practice and against the CAA’s statutory
                   duties governing its price control regulation.

              This advice could draw on any relevant audits conducted for BAA of its
                                                               ”10
              own accounting systems and practices.


2.14   Following LECG’s appointment, and after an initial review of information received
       from BAA, the CAA and LECG agreed that certain changes should be made to the
       scope of work. Specifically, it was agreed that LECG should no longer review
       BAA’s revenue allocation policies if they related to externally generated, third party
       revenues. Internally generated revenues, which result in income in one business
       within the group and costs in another, remained within LECG’s scope. It was also
       agreed that the scope should be extended to include “Other charges”, such as
       from BAA’s Business Support Centre (“BSC”), Heathrow Express (“HEX”) and
       certain other Corporate Office costs11.




       10
                ”The Requirement – Tender no. 1134, Advice to CAA on revenue and cost allocation for
       BAA’s designated airports”, CAA, April 2006.
       11
                  Other Corporate Office costs include costs that are allocated to Airports and other business
       directly or via some mechanism, approach or process other than that applied to the CAS and PLC
       costs.




                                                                                                  CAA|     22
                                                                           December 2006




       LECG overview
2.15   LECG is a global consulting firm, which provides independent and objective advice
       and analysis on matters of economics, finance, and strategy, to law firms,
       businesses, regulators, and governments.      Founded in 1988, LECG has 1280
       professional staff, including 381 experts, operating in 36 offices throughout the
       Americas, Europe, and Asia-Pacific.


2.16   LECG has extensive regulatory experience.       We have a long track record of
       working with regulators and regulated companies. Our experts have advised a
       wide range of regulators and regulated companies in the UK and throughout
       Europe on how to allocate revenues and costs between businesses for regulatory
       pricing purposes. We have assisted UK regulators, including Postcomm, Ofgem
       and the ORR on issues of cost allocation.


2.17   The skills required to complete the scope of work of this project for this work are
       embodied in the members of the team who have worked actively on the project.
       Members of the team have extensive regulatory experience.          The team has
       worked extensively on cost allocation issues on other price control reviews. The
       team assigned to work on this project contains a combination of accountants and
       economists with cross industry and airport specific experience.

       LECG’s approach
2.18   LECG’s approach to assessing BAA’s cost allocation process can be summarised
       as follows.




                                                                                CAA|   23
                                                                                             December 2006




       Figure 2:           LECG approach
        •   Review BAA documented cost allocation process
        •   Discuss process with key BAA management
        •   Review of the accounting system and data hierarchy           BAA’s allocation process
        •   Check consistency with regulatory precedent and CAA’s
            preferred approach

        • Build model for testing allocation process
        • Review the mechanics of the allocation process to
          identify inconsistencies and errors                        LECG review of allocation process
        • Transparency of the process

        • Review the different types of CAS and PLC costs
          allocated to the Airports and other businesses
        • Understand the nature of the different cost activities            CAS and PLC costs
        • Review how costs are calculated for each CAS and PLC
          department

        • Understand the process for calculating IT lease charges
        • Review the calculations
        • Review how costs are calculated to the Airports and                    IT leases
          other businesses
        • Consistency with RAV

        • Review other charges directly allocated to the Airports
        • Understand the nature of the different cost activities
        • Understand the process for how these charges are
          allocated                                                           Other charges
        • Consistency of application of processes across all BAA’s
          businesses

        • Review the appropriateness of applying a mark-up on
          allocated costs
        • Perform benchmarking analysis                                          Mark-up
        • Consistency of application with other regulated sectors
        • Reasonableness assessment of the level of the mark-up

        •   Understand the process of capping costs
        •   Review the basis for capping charges
        •   Review BAA supporting analysis for capping                           Capping
        •   Review the appropriateness for applying caps

        • Review the appropriateness of revenue and cost drivers
          for CAS and PLC costs
        • Compare the cost drivers used with commercial best               Cost driver analysis
          practice
        • Review alternative cost allocation drivers


       Source: LECG


2.19   We discuss each step of our approach in detail in the subsequent sections of this
       report.       We provide an overview of each step together with an outline of the
       structure of this report below.

       BAA’s allocation process

2.20   We obtained a detailed understanding of BAA’s cost allocation process and
       approach. We understand that the CAA has not examined BAA’s cost allocation
       process in detail previously. We summarise our understanding of BAA’s allocation
       process in Section 3.

       LECG review of allocation process

2.21   BAA uses a series of linked spreadsheets to allocate CAS and PLC costs. To
       evaluate BAA’s allocation process, we constructed a spreadsheet model that
       replicates BAA’s allocation methodology.                      This helped us to assess the
       transparency and accuracy of BAA’s process. Additionally, the model allows us to




                                                                                                  CAA|   24
                                                                           December 2006




       consider the impact of allocating costs on different bases.     In Section 4, we
       discuss our approach to, and the results of, our review of BAA’s allocation
       process.

       CAS and PLC costs

2.22   We obtained an understanding of the costs that are subject to BAA’s core
       allocation methodology (i.e. CAS and PLC costs). We have sought to understand
       the cause and nature of these costs. Based on information and explanations
       provided by BAA, we have reviewed individual department costs to assess the
       causal link between the costs and the Airports and the other businesses within the
       BAA group. In Section 5, we summarise the nature of CAS and PLC costs and
       the basis on which they are allocated.

       IT leases

2.23   IT lease costs are a specific category of CAS costs.        The term lease is a
       convenient term used by BAA rather than what would normally be understood by
       this term for legal or accounting purposes.       These costs are of particular
       significance as they involve complex calculations and represent one of the largest
       individual groups of allocated costs. In Section 6, we set out our understanding of
       IT lease costs, how they have been calculated and allocated. Additionally, we
       assess whether the approach adopted by BAA is appropriate for price control
       purposes.

       Other charges

2.24   The scope of the costs to be covered by LECG’s work was extended to include a
       number of additional BAA central costs, which are charged directly to the Airports
       and to BAA’s other businesses. In Section 7, we explain the nature of these costs
       and the basis on which they are allocated.

       Mark-up

2.25   Much of the cost incurred centrally is allocated at cost plus a mark-up of 7.5%.
       Different levels of mark-up, and in some cases management fees, are applied to
       other costs allocated or charged within the BAA group. In Section 2, we assess,
       for price control purposes, the appropriateness of applying a mark-up or
       management fee to operating costs allocated or charged between BAA
       businesses.    This analysis considers the appropriateness, conceptually, of
       applying mark-ups, as well as examining the level of mark-ups actually applied by
       BAA.




                                                                                CAA|   25
                                                                                       December 2006




       Capping

2.26   BAA states that their relatively simple and pragmatic approach to the allocation of
       CAS and PLC costs, might not take adequate account of the specific
       circumstances of individual airports when calculating the costs to be allocated.
       Consequently, BAA’s management exercises its judgement to adjust the allocation
       of CAS and PLC costs to the Airports in circumstances where of the application of
       the initial steps in the allocation process result in inappropriate levels of allocation.
       BAA refers to this process as ‘Capping’. In recent years, the application of this
       policy has resulted in BAA capping the level of the costs allocated to STAL.
       These costs have been reallocated from STAL to HAL and GAL. In Section 8, we
       set out BAA’s approach to capping costs and consider the appropriateness of the
       capping policy in the context of setting the Q5 price controls.

       Cost driver analysis

2.27   In Section 10, we provide a detailed review of the cost drivers used by BAA. We
       assess the appropriateness of the drivers used to allocate individual categories of
       costs between the Airports and the other businesses.                       We assess whether
       alternative drivers and allocation methods could be applied. We pay particular
       attention to the allocation of costs for which BAA has not identified a causally
       based allocation driver, and to which a default driver is applied. In addition, we
       take into consideration how such costs have been allocated in other regulated
       sectors.     In presenting our findings, we assess the sensitivity of BAA’s cost
       allocations to a range of alternative drivers.

       Information used
2.28   LECG has relied on the information provided by BAA and the CAA. This is normal
       in reviews of this nature. We summarise the key sources of information on which
       we have relied below. We also provide observations on the information provided
       to us by BAA during the conduct of our work.

       Information sources

2.29   The findings presented in this report are based largely on our review and
       consideration of the information obtained from BAA. The following are the key
       documents on which LECG has relied12:

       •    BAA/Q5/54 - Revenue and cost allocation process, BAA, January 2006;

       •    BAA/Q5/171 – BAA Central Cost, Re-charging methodology and principles,
            June 2006;

       12
                  A complete list of BAA submissions is included in Appendix 1.




                                                                                           CAA|   26
                                                                            December 2006




       •   BAA/Q5/185 – BAA CAS, PLC, IT, and Intercompany cost files;

       •   BAA/Q5/186 - BAA plc and CAS Departments, Allocations Capping and
           Pricing Margin, BAA, June 2006;

       •   CAS and PLC Group Strategic Model to 2017-18;

       •   BAA/Q5/199 and 216 – BAA cost allocation driver files;

       •   BAA/Q5/237 – BSC cost and allocation information; and

       •   BAA/Q5/300 – The Q5 Regulatory Submission.

2.30   To assist us with reaching our conclusions we have also considered a number of
       other documents. These include, but are not limited to:

       •   Airports review – policy issues, Consultation paper, CAA, December 2005;

       •   Airports review – policy update, CAA, May 2006;

       •   Economic Regulation of BAA London Airports (HAL, GAL and STAL) 2003-
           2008: CAA decision, CAA, February 2003;

       •   Airport Cost Allocation - Report for the CAA by Europe Economics, Europe
           Economics, April 2001;

       •   BAA plc: a report on the economic regulation of the London airports
           companies (Heathrow Airport Ltd, Gatwick Airport Ltd and Stansted Airport
           Ltd), Competition Commission, November 2002;

       •   High Level Review of Cost and Revenue Allocations at BAA London Airports
           under a RRCB, AviaSolutions, February 2002;

       •   The Economic Regulation of Airports, Recent developments in Australasia,
           North America and Europe, Edited by Peter Forsyth et al; and

       •   other regulator’s reports, which are referenced in the relevant sections of this
           report.

       Information process and quality

2.31   During our review, we worked with the CAA to gather the information necessary to
       complete our agreed scope of work. In so doing, we sought to ensure that all
       information requests were made on a timely and reasonable basis, prioritised and
       documented. We sought to agree the timing of BAA’s responses in advance.




                                                                                 CAA|   27
                                                                                          December 2006




2.32   A significant amount of data was requested and we acknowledge that the
       impending take-over of the company, and the associated work and information
       requirements, meant that BAA was unable to respond to the information requests
       as efficiently as would otherwise be possible.               Notwithstanding the above, we
       believe that there were important areas in which BAA’s responses were deficient.


2.33   Central to this observation was the lack of standing documentation, such as an
       accounting procedures manual, which would normally provide details on the basis,
       operation and rationale underlying the cost allocation process.                    Consequently,
       many of BAA’s responses appeared to be generated specifically in response to
       LECG’s requests.         Normally we would expect to be provided with existing or
       contemporaneous documentation.


2.34   Additionally, as is explained subsequently in this report, LECG identified a number
       of areas in which the documentation, spreadsheets and other aspects associated
       with BAA’s approach appeared to contain errors, inaccuracies or inconsistencies.


2.35   We believe that as a function of the lack of documentation and/or the way in which
       calculations are performed, BAA’s allocation process lacks transparency in a
       number of areas.


2.36   Based on our experience, and our understanding of the requirements and practice
       in other regulated companies and sectors, we believe that the quality of BAA’s
       documentation, its processes and its application of quality assurance procedures
       falls short of best practice13.


2.37   If the CAA wishes to apply the concept of separate regulation and monitor its
       implementation effectively and efficiently, we believe that this requires improved
       documentation, information systems, processes and controls on the part of BAA,
       in relation to cost allocation.

       Limitations to our work
2.38   LECG has reviewed the internal consistency of data supplied to us by BAA.
       However, nothing in this report should be taken to imply that we have conducted
       any procedures or investigations in an attempt to verify or confirm, by means of
       reviewing source documentation or processes, the accuracy of the data underlying

       13
                  LECG has recently completed a project for the Commission for Communications Regulation
       (“ComReg”), the telecommunications and postal sector regulator in Ireland, in which we advised on the
       regulatory financial reporting and cost accounting obligation that should apply to AnPost. As part of
       LECG’s work, we reviewed the reporting and costing standards and policies in a range of regulated
       industries.    LECG’s report has been published on the ComReg website, www.comreg.ie/-
       fileupload/publications/ComReg0655a.pdf.




                                                                                                CAA|     28
                                                                                       December 2006




       BAA’s cost accounting systems or other supplementary information. Our work
       does not constitute an audit14.


2.39   This report has been written solely for the use of the CAA. We are aware that the
       CAA may rely in part on our findings, as set out in this report, in its determination
       of the price controls applicable to the Airports. We are also aware that the findings
       of this report will be provided to BAA before publication as part of the process of
       the determination of the price control and may be made publicly available by the
       CAA15.




       14
                 Based on the terms of our agreed scope of our work we have not substantiated the numbers
       included in BAA’s financial and accounting systems.
       15
                  We understand that the CAA may decide to excise commercially confidential information
       from the final report.




                                                                                              CAA|    29
                                                                                      December 2006




3     BAA’s allocation process

      Introduction
3.1   Within the BAA group, a range of support functions and services are provided
      centrally. Where these costs are incurred in relation to the provision of goods or
      services from one company to another in the normal course of business, these
      costs are charged directly to each company. Where a direct relationship cannot
      be identified, which applies to many of the support services provided by BAA
      centrally, the relevant costs are allocated by BAA in accordance with its allocation
      methodology.


3.2   In this section, we first provide context to BAA’s approach to recharging and
      allocating costs. We provide a diagrammatic illustration of BAA’s methodology.
      We describe BAA’s processes for charging and allocating central costs to the
      Airports and to BAA’s other businesses. Finally, we provide observations and
      concluding remarks on BAA’s approach and processes.

      Context to BAA’s approach
3.3   We understand that BAA’s approach to charging and allocating costs has been
      developed over time. It has evolved to take account of the development of BAA’s
      business and changes to the nature of centrally incurred costs. When developing
      and applying its approach, BAA’s objectives have been to:


            “ensure that individual businesses and company entities reflect the
            proper cost of operations.          This is necessary to ensure that the
            companies’ accounts comply with current accounting standards”;

            “ensure that, from a taxation point of view, costs which are relevant to
            other group businesses are borne by those companies”; and

            “create a robust accounting relationship between the providers of
            services and the businesses they support 16.“

3.4   BAA states that its charges and allocations of costs to the Airports and its other
      businesses are:

            “…. based on pragmatic, simple and cost effective principles and
            methods which do not require the use of specialist systems, excessive



      16
              BAA/Q5/54 – “Revenue and cost allocation process”, BAA, January 2006.




                                                                                          CAA|   30
                                                                                    December 2006




             administration or maintenance (unless clear benefits of the use of more
             sophisticated specialist approaches can be justified)”17.

3.5   In relation to its choice of drivers on which to allocate costs, BAA has informed
      LECG that:


             “The basis of allocation generally emphasises the virtues of a relatively
             simple and pragmatic approach.            Bases of allocations vary but are
             largely related to passengers volumes or operating profit (with some
             instances of allocation on the basis of other ‘drivers’ where
             appropriate)”18.

3.6   The results of applying BAA’s approach to the allocation of costs are recorded in
      the statutory financial statements of each entity within the group, and these
      financial statements are annually subject to audit by BAA’s external auditors.


3.7   BAA accepts that a more sophisticated methodology (e.g. using a more advanced
      ABC system) might result in different allocations. However, BAA feels this would
      not materially affect the overall results. Consequently, the cost and additional
      effort of developing a more advanced system cannot be justified19.

3.8   BAA’s allocation process is not documented extensively. Accordingly, BAA has
      been unable to provide standing documentation (such as accounting procedures
      manuals) detailing its approach, or contemporaneous documents supporting the
      derivation of the process. For the purposes of the price control review, BAA has
      produced and provided to LECG documents that explain its approach and the
      underlying rationale.       BAA’s approach has also been communicated and
      discussed in numerous meetings with LECG.

      Identification of costs to be charged or allocated
3.9   In the absence of documentation from BAA, we set out below our understanding of
      BAA’s overall approach to identifying and allocating costs.




      17
               BAA/Q5/171 – “BAA Central Cost Re-charges Principles”, BAA, June 2006.
      18
               BAA/Q5/186 – “BAA plc and CAS Departments: Allocations Capping and Pricing Margin”,
      BAA, June 2006.
      19
               Communicated to LECG during meetings with BAA.




                                                                                        CAA|   31
                                                                                                                            December 2006




       Figure 3:         BAA’s process for determining appropriate levels of costs to be
                         allocated or directly charged to the Airports and other
                         businesses

                                                            OFA data (general ledger detail)




                                                            Cost centre financial statements



                                                                  Deduct net interest /
                                                                     exceptionals



                                                             Adjusted cost centre financial
                                                                      statements




                                                                       CAS & PLC cost
                        Other cost centres
                                                                          centres




                                                            ‘Direct’                               ‘Indirect’
                                                           charges                                 charges



                                                                                 CAS & PLC Non
                                                                                                                       IT cost centres
                                                                                 IT cost centres




                                                                                                            Group IT                 IT ‘lease’
                                                                                                              cost                     costs




                                                                                      CAS & PLC
                                                                                        ‘Bible’




                                                                         CAS & PLC                        CAS & PLC
             Airports       BSC              HEX   Other                   ‘Direct’                        ‘Indirect’
                                                                          charges                          charges



       Source: LECG analysis.


3.10   BAA’s approach is based upon a detailed, bottom-up analysis of the projected
       costs undertaken at the level of individual budget centres using information
       contained within BAA’s financial and accounting systems20. This information is
       used to produce financial statements for each cost centre.21


3.11   Consistent with its usual business planning processes, BAA has developed
       bottom-up forecasts at the budget centre level for each of the years up to and
       including 2008/09. For future periods, BAA rolls forward the 2008/09 forecast
       using inflation, high-level Corporate Office staff real wage growth assumptions,



       20
                 A budget centre, in BAA’s terms, is the lowest level in the organisational hierarchy for which
       BAA projects or records cost and revenue information. This corresponds to what in many
       organisations, and more generally, is referred to as a cost centre.
       21
                   This corresponds to the top two boxes in Figure 3.




                                                                                                                                         CAA|     32
                                                                                         December 2006




       taking into account the contribution of staff costs to the total costs of each CAS
       and PLC department and other reasonably certain factors22.


3.12   When developing its projections of costs to be charged or allocated, BAA makes
       two adjustments, both of which are appropriate for price control purposes. The
       first adjustment is to deduct net interest on internal loans and receivables. Interest
       is not normally included within the consideration of efficient operating costs for
       price control purposes. Financing costs, including those related to working capital,
       are normally taken into account when setting the allowable rate of return and the
       regulatory capital value (“RCV”) to which it should be applied.


3.13   The second adjustment is to remove all exceptional costs. To make forward-
       looking projections of efficient operating costs for price control purposes, it is
       normal practice to remove the effect of exceptional items and any one-off costs, as
       they are not expected to be incurred in a normal year of operation23.


3.14   The projected level of costs calculated by BAA is prepared on an accounting
       basis, rather than the cash basis24. We have discussed this issue with BAA. We
       understand that the principal non-cash item included within the costs is
       depreciation. On average, depreciation accounts for approximately 2.3% of total
       costs between 2005/06 & 2008/09 (i.e. £3.7m in 2005/06) 25. This depreciation
       principally relates to fixtures and fittings, furniture, IT assets and other office
       equipment used by the CAS and PLC departments.


3.15   For the purposes of setting the price control, this may not be an issue (i.e. no
       adjustment need apply) because the projected costs to be allocated do not include
       any allowance for capital expenditure.                 Hence, no double counting arises.
       However, to the extent that the CAA makes an allowance for capital expenditure
       on assets to be used in the provision of central services when setting the overall
       allowance for capital expenditure, the level of allocated costs would need to be
       adjusted to exclude depreciation costs.




       22
                 For example, the profile of costs of the Economics and Regulation department takes into
       account the timing of work associated with the quinquennial reviews. BAA has also included specific
       assumptions on likely trends in insurance costs.
       23
                 We recognise that in future years such events may occur and understand that to the extent
       that these can be forecast, the CAA will consider these separately when developing its price control
       proposals.
       24
                A cash basis is normally used for price control purposes.
       25
                This assessment of the level of depreciation included in total allocated costs excludes an
       immaterial level of depreciation contained within the costs recharged from BSC to corporate
       departments.




                                                                                               CAA|     33
                                                                                           December 2006




3.16   BAA then separates the cost centres between those relating to specific
       businesses, such as BSC and HEX, which each have their own basis for charging
       costs, and those associated with CAS and PLC department costs. This step in the
       process is illustrated in the middle of Figure 3 above.


3.17   BAA then identifies costs that can be charged directly to the Airports, and
       separates these from the remaining CAS and PLC costs, which will be allocated
       as an indirect charge.


3.18   The next stage, separates costs relating to IT cost centres from those associated
       with non-IT cost centres.              The non-IT cost centres are aggregated into
       departments, the costs of which are subsequently allocated on a common basis.
       In the remainder of this section, we refer to these aggregations of non-IT cost
       centres as central “cost categories”. The total cost of each central cost category is
       summarised in the CAS and PLC ‘Bible’26.


3.19   BAA’s allocation of IT cost centres is more complex than that applied to central
       cost categories. BAA undertakes a more detailed analysis of the IT costs incurred
       at the budget centre level and aggregates, for allocation purposes, the costs of
       those budget centres that are to be allocated using the same driver.


3.20   The final stage in BAA’s process is to combine CAS and PLC ‘Bible’ data with the
       analysis of IT costs into a single summary document, which contains total CAS
       and PLC indirect charges. This data is the starting point for the allocation process
       described below.


3.21   The table below identifies the different CAS and PLC departments included in the
       ‘Bible’




       26
                 The Bible lists all of the budget centre codes that BAA uses in its CAS and PLC indirect cost
       allocation process, and summaries how costs are aggregated into cost categories. The Bible
       documents are contained within BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls” (2005/06) and BAA/Q5/252 “OFA ORG’s.xls” (2006/07-2008/09).




                                                                                                  CAA|     34
                                                                            December 2006




       Table 6:        CAS and PLC departments in 2005/06

                       CAS departments                        PLC departments

       GPIT                                      Board

       GPIT Lease Plan                           Finance (including Insurance)

       AMA                                       Business Assurance

       Group Health & Safety                     HR

       Group security                            Facilities Management/Property

       Research                                  Corporate Affairs

       Airport planning                          Corporate Affairs

       Airline Relations Team                    Economics & Regulation

       Corp Responsibility & Environment         Legal

       Rail strategy                             Company secretary

       Divisional Managing Director              SMIS & NIC

       Divisional Airport Director

       Group Marketing

       Olympic 2012

       UK airports retail

       Chief Fire Officer

       Group Services Director

       Airport Operations

       Group retail

       WDF Finance & Customer progs

       Common Costs

       Common Costs - exceptional receipt

       Source: BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06 SUMMARY.xls”.


3.22   We discuss the activities of each department in more detail in Section 5.         In
       Appendix 2, we show BAA’s original cost allocation submissions for 2005/06 to
       2012/13. These tables disclose the various different CAS and PLC departments
       and their associated costs and drivers.

       BAA’s cost allocation methodology
3.23   The figure below summarises our understanding of BAA’s approach to allocating
       costs to the Airports and to BAA’s other group businesses. In the interest of
       completeness and consistency with the information contained in Figure 3 above,
       we summarise how direct costs are charged from HEX and BSC.



                                                                                  CAA|   35
                                                                                                                       December 2006




       Figure 4:            BAA’s cost allocation process
                                Pre
                                March                Total CAS and PLC costs (Indirect costs)
                                 06


                                                                                                               7.5%
                                                                                                               M ark           BSC
                                                            em
                                                           R ove inappropriate costs
                                                                                                                -up



                                                                                                                              7.5%
            IT ‘lease’
                                                        Mark-up remaining costs by 7.5%                                       Mark
              costs                                                                                                            -up
                                     Post
                                     March
                                      06
                                                    Applymarked-up costs to allocation drivers




                         Heathrow        Gatwick    Stansted           Other              Other      Other         Other



                                                                Capping adjustments


            10%
                         Heathrow        G atwick   Stansted           Other              Other      O ther       O ther
            Mark
                          adjusted       adjusted   adjusted          adjusted           adjusted   adjusted     adjusted
            -up


            HEX
                                                               Corporate Office direct
                                                                     charges


       Source: LECG analysis, BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”, BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”, and BAA
       submission “CAS and PLC GSM TO 2017-18.xls”


3.24   We provide below an overview of each step in BAA’s process.

       Total CAS and PLC costs

3.25   Total CAS and PLC indirect costs represent the total of each cost category
       (including Group IT and IT lease costs27) to be allocated to the Airports and to
       BAA’s other group businesses. They are the output of the cost identification and
       calculation process described above.

       Remove inappropriate costs

3.26   Before allocating CAS and PLC costs to the Airports and to BAA’s other
       businesses, BAA deducts certain costs, which it believes it would be inappropriate
       to allocate. BAA states:




       27
                  IT leases are shown separately on the diagram because they are the only cost category,
       after inappropriate costs have been removed, which is not marked up.




                                                                                                                            CAA|     36
                                                                                           December 2006




               “Costs which are uniquely related to the activities of the plc entity and in
               all likelihood would not otherwise be incurred by the subsidiary
               businesses should NOT be recharged”28.

3.27   The following costs are not allocated to the Airports29: Common Costs; Common
       Costs – exceptional receipt; Group Airports; WDF Finance & Customer
       programmes; Board; Company secretary; Travelex; and Senior Management
       Incentive Scheme and National Insurance Contributions (SMIS & NIC). The level
       of excluded costs from the cost allocation process is summarised below.

       Table 7:       Unallocated CAS and PLC department costs

       £k Nominal                            05/06           06/07           07/08              08/09
                        30
       Common Costs                             |||||||         |||||||          |||||||        ||||||||||

       Exceptional receipt                 |||||||||||||             ||               ||                ||

       Group Airports                                ||              ||               ||                ||

       WDF Finance & Customer                ||||||||||              ||               ||                ||

       Corporate Affairs                     ||||||||||      ||||||||||       ||||||||||        ||||||||||

       Board                                 ||||||||||      ||||||||||       ||||||||||        ||||||||||

       Company secretary                     ||||||||||      ||||||||||       ||||||||||        ||||||||||

       Travelex                                      ||      ||||||||||               ||                ||

       SMIS & NIC                            ||||||||||      ||||||||||       ||||||||||        ||||||||||

       Total                                |||||||||||     |||||||||||      |||||||||||       |||||||||||

       Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”, BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”. Note: negative
       numbers represent reductions in costs.


       Adjustments to CAS and PLC costs

3.28   It is sometimes necessary for BAA to make further adjustments to CAS and PLC
       costs. Two adjustments are made by BAA: (i) changes to CAS and PLC forecasts
       by senior management after the original detailed cost centre forecasts are
       finalised; and (ii) changes to the profiling of IT lease costs.




       28
                  BAA/Q5/171 – “BAA Central Cost Re-charges Principles”, BAA, June 2006.
       29
                 These costs are described in more detail in Section 5 and are identified as those cost
       categories in Appendix 2 that are entirely allocated to the Corporate Office (“CO”).
       30
                 Common Costs relate to a variety of miscellaneous costs, such as employers’ national
       insurance contributions on bonuses.




                                                                                               CAA|          37
                                                                                         December 2006




       Senior management adjustment

3.29   These adjustments are made by BAA’s senior management to reflect changes to
       the budgets of certain departments. These adjustments are applied on a bottom-
       up basis, through the relevant codes, to alter the costs of specific CAS and PLC
       departments31.


3.30   Adjustments are applied from 2005/06 to 2008/09.                   There is no management
       adjustment beyond 2008/09. This reflects the top down approach adopted by BAA
       at this stage, where CAS and PLC costs in 2009/10 to 2012/13 are rolled forward
       from 2008/09 using inflation and growth rates. We detail in the table below the
       senior management adjustments that have been included in the projected cost
       information provided by BAA.




       31
                 There is one exception to how senior management adjustments are applied. In the OFA
       data supplied to LECG for 2006/07, the adjustment for UK Airports Retail had not been applied to the
       cost categories. BAA were unable to provide us with an explanation as to why and therefore we are
       unable to comment on the manner in which this particular adjustment has been applied or its
       appropriateness.




                                                                                               CAA|     38
                                                                                               December 2006




       Table 8:        BAA senior           management             adjustments           (CAS        and             PLC
                       departments)

                                                            2006/07           2007/08                2008/09

       BAA IT                                              |||||||||||||         |||||||||                     ||

       AMA - Capital                                       |||||||||||||     |||||||||||||           |||||||||||||

       AMA – Supply Chain                                      |||||||||         |||||||||              |||||||||

       Rail Strategy                                                  ||                ||                     ||

       UK Airports Retail                                      |||||||||         |||||||||              |||||||||

       Common Costs32                                      |||||||||||||           |||||||                |||||||

       Finance (including Insurance)                                  ||         |||||||||              |||||||||

       HR                                                      |||||||||         |||||||||              |||||||||

       Facilities Management/Property                         ||||||||||           |||||||                |||||||

       Corporate Affairs                                       |||||||||         |||||||||              |||||||||

       SMIS & NIC                                              |||||||||         |||||||||              |||||||||

       Total                                              ||||||||||||||      ||||||||||||           ||||||||||||

       Source: BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”. Note: negative numbers
       represent reductions in costs.


       IT lease adjustment

3.31   We understand that BAA has reappraised the useful economic life of certain IT
       assets. The adjustment reflects changes to the projected allocation and profiling
       of IT lease costs. The adjustment is allocated to the Airports and to BAA’s other
       businesses on the same basis as the leases to which it relates. We detail the
       adjustments to IT lease costs in the table below.

       Table 9:        IT lease adjustments

                                   05/06         06/07         07/08       08/09             09/10            10/11

       BAA IT lease plan              -         (7,000)       (4,200)      4,200             3,351            2,513

       Source: BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”. Note: negative numbers
       represent reductions in costs.

       32
                  As stated previously, these costs are not applicable for the cost allocation to the regulated
       airports. For completeness, however, we state the adjustment applied to this cost category.




                                                                                                          CAA|        39
                                                                                           December 2006




       Mark-up to CAS and PLC costs

3.32   Adjusted CAS and PLC costs to be allocated to the Airports and to BAA’s other
       businesses are then marked-up by 7.5%. BAA applies a mark-up to all of the
       remaining costs with the exception of the IT lease costs33. The appropriateness of
       applying a mark-up and of the level of the mark-up applied by BAA is addressed in
       more detail in Section 2.

       Cost allocation drivers

3.33   BAA then applies selected drivers to allocate adjusted CAS and PLC costs. The
       IT lease costs and Group IT costs are subject to a more detailed, bottom-up,
       allocation process, which is intended to reflect the usage of individual systems and
       services. In Section 10, we discuss the basis on which BAA has selected the
       allocation drivers, together with LECG’s views on their appropriateness.

       Capping

3.34   BAA has explained that its methodology relies on high-level principles and drivers.
       BAA recognised that these high-level principles might not adequately reflect the
       particular circumstances of the individual airports. In particular, they might not
       reflect the degree to which operational complexity at larger airports (particularly
       Heathrow) drives solutions and costs, which would otherwise not be adopted by
       the smaller locations. Subsequently, there is a risk that the allocation process
       would unfairly burden smaller airports unless adjustments are made to the output
       of BAA’s calculations34.

3.35   Consequently, BAA’s overall cost allocation process involves a step in which
       senior managements review the allocations of costs, resulting from the
       calculations described above.            Commercial judgement is then exercised to
       determine what senior management believes represents a more appropriate
       allocation of costs. BAA applies this judgement through an adjustment referred to
       within BAA as ‘capping’.

3.36   LECG has reviewed the application of the capping process in detail. The results
       of our review are set out in Section 9.

       Costs allocated to the Airports and the other businesses

3.37   The results of the application of BAA’s process, for CAS and PLC costs, for the
       period 2005/06 to 2012/13, are shown in Appendix 2. The table below shows the
       allocation of CAS and PLC costs for 2005/06.


       33
               Until the start of 2006/07, BAA also applied a mark-up to the IT lease costs.
       34
               BAA/Q5/1871 – “BAA Central Cost, Re-charging methodology and principles”, BAA, June
       2006




                                                                                               CAA|   40
                                                                                       December 2006




       Table 10:    Allocated CAS and PLC costs in 2005/06

       £ 000                            HAL          GAL          STAL         Other            Total

       CAS                              58,744       22,022       10,404       ||||||||||||   ||||||||||||||

       PLC                              15,280        3,817        1,741       ||||||||||||    ||||||||||||

       Total                            74,024       25,840       12,145       ||||||||||||   ||||||||||||||

       Source: BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06 SUMMARY.xls”


       Other charges
3.38   A number of additional costs are charged to the Airports and to BAA’s other
       businesses. These costs include: (i) Corporate Office ‘direct’ costs; (ii) BSC; and
       (iii) HEX.

3.39   Corporate Office ‘direct’ costs are charged directly to the Airports and to BAA’s
       other businesses. BAA does not apply a mark-up on Corporate Office ‘direct’
       costs.

3.40   BSC costs are allocated to the Airports and BAA’s other businesses using various
       allocation drivers. Some of BSC’s costs are also allocated to the CAS and PLC
       departments. Consequently, these costs are included in the allocation of CAS and
       PLC costs to the Airports. BSC costs are allocated to CAS and PLC with a 7.5%
       mark-up.


3.41   HEX operating costs are directly charged to HAL. HEX also charges HAL a 10%
       management fee on the costs it incurs.

       LECG’s observations and conclusions
3.42   BAA’s approach to charging and allocation is designed to meet statutory financial
       reporting and taxation requirements as well as for use in budgeting and long term
       financial planning.    It has not been developed specifically for the purposes of
       providing information to the CAA or producing results that are necessarily
       appropriate for price control purposes35.

3.43   We take comfort from the fact that the financial statements, which incorporate the
       results of BAA’s charging and allocation process, have been subject to external
       audit. However, we note that the scope and materiality of this audit, particularly in


       35
                We note that output from applying BAA’s approach has been supplied to the CAA and the
       CC at previous price control reviews.




                                                                                              CAA|       41
                                                                              December 2006




       relation to items that are eliminated on consolidation to produce the accounts of
       BAA, may not result in the level of scrutiny that is appropriate for price control
       purposes.

3.44   In the interests of economy, BAA adopts a simple and pragmatic approach to the
       allocation and charging of costs. It seeks only to bring in complexity where it
       believes that the scale and nature of the costs involved, for example IT costs,
       warrant the additional effort required to undertake a more detailed approach.

3.45   BAA relies on management review and the use of ex-post adjustments to address
       situations in which the allocation of costs implied by its calculations appears
       unreasonable.

3.46   However, BAA’s approach is poorly documented and there does not appear to be
       a procedures manual or other standing documentation.             There is a lack of
       contemporaneous documentation explaining the basis for particular assumptions
       and decisions.    Consequently, there is no record of how and why particular
       allocation drivers are assigned. In addition, there is no stated explanation of how
       the capping adjustments are calculated.

3.47   A final issue with a high-level process, such as that adopted by BAA, is that it is
       difficult to assess whether an alternative more detailed approach would result in
       significantly different allocations of costs. Whilst BAA’s management argue that
       they use their experience to adjust costs through capping to ensure an equitable
       allocation of costs, it is important to recognise that this approach is not necessarily
       accurate and is extremely judgmental. Consequently, the lack of evidence and
       analysis supporting BAA’s methodology raises concerns as to the appropriateness
       of the allocation process in the context of this study.




                                                                                    CAA|   42
                                                                                          December 2006




4     LECG review of BAA’s allocation process

      Introduction
4.1   In this section, we review the accuracy of BAA’s approach. We first discuss our
      approach to testing BAA’s allocation process. We then summarise our findings in
      relation to two areas: (i) ad hoc errors and inconsistencies identified in BAA’s cost
      allocation calculations; and (ii) specific errors in BAA’s calculation of IT lease
      costs.

      Testing BAA’s allocation process
4.2   To test the accuracy of BAA’s allocation process, LECG constructed a
      spreadsheet model to replicate BAA’s cost allocation methodology and
      calculations. We compared the output generated from our model with the output
      from BAA’s own cost allocation process. We then investigated the cause of any
      differences with BAA. From this analysis, we were able to assess the accuracy of
      BAA’s cost allocation methodology.


4.3   The LECG cost allocation model also allows us to test alternative cost allocation
      drivers, as required by our terms of reference. The results of this analysis are
      summarised in Section 10.

      The model

4.4   LECG’s model was built in Microsoft Excel and uses BAA’s cost and allocation
      driver data36. The model uses BAA’s data to calculate the allocation of CAS and
      PLC costs to each of the Airports and to BAA’s other businesses for the period
      2005/06 to 2012/13. The figure below provides a conceptual summary of how the
      LECG model operates. A more detailed description of the LECG model is set out
      in Appendix 3.




      36
                 The key assumptions used in the model are those contained in the summary documents,
      which BAA has referred to as the ‘Bible’. These documents list all of the budget centre codes that BAA
      uses in its CAS and PLC indirect cost allocation process, and summaries how costs are aggregated
      into cost categories. We have tested whether BAA’s application of its allocation process includes each
      budget centre code listed in the ‘Bible’ documents. We have not been asked to substantiate the raw
      data included in BAA’s accounting systems or the validity of the assumptions summarised in the ‘Bible’
      documents.




                                                                                                CAA|     43
                                                                                                   December 2006




      Figure 5:       LECG’s cost allocation model
                                BAA
          LECG                                                                           OFA data
                                driver               CAA data
           data                                                                      (CAS & PLC and IT)
                                 data




                                                 General Inputs
           Allocation Drivers                                                       OFA data assumptions
                                              (including scenarios)




                                Allocation of OFA data




                                    Outputs before                       Output post adjustment
                                     adjustments                             from prior year




                                   BAA adjustments
                                                                          Inflation adjustment
                                      to output




                                  LECG adjustments
                                                                            Real cost growth
                                     to output



                                         2005/06 –                             2009/10 –
                                          2008/09                               2012/13




                                                           Output post               Mark up
                                                           adjustments               or not




      Source: LECG


4.5   The comparison of outputs between LECG’s and BAA’s models highlighted
      various differences. LECG discussed these differences with BAA and agreed that
      they related inconsistencies between the models or to errors in BAA’s model.
      Specifically, these related to:

      •      the application of a mark-up to IT lease costs in 2005/06 resulting in an
             overstatement of allocated costs of |||||||||||;




                                                                                                           CAA|   44
                                                                                                                December 2006




       •        the exclusion of ||||||||||| of SMIS & NIC costs in 2005/0637; and

       •        the exclusion of ||||||||||| of BAA Retail costs in 2006/0738.

4.6    The first item above does not constitute an error because during 2005/06 it was
       BAA’s policy to apply a mark-up to IT lease costs and hence it would be
       appropriate for this to be included in BAA’s figures.                                      From the beginning of
       2006/07 BAA no longer applies a mark-up to these costs.                                               An adjustment is
       required to remove the mark-up applied in 2005/06, to update the information for
       BAA’s current policy, and to state all of the figures on a consistent basis.


4.7    The ||||||||||| difference in the SMIS and NIC costs represents a movement in a
       provision. We have adjusted for this in our modelling.


4.8    The third item relates to forecast 2006/07 OFA data39 that has been superseded by
       the OFA data supplied to LECG40. This was the only observed instance of where
       BAA had not used the most up to date forecasts (as provided to LECG) in any of
       its calculations.


4.9    The table below provides a reconciliation between the output of the LECG model
       and BAA’s submissions.

       Table 11:         Comparison of allocation outputs (pre capping)

           £m nominal             05/06       06/07        07/08        08/09        09/10         10/11        11/12        12/13


           BAA’s original
                                 ||||||||||   ||||||||||   ||||||||||   ||||||||||   ||||||||||    ||||||||||   ||||||||||   ||||||||||
           submission

           Corrections            (0.8)*           0.5           -            -            -             -            -            -


           LECG output           ||||||||||   ||||||||||   ||||||||||   ||||||||||   ||||||||||    ||||||||||   ||||||||||   ||||||||||

       Source: LECG analysis, BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”, BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”, and BAA
       submission “CAS and PLC GSM TO 2017-18.xls” * Note: calculated as the net impact of IT lease cost
       adjustments (||||||||||| reduction in costs) and SMIS & NIC costs (||||||||||| increase to costs).


4.10   The table below summarises how correcting for the errors and inconsistencies
       identified above changes the allocation of costs to each Airport.

       37
                  These costs are not allocated to the Airports and to BAA’s other businesses.
       38
                  This would be ||||||||||||| after application of the mark-up.
       39
                  In BAA’s submission: “CORP OFA STRUCTURE & ACTUALS MAR 06 SUMMARY.xls”.
       40
                  As contained in BAA/Q5/185 -20 “corp p&l bus plan 06-09 UKA Retail.xls”.




                                                                                                                          CAA|     45
                                                                                                   December 2006




       Table 12:      Impacts on Airport allocations for 2005/06

       £k nominal              HAL               GAL              STAL              Other                 Total


       BAA’s original
                              74,025            25,839            12,145            ||||||||||||        ||||||||||||||
       submission

       Corrections             (1,414)             (667)             (258)           ||||||||||              |||||||||

       LECG model
                              72,611            25,172            11,887            ||||||||||||        ||||||||||||||
       output

       Source: LECG analysis, BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”.


       IT lease calculation

4.11   To test BAA’s allocation process further we used our model to perform a detailed
       review of BAA’s calculation and allocation of IT lease costs. IT lease costs were
       reviewed in detail due to the complexity of the calculations involved and the
       materiality of the costs in the context of total CAS and PLC costs41.


4.12   In summary, this review entailed replicating BAA’s stated calculations and
       investigating the cause of any observed differences. From this we discovered
       calculation errors in two areas:

       •      the calculation of lease charges in the years 2005/06 to 2008/09: errors
              were identified in BAA’s mechanism for aggregating groups of leases into a
              single annual charge. Observed errors included double counting leases and
              using incorrect asset life assumptions; and

       •      the calculation and application of top down management adjustments
              affecting the level of IT lease costs in the years 2006/07 to 2010/11: an error
              was carried forward from the 2005/06 to 2008/09 charges, meaning that the
              adjustment was incorrectly calculated.

4.13   The table below summarises the impact of correcting these errors42.


       41
                  For the period 2005/06 to 20012/13, IT lease costs represent, on average, 26% of total CAS
       and PLC costs. Group IT costs account for 33% of total CAS and PLC costs. Therefore, on average,
       total IT related costs account for over 50% of CAS and PLC costs. We understand that the risk of a
       material error arising in the calculation of Group IT costs is lower than for IT lease costs, because the
       former can be verified to underlying transactions recorded within BAA’s accounting records and to
       supporting documents in a way that is not possible with the IT lease costs.
       42
               BAA has acknowledged these errors, which are contained in its main Regulatory submission
       (BAA/Q5/300).




                                                                                                       CAA|         46
                                                                                                            December 2006




       Table 13:     IT lease costs (post adjustment)

       £m
                      05/06      06/07          07/08          08/09          09/10          10/11          11/12            12/13
       nominal

       BAA
                      37,932    ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||     ||||||||||||
       original

                                ||||||||||||   ||||||||||||                  ||||||||||||   ||||||||||||
       Correction     (2,844)                                      |||||||                                    |||||||||        |||||||||
                                           |              |                             |              |

       BAA
                      35,088    ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||   ||||||||||||     ||||||||||||
       adjusted

       Error as %
                      (7.5%)    ||||||||||||   ||||||||||||      |||||||||   ||||||||||||   ||||||||||||   ||||||||||||     ||||||||||||
       of original

       Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”, BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”, and BAA
       submission “CAS and PLC GSM TO 2017-18.xls”


       Results and conclusions
4.14   We have been able to replicate BAA’s cost allocation process based on its stated
       assumptions and approach. In so doing, we identified a number of inconsistencies
       and errors in BAA’s calculations. We note that the majority of the errors relate to
       small mistakes in the development or use of BAA’s cost allocation spreadsheets,
       which were not detected by BAA’s internal review procedures.


4.15   The total impact of the adjustments identified above are summarised in the table
       below.




                                                                                                                          CAA|      47
                                                                                                                         December 2006




       Table 14:      Summary of errors in BAA calculation of allocated costs


        £m nominal          05/06         06/07         07/08          08/09           09/10             10/11            11/12             12/13


        Process
                               (0.8)           0.5                 -               -                -                -                -                -
        corrections

        IT Lease
                               (2.8)         (1.4)         (2.2)            0.7           (2.3)             (1.0)            (0.3)             (0.8)
        corrections


        Total
                               (3.6)         (0.9)         (2.2)            0.7           (2.3)             (1.0)            (0.3)             (0.8)
        Correction

        % of CAS and        |||||||||||   |||||||||||   |||||||||||                    |||||||||||       |||||||||||      |||||||||||       |||||||||||
                                                                         |||||||||
        PLC costs                     |             |             |                              |                 |                |                 |

       Source: LECG analysis. Note: negative numbers represent reductions in costs


4.16   We illustrate the impact of these errors on the allocation of costs to the Airports
       and other businesses in the tables below.                                  First, we show BAA’s costs pre
       adjustment and pre capping.

       Table 15:      BAA’s CAS and PLC costs pre capping

        £m nominal            05/06        06/07         07/08         08/09           09/10            10/11            11/12            12/13


        HAL                     74.0      ||||||||      ||||||||       ||||||||        ||||||||||       ||||||||||       ||||||||||       ||||||||||


        GAL                     25.8      ||||||||      ||||||||       ||||||||        ||||||||         ||||||||         ||||||||         ||||||||


        STAL                    12.1      ||||||||      ||||||||       ||||||||        ||||||||         ||||||||         ||||||||         ||||||||


        Other                   34.2      ||||||||      ||||||||       ||||||||        ||||||||         ||||||||         ||||||||         ||||||||


        Total                 146.1       |||||||||     |||||||||      |||||||||       |||||||||        |||||||||        |||||||||        |||||||||

       Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls”, BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”, and BAA
       submission “CAS and PLC GSM TO 2017-18.xls”


4.17   In the table below, we show BAA’s costs after adjustment and pre capping.




                                                                                                                                    CAA|         48
                                                                                                      December 2006




       Table 16:       BAA’s adjusted CAS and PLC costs pre capping

        £m nominal            05/06       06/07       07/08       08/09       09/10       10/11       11/12         12/13


        HAL                     72.7      ||||||||    ||||||||    ||||||||    ||||||||    ||||||||    ||||||||     ||||||||


        GAL                     25.1      ||||||||    ||||||||    ||||||||    ||||||||    ||||||||    ||||||||     ||||||||


        STAL                    11.8      ||||||||    ||||||||    ||||||||    ||||||||    ||||||||    ||||||||     ||||||||


        Other                 ||||||||    ||||||||    ||||||||    ||||||||    ||||||||    ||||||||    ||||||||     ||||||||


        Total                 |||||||||   |||||||||   |||||||||   |||||||||   |||||||||   |||||||||   |||||||||    |||||||||

       Source: LECG Analysis. Note: figures may not sum exactly due to roundings.


4.18   Our analysis confirms that BAA’s cost allocation process operates in the way that
       it is described and, but for a number of small errors, appears to produce accurate
       calculations.     Consequently, we believe that it can be relied upon to produce
       materially correct cost allocations.


4.19   The errors and inconsistencies we have identified are easily rectified. We suggest
       that the CAA actively encourages BAA to effect the changes and that the CAA
       adopts the revised figures for the purposes of setting the next price control43.




       43
                 In considering the impact of alternative allocation drivers in Section 10 of this report, LECG
       has used the corrected figures as the base case.




                                                                                                                 CAA|     49
                                                                                            December 2006




5     CAS and PLC costs

      Introduction
5.1   In this section we describe the activities and costs of the CAS and PLC
      departments. We also summarise how these costs are allocated to the Airports
      and to the other businesses within the BAA group through the indirect recharge
      process44.


5.2   In general, BAA uses three different approaches to allocate CAS and PLC costs45.
      We have grouped the different costs according to the basis on which they are
      allocated, as follows: (i) IT lease costs; (ii) group IT costs; and (iii) other.

      IT lease costs
5.3   IT lease costs refer to the costs that BAA charges each airport and the other
      businesses for the use of, or access to, common centrally held IT systems46. IT
      lease costs totalled |||||||||| ||||||||||| in 2005/0647.


5.4   IT lease costs relate to the use of a large number of individual systems and groups
      of assets. We describe below our understanding of some of the key systems
      included within IT lease charges and then summarise how they are allocated to
      the Airports48.       The key systems, which together account for 90%49 of the IT lease
      charge, include:


      •      BAA’s Oracle Enterprise suite (“Enterprise”) is an integrated suite of
             modules and packages within the ERP system, which is used for business
             planning and management.                 The activities it supports include budgeting,
             financial reporting and the processing of staff time sheets. Enterprise is
             used across the UK airports and in some of BAA’s other operations.
             Enterprise leased assets are allocated using an Enterprise specific driver;


      44
                   The indirect recharge process was explained in Section 3.
      45
                The general principles for each approach are the same, with allocation drivers used to
      allocate costs. The key difference is the level at which the allocation occurs. For example, IT lease
      and Group IT costs are allocated at a more detailed level than the Other CAS & PLC indirect costs.
      46
                   Additional information on the leased assets and how they are calculated is contained within
      Section 6.
      47
                   Excluding mark-ups, based on the corrected IT lease number as stated in Table 13.
      48
                The descriptions that follow are based on information provided by BAA during our meetings
      with them.
      49
               This estimate is based on the proportion of lease assets organised by asset type (as
      opposed to the quarter in which they go live). The estimate is sourced from BAA submission “IT leases
      Mar 2006_07v1 actuals”.




                                                                                                  CAA|     50
                                                                                       December 2006




•      the Resource Management System (“RMS”) is a tool for forecasting the
       operational staff requirements at each airport. It is used to specify how
       many engineers, security guards and certain other categories of staff will be
       required (including where and when) to process a given arrival and
       departure schedule.            Although it currently only covers the operational
       resource requirements at the Airports, the DEE programme (which is
       described below) will expand its scope to cover all of BAA. RMS system
       leased assets are allocated using an RMS specific driver;


•      the Airport Operating System (“AOS”) refers to a range of systems used to
       support efficient airport operations, including stand allocation and flight
       information display management. Not all of the functionality of the AOS is
       used by each of the airports and this is reflected in the allocation of charges.
       For example, when AOS was introduced, HAL already had a system that
       overlapped with AOS. HAL has retained the use of its original systems. As
       such, it uses around half of AOS’ capabilities. GAL also had an overlapping
       system in place when AOS was introduced, and has retained its original
       systems. It only uses a very small proportion of AOS’ capabilities. Usage is
       deemed so small that no AOS cost is allocated to GAL;


•      Deliver Excellent Experience (“DEE”) is a process re-engineering project
       within BAA designed to improve the efficiency and effectiveness of airport
       operations.        The scope of the project includes improvements to the
       allocation and scheduling of all types of staff. The DEE IT lease cost relates
       to the development of new systems and changes to existing systems.
       DEE 50 IT lease costs are allocated using passenger numbers (i.e. PAX).
       This driver is inconsistent with the method used to allocate the CAS and
       PLC DEE cost category51, which uses a DEE specific driver based on an
       estimate of benefits to the business;


•      Shield refers to the costs associated with improvements to the security of
       BAA’s IT systems. Shield assets are allocated using passenger numbers;


•      WebTop covers a subset of the common infrastructure programmes
       included on the desktops of BAA staff52. Specifically, it relates to bespoke
50
        An example of such a group of assets is contained within the worksheet ‘Qtr 2 2008_09’ of
BAA submission “IT leases Mar 2006_07v1 actuals”.
51
          This cost category does not contain DEE IT assets. It includes the costs of the central team
due to be established in 2008/09 to help embed the DEE initiative. As such, there is no financial
reporting overlap between the DEE IT lease costs and the DEE cost category.
52
         ‘Infrastructure software’ is defined as non-airport related IT software, such as Microsoft Office
or bespoke head office programmes. ‘Application software’ is defined as those bespoke software
packages required to run an airport, such as AOS.




                                                                                              CAA|     51
                                                                                                  December 2006




               BAA software, rather than generic software such as Microsoft Office. All
               Webtop assets are allocated using passenger numbers; and


      •        Maximo is a group wide engineering support system. All Maximo assets are
               allocated using passenger numbers.


5.5   BAA uses a wide array of drivers to allocate lease costs to airports and to the
      other businesses within the BAA group. Generally, if a certain driver is known to
      reflect best the usage of a given lease, then that driver is selected. For example,
      the leased assets that relate to the Enterprise system are allocated using an
      Enterprise specific driver. However, where there is no clear causal link between
      the IT lease cost and usage, BAA uses PAX as a default driver. BAA explained
      that passenger numbers are the ultimate driver of airport activity and, in turn, IT
      usage.


5.6   The table below shows the proportion of IT leases acquired between 2001/0253 to
      2008/09 (by nominal capital value) which are allocated using different drivers54:

      Table 17:         IT lease allocation driver usage

                                                    Nominal Capital Value               Percentage of lease
          Allocation Driver
                                                          (£ 000)                        costs using driver

          PAX based driver                                    173,417                                    83.1%

          Enterprise projects specific                          10,351
                                                                                                          5.0%
          driver

          RMS projects specific driver                           7,973                                    3.8%

          AOS projects specific driver                           7,305                                    3.5%

          Airport specific driver                                8,809                                    4.2%

          Other                                                     810                                   0.4%

          Total                                               208,665                                    100.0%

      Source: BAA submissions “IT leases Mar 2006_07v1 actuals.xls” and LECG analysis.


5.7   PAX is the most common allocation driver for IT leases accounting for 64.5% of
      total lease costs. Over 20% of total lease costs are allocated by project specific
      drivers with most of the remaining leases allocated to individual airports.




      53
                   We have considered assets purchased from 2001/02 as any asset purchased from this year
      will still impact IT lease charges in 2005/06, since the minimum lease life is 4 years.
      54
                  Nominal capital value refers to the historical capital cost of the individual asset.




                                                                                                          CAA|    52
                                                                                                   December 2006




       Group IT costs
5.8    Group IT (“GPIT”) refers to IT system costs incurred in relation to procurement,
       operations, network management, maintenance and support activities.                                    GPIT’s
       costs are reported in approximately 50 different categories, defined as OFA
       budget centres by BAA. We set out below our understanding of the nature of the
       activities undertaken by the largest of these GPIT budget centres (in terms of
       expenditure). We then discuss the different drivers used by BAA to allocate GPIT
       costs to the Airports and other businesses55. GPIT costs totalled |||||||||| ||||||||||| in
       2005/06.


5.9    The table below summarises the costs incurred in the 10 largest budget centres
       within GPIT (after adjusting for exceptional costs), which represent approximately
       70% of GPIT costs (between 2005/06 and 2008/0956).

       Table 18:      Largest ten GPIT budget centres by expenditure

        OFA code                                             05/06          06/07           07/08            08/09

        Production Services                                   ||||||||||     ||||||||||     ||||||||||||     ||||||||||||

        Applications Support                                  ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Network Management Team                               ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Enterprise Revenue                                    ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Technology Group                                      ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Server Support                                        ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Applications Project Management                       ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Group IT Director                                     ||||||||||     ||||||||||      ||||||||||       ||||||||||

        IT Operations management                              ||||||||||     ||||||||||      ||||||||||       ||||||||||

        Telecoms Architecture & Strategy                         |||||||     ||||||||||          |||||||      ||||||||||

        Sub total                                           ||||||||||||    ||||||||||||    ||||||||||||     ||||||||||||

        Sub total as % of Total Group IT costs                |||||||||||     |||||||||||     |||||||||||      |||||||||||

        Total Group IT costs                                ||||||||||||    ||||||||||||    ||||||||||||     ||||||||||||

       Source: BAA submission “IT Allocations Pre Except IMG 0704 re March 06 actuals.xls”, BAA/Q5/199-
       1”Bus Plan 06-07 to 08-09 IT Allocations Finall.xls”, and LECG analysis. Note: BAA rolls forward costs
       from 2009/10 to 2012/13 using inflation and growth assumptions. For ease of presentation, the costs
       for these years are omitted here.


5.10   The activities of the relevant GPIT budget centres are summarised below:

       55
                 Our understanding is based on the discussions we held with BAA. Due to time constraints,
       our discussions were limited to the top 10 largest account codes only.
       56
                 No forecast data at the OFA level is available after 2008/09.




                                                                                                            CAA|       53
                                                                                    December 2006




•      the Production Services budget centre relates to the administrative team
       responsible for the day-to-day maintenance and operations of BAA’s IT
       systems and includes the costs associated with infrastructure software
       contracts 57 .    These costs are allocated using a combination of logins
       (excluding those from corporate office staff) and AOS cost drivers58;


•      the Applications Support team provides support for infrastructure and
       application software. The budget centre’s expenditure includes application
       software licence fees. The costs of the budget centre are allocated using a
       combination of the AOS allocation driver, the Enterprise allocation driver and
       a general weighted average composite of all the other drivers used
       (excluding WDF and before depreciation);


•      Network Management Team oversees the functions and activities
       undertaken by the Applications Support and Network Site Services budget
       centres. These costs are allocated on the basis of IT equipment;


•      Enterprise Revenue covers the cost of internal expert resources supporting
       the Oracle Enterprise suite and are allocated using the Enterprise allocation
       driver;


•      the Technology Group comprises the software architects responsible for
       implementing any patches released for infrastructure or application software.
       These costs are allocated using a logins driver (excluding those relating to
       corporate office staff);


•      Server Support relates to maintenance of hardware at BAA’s server farms.
       It is allocated using a logins driver (excluding those relating to corporate
       office staff);


•      Applications Project Management covers the costs of the project managers
       engaged in the development of application software.                      These costs are
       allocated using a logins driver (excluding those relating to corporate office
       staff);


•      the Group IT Director budget centre covers the salary and other costs of the
       IT director, his personal assistants, and the rent and utilities charges for the

57
           ‘Infrastructure software’ is defined as generic non-airport related IT software, such as
Microsoft Office. ‘Application software’ is defined as those bespoke software packages required to run
an airport (e.g. AOS).
58
           Certain account codes are allocated by a composite of drivers. Analysis was used to further
divide the OFA code between different components and assign drivers to them.




                                                                                          CAA|     54
                                                                                            December 2006




              office space occupied by senior members of BAA’s IT team. These costs
              are allocated on the basis of the general weighted average composite of all
              the other drivers used (including WDF and before depreciation);


       •      IT Operations covers the costs of the management team responsible for all
              of the Production Services activities and budget centres. These costs are
              allocated using a logins driver (excluding those relating to corporate office
              staff); and


       •      Telecoms Architecture & Strategy covers the costs of the senior
              management team who are responsible for the IT Operations Management
              and Network Management Team budget centres and their activities. These
              costs are allocated based on IT equipment59.


5.11   It is clear that BAA uses a range of different drivers for allocating GPIT costs.
       Where no causal links can be identified between the costs incurred and usage,
       BAA adopts Logins (excluding those from the corporate office staff) as the default
       driver60.


5.12   The table below shows the percentage of Group IT costs allocated by the different
       GPIT drivers for 2008/09, the first year of the forthcoming price control.




       59
                  The IT equipment driver relates to the number of pieces of IT hardware that are linked by
       cable to the host BAA IT system. For example, a computer that is linked to the BAA network by a cable
       that also has an external keyboard and mouse would represent 3 pieces of equipment.
       60
                 Logins (before any adjustments) represents the number of IT access rights granted to the
       staff operating in the offices at BAA’s airports. The adjustment for corporate office staff is necessary
       because some of these staff operate from those offices at the airports (principally HAL). Without this
       adjustment, the corporate logins might bias the allocation proportions.




                                                                                                   CAA|     55
                                                                                              December 2006




       Table 19:       2008/09 GPIT costs (excluding depreciation 61 ) by allocation
                       driver

                                                                                           Percentage of
        Allocation Driver                                        Cost (£’000)
                                                                                        leases using driver

        Logins (excluding Corporate office staff)                       ||||||||||||                    48.5%

        Equipment                                                        ||||||||||                     10.0%

        Enterprise project specific drivers                              ||||||||||                       9.0%

        AOS project specific drivers                                     ||||||||||                       2.6%

        Airport specific driver                                          ||||||||||                     16.8%

        Composite driver – all costs other than
                                                                         ||||||||||                       7.3%
        WDF and depreciation
        Composite driver – all costs other than
                                                                         ||||||||||                       5.8%
        depreciation

        Total                                                           |||||||||||                    100.0%

       Source: BAA submission “IT leases Mar 2006_07v1 actuals.xls” and LECG analysis.


5.13   Approximately 58.5% of GPIT costs are allocated based on logins (excluding
       corporate office staff) or equipment. BAA indicated that it believed that these
       drivers were good proxies of IT usage.


5.14   Additionally, 11.6% of GPIT costs are allocated using specific Enterprise or AOS
       project drivers and 16.8% are allocated directly to the Airports. The remaining
       23.1% of Group IT costs are allocated using a combination of cost drivers62.

       Other CAS and PLC costs
5.15   The tables below summarise the remaining CAS and PLC department costs and
       the relevant allocation drivers applied to each by BAA. These costs relate to a
       variety of BAA central support functions.


5.16   The table below summarises CAS department costs and the relevant allocation
       drivers applied to each by BAA.


       61
                  Group IT includes £2.4m of depreciation relating to IT assets held within corporate (such
       assets include, for example, the computers of the Economics & Regulation team). This amount is not
       allocated, and so has been excluded when deriving the percentages in this table.
       62
                  Composite drivers represent an average of all the other drivers weighted by reference to the
       proportion of costs each driver allocates. Our understanding is that BAA uses these drivers when
       neither the default driver nor any other available basis of allocation would adequately reflect underlying
       usage.




                                                                                                     CAA|     56
                                                                                     December 2006




Table 20:       2008/09 CAS department costs (excluding IT)

                                                                                       % of CAS
                                                                 CAS costs
 CAS department                         Allocation Driver                                costs
                                                                  (£’000)
                                                                                     (excluding IT)


 Acquire & Maintain Assets                    CAPEX                   ||||||||||           26.2%


 Group Health & Safety                         PAX                         |||||||          3.3%


 Group Security                                PAX                    ||||||||||            7.1%


 Research                                      PAX                    ||||||||||           13.4%


 Airport planning                              PAX                    ||||||||||            8.6%


 Airline Relations Team                        PAX                         |||||||          3.2%

 Corporate Responsibility &
                                                PAX                        |||||||          3.4%
 Environment

 Rail Strategy                                 HEX                             ||           0.0%

 Managing and Divisional
                                                PAX                   ||||||||||            5.3%
 Directors

 Group Marketing                               PAX                    ||||||||||            8.5%

                                            South east
 Olympic 2012                                                              |||||||          1.4%
                                           airports’ PAX

 UK Airports retail                      Net retail income             |||||||||            (2.2%)


 Chief Fire Officer                            PAX                         |||||||          1.6%


 Group Services Director                 Operating Profit                  |||||||          3.5%


 Airport Operations                      Operating Profit                  |||||||          2.2%


 Group Retail                            Net retail income            ||||||||||            8.3%


 DEE AOE from 2008/9                           DEE                         |||||||          2.6%


 Common costs                            Corporate Office             ||||||||||            3.8%


 Total                                                               |||||||||||          100.0%

Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls“




                                                                                          CAA|   57
                                                                                        December 2006




5.17   The table below summarises PLC department costs and the relevant allocation
       drivers applied to each by BAA.

       Table 21:      2008/09 PLC department costs

                                                                      PLC costs           % of PLC
        PLC department                     Allocation Driver
                                                                       (£’000)             costs


        Board                               Corporate Office               ||||||||||            8.2%

        Finance (including                                                 ||||||||||
                                            Operating Profit                                    26.6%
        insurance)

        Business Assurance                  Operating Profit               ||||||||||            5.0%


        Human Resources                     Operating Profit               ||||||||||           17.7%


        Property                            Operating Profit               ||||||||||            6.6%

                                         50% Operating Profit,             ||||||||||
        Corporate Affairs*                                                                      13.2%
                                         50% Corporate Office

        Economics & Regulation              Operating Profit               ||||||||||            4.6%


        Legal                               Operating Profit               ||||||||||            3.2%


        Company Secretary                   Corporate Office               ||||||||||            6.7%


        SMIS & NIC                          Corporate Office               ||||||||||            8.2%


        Travelex                             Not Allocated                         ||            0.0%

        Total                                                             |||||||||||          100.0%

       Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls“. * Note 50% of Corporate
       Affairs is allocated directly to the Corporate Office with the remaining 50% being allocated to the
       Airports and other businesses using operating profit.


5.18   We discuss in detail the allocation drivers used for CAS and PLC department
       costs in Section 10. We set out our understanding of the activities undertaken
       within each CAS department63 below:




       63
                  The information presented here is based on Appendix 1 of BAA/Q5/54 “Revenue and cost
       allocation process” and from our meetings with BAA. Although we advised BAA that we wished to gain
       a deeper understanding of the activities covered under each area, BAA only provided limited
       information in support of this request.




                                                                                               CAA|     58
                                                                                     December 2006




•      Acquire and Maintain Assets (“AMA”) costs mainly relate to capital and
       maintenance expenditure on the group’s assets.                           These costs are
       capitalised and therefore, do not form part of the operating costs that are
       allocated to the Airports. The remaining costs in this department relate to
       operational expenditure64. These costs comprise around 40 individual sub-
       departments, which can be divided into: (i) Capital and (ii) Supply Chain.
       Capital departments are responsible for the development, design and
       construction of the group’s assets. The Supply Chain departments include:


       -       Practice Management defines the overall procurement process for
               third party expenditure. It also manages low value transactions and is
               responsible for Supply Chain’s risk management;


       -       Airport teams act as a single point of contact for a specific airport and
               liaise with the rest of the Supply Chain department on their behalf; and


       -       Category teams are responsible for the procurement of particular
               types of products or services. They are centres of specific expertise
               and knowledge that can be leveraged by the whole department;


•      Group Health & Safety is responsible for providing expert support to BAA’s
       UK airports on all health and safety related issues and for developing and
       sustaining best practice standards and processes;


•      Group Security is responsible for the security operations and liaising with the
       government, security services, police etc on security issues;


•      Research comprises three departments:


       -       Forecasting & Statistics which is responsible for monitoring key air
               traffic patterns, trends and forecasting relevant statistics for air
               passengers, cargo, fleet composition etc;


       -       Operational Research is an internal consultancy group which uses
               specialist research techniques to advise the airport planning and
               management teams on a wide range of service and performance
               issues; and


64
           LECG understands that the information stated in the profit and loss accounts supplied for
each OFA code is stated after the adjustments to capitalise maintenance and capital expenditure (i.e. it
is not actually possible to see the capitalising adjustments). However, the total amount capitalised is
disclosed and it can be seen that this relates to the majority of AMA costs (e.g. 85% in 2008/09).




                                                                                            CAA|     59
                                                                               December 2006




       -      Market Research provides regular generic research and ad hoc
              bespoke material on areas spanning retail, airport competition,
              sustainability development etc. These services are provided to the
              UK airports and to BAA’s international operations.


•      Airport Planning maintains a policy framework for, and provides technical
       advice on, strategic planning for areas such as airport transport links, noise
       and air pollution/quality and blight/passenger safety zones;


•      the Airline Relationship Team is responsible for coordinating relations and
       developing joint strategies with key airlines.           The team’s purpose is to
       facilitate better long term planning and management of capital investment;


•      Corporate     Responsibility     &    Environment       provides    support     on    all
       environmental matters, including development and implementation of a
       group framework, liaising with stakeholders and legislators, and keeping
       abreast of best practice and legislative changes in the environmental arena;


•      Rail Strategy is responsible for managing BAA’s rail operations, such as
       HEX, and for developing plans for connecting BAA’s airports with the UK rail
       network;


•      the Divisional Managing Director and his department, are responsible for the
       management of GAL, STAL and Southampton airports and some of BAA’s
       European and Australian operations;;


•      the Divisional Airport Director, and his department, are responsible for
       BAA’s operations in Scotland and America;


•      Group Marketing is responsible for developing the BAA brand and the
       identity of BAA’s UK airports, and for relationships with stakeholders such as
       government departments and bodies such as Visit Britain;


•      the Olympics 2012 department was responsible for BAA’s involvement in
       and support for London’s bid and is now engaged in preparing the airports in
       the South East of England for the additional traffic expected for the London
       Olympic games65;



65
          In BAA/Q5/300 “The Q5 Regulatory Submission” BAA is forecasting that the costs of this
department will continue beyond the end of the Olympics in 2012. At a meeting BAA explained that
post the games, it was likely that they would have to support other events.




                                                                                     CAA|    60
                                                                        December 2006




•    the UK Airports Retail department is responsible for decisions on product
     offerings, promotions and marketing within BAA’s UK retail operations.
     LECG understands that the majority of UK Airport retail’s costs are directly
     charged to the Airports66. The remaining elements relate to ad hoc costs
     (such as for the BAA credit card) where it is not possible to allocate costs
     directly;


•    the Chief Fire Officer supports the UK airports in maintaining standards to
     ensure compliance with fire safety legislation and operational requirements;


•    the Group Services Director oversees security, health & safety, fire service,
     IT and pension functions;


•    Airport Operations is responsible for developing standards, ensuring
     compliance and managing air traffic management, airspace issues,
     aerodrome licensing and other operations necessary for the functioning of
     the Airports;


•    Group Retail is responsible for consumer marketing and the cost of UK
     airports’ retail function. Its activities include advertising and public relations,
     customer service development and market research into consumer
     activities.   The department also negotiates trading terms and manages
     business partner relationships across the UK airports;


•    Deliver Excellent Experience (“DEE”) is a process re-engineering project
     within BAA designed to improve the efficiency and effectiveness of airport
     operations; and


•    Common costs relate to a variety of miscellaneous costs, such as
     employers’ national insurance contributions on bonuses. At a meeting with
     BAA, they stated that it would be inappropriate to allocate any of these costs
     outside of the Corporate Office. They are not allocated to the Airports. At
     the time of writing, LECG has not been able to determine BAA’s rationale for
     not allocating these costs.




66
       See Section 7.




                                                                              CAA|   61
                                                                                       December 2006




5.19   We set out below our understanding of the activities undertaken within each of the
       PLC departments67:


       •      the Board covers the costs associated with the senior management team of
              BAA and is responsible for overseeing the activities of the entire group;


       •      Finance covers the activities of the central finance team, the tax department,
              treasury operations and the risk and insurance functions.                  Finance also
              includes group insurance premiums relating to motor vehicles, directors and
              officers liability, personal accident and travel, combined liability and crime
              insurance;


       •      Business Assurance includes the internal audit function, which is
              responsible for devising and ensuring compliance with key internal controls
              as well as supporting the audit and assurance committee;


       •      Human Resource supports BAA businesses in resourcing, developing and
              managing people. Its is also responsible for learning and development and
              organisational design and development;


       •      the Property department has administrative responsibility for running BAA’s
              central London headquarters and for organising office space for BAA
              corporate staff based at the airports;


       •      Corporate Affairs manages BAA’s public affairs, including press releases,
              public announcements and contacts with government, local authorities and
              interest groups. It also provides support to the corporate affairs team at
              each airport;


       •      the Economics and Regulation team manages BAA’s regulatory reviews and
              ensures compliance with regulatory obligations;


       •      the Legal department provides a full range of legal services to the Airports
              and to BAA’s other businesses including contract drafting and litigation
              support, legal advice and training;


       •      the Company Secretary department performs company secretarial duties,
              such as ensuring statutory filing requirements are met;

       67
                  The information presented here is based on Appendix 1 of BAA/Q5/54 “Revenue and cost
       allocation process” and additionally on our meetings with BAA. Although we advised BAA that we
       wished to gain a deeper understanding of the activities covered under each area, BAA only provided
       limited information in support of this request.




                                                                                              CAA|    62
                                                                                    December 2006




       •           Travelex is a department that deals with the renegotiation of BAA’s
                   commercial outlet leases with Travelex Holdings Limited; and


       •           SMIS & NIC relates to the costs of BAA’s senior management incentive
                   scheme.


5.20   We show in the table below the proportion of non-IT CAS and PLC costs
       recharged by BAA by cost driver. LECG’s observations on the appropriateness of
       each driver are set out in Section 10.

       Table 22:         Percentage of non-IT CAS and PLC costs allocated by driver
                         type in 2008/09

           Allocation Driver            CAS and PLC costs (£’000)    Percentage of non IT costs


           CAPEX                                  ||||||||||                    11.1%


           Passenger numbers                     ||||||||||||                   23.1%


           HEX                                            ||                        0.0%


           SE passenger numbers                       |||||||                       0.6%


           Net retail income                      ||||||||||                        2.6%


           Operating profit                      ||||||||||||                   42.8%


           DEE                                        |||||||                       1.1%


           CO                                    ||||||||||||                   18.7%

           Total                                 |||||||||||                   100.0%

       Source: BAA submissions “CAS and PLC GSM To 2017-18.xls and LECG analysis.




                                                                                           CAA|   63
                                                                                    December 2006




6     IT leases

      Introduction
6.1   This section explains BAA’s approach to allocating IT lease costs. We start with a
      description of what IT lease costs represent and our understanding of why they
      form part of the costs to be allocated. We then set out some initial observations
      on BAA’s approach in the context of a regulatory price control. This is followed by
      an explanation of why it is particularly important to understand how IT lease costs
      are estimated and allocated. We then set out our understanding of how the costs
      have been calculated by BAA. Finally, we assess whether the approach adopted
      by BAA is appropriate for price control purposes.

      IT leases within BAA
6.2   IT lease costs represent the mechanism by which BAA charges each of the
      Airports and BAA’s other businesses an appropriate annual amount for their use of
      the IT software and systems68. BAA’s IT systems are owned by HAL, rather than
      by each of BAA’s businesses.              These assets are incorporated within HAL’s
      Regulatory Asset Base (“RAB”).


6.3   Hence, the IT lease cost reflects the use, by other businesses, of assets, which
      are owned by HAL. This is different to the other recharged and allocated costs,
      which relate to services provided by a corporate office department or a ring fenced
      subsidiary69.


6.4   There are two principal reasons why HAL owns the IT assets. First, HAL is able to
      maximise the value of the capital allowances, because it is a trading entity and it
      generates sufficient taxable profits to make immediate use of the allowances, as
      they become available. Second, HAL is the largest user of the IT assets.


6.5   BAA’s annual lease cost, for each IT asset, is based on an annuity calculation.
      The calculation assesses the amount to be paid annually such that the NPV of the
      lease annuity over the life of the asset is equal to the original investment cost of
      the asset. The lease cost for each IT asset is allocated to each of the Airports and
      to each of BAA’s other businesses, based on the usage of the particular system.
      HAL receives an allocation of the IT lease costs if it is a user of the asset.



      68
               These systems are described in more detail in Section 5.
      69
                For example BAA Business Support Centre Ltd. See Section 7 for more information about
      the services provided by this entity and the charges it makes to other parts of the BAA group.




                                                                                          CAA|    64
                                                                                             December 2006




6.6    Total IT lease costs allocated to the Airports and to BAA’s other businesses,
       including those amounts allocated to HAL, are recorded as income in the financial
       records of HAL.         For regulatory purposes, all of this income is regarded as
       commercial revenue, and is therefore deducted when calculating HAL’s
       aeronautical revenue requirement under the single till approach70.


6.7    The nature of the relationship between HAL and the other parts of BAA is not
       formally that of lessor and lessee. That is, there is no formal or contractual lease
       arrangement in place that is consistent with the way the term ‘lease’ would
       normally be understood for legal or accounting purposes.

       Initial observations
6.8    The use of the lease mechanism adopted by BAA to calculate and allocate costs
       associated with the use of shared assets differs from that what might be expected
       under a ‘normal’ regulatory approach. Under a normal regulatory approach, the
       total regulatory revenue requirement is calculated using a building block approach.
       At its simplest, this comprises the sum of an allowance for efficient operating
       costs, an allowance for capital expenditure and a return on the amount invested.
       The return element of the building block is normally calculated as a return at the
       allowed regulatory cost of capital on the value of the Regulatory Capital Value
       ”RCV”. This is referred to in the remainder of this section as the RCV approach71.


6.9    In theory, the annual cash allowance under the RCV approach could be allocated
       to each user of the asset72. In general terms, it might be equally valid to use a
       lease approach and this may have some regulatory merit.                              However, both
       approaches should give rise to equivalent cost allocations (in NPV terms).

       The importance of the IT leases
6.10   LECG agreed with the CAA that we should perform a detailed review of IT lease
       costs for the following reasons:



       70
                   Under the single till approach, revenues generated from the conduct of specified commercial
       activities are deducted from total costs when calculating the aeronautical revenue requirement. In its
       policy paper published in December 2005, Airports review – policy issues, Consultation paper”, CAA,
       December 2005, the CAA states that it intended that the Q5 price control be set on the single till basis.
       This position was restated by the CAA in May 2006, “Airports review – policy update”, CAA, 15 May
       2006.
       71
                  For a one-year period, the return component of a regulatory revenue requirement, calculated
       under the RAB approach is equal to: [RCV at the start of the period - NPV of the RCV at the end of the
       period] * [1 + cost of capital].
       72
                  An alternative would be to divide the value of the asset and apportion it between the RCV of
       the different users. In theory, this should yield the same results, as apportioning the allowance under
       RCV approach but in many cases may be administratively more cumbersome.




                                                                                                    CAA|     65
                                                                                               December 2006




       •        IT lease costs represent, on average, approximately 26% of total CAS and
                PLC costs73, and hence on the basis of materiality, they warrant particular
                attention;


       •        the allocation is more complex to understand, validate and evaluate than a
                simple driver such as passenger numbers;


       •        the level of the costs to be allocated is generated internally and is not as
                easy to validate as other CAS and PLC costs that are supported by
                transaction histories contained within BAA’s accounting system and by other
                records;


       •        many individual lease cost calculations are performed in large, complex
                spreadsheets with the associated risk of undetected errors if not subjected
                to adequate and periodic review74; and


       •        the CAA has not previously reviewed IT lease costs in detail.


6.11   In general, the CAA wished to have a better understanding of how the creation of
       lease costs and revenues in HAL influenced the calculation of the aeronautical
       revenue requirement under a single till mechanism.

       BAA’s calculation of IT lease costs
6.12   BAA derives a separate lease cost for each IT system.                             The IT lease cost
       represents a constant nominal annuity, which is paid over the useful economic life
       of the asset. The annuity is calculated to ensure that the Internal Rate of Return
       (“IRR”) of the resulting post-tax cash flows is equal to a predetermined required
       rate of return.


6.13   BAA calculations include the following assumptions: (i) corporation tax is payable
       at a rate of 30%, half yearly in arrears; (ii) writing down allowances on capital are
       available at a rate of 25% per annum on a reducing balance basis; and (iii) the
       required rate of return on its investment is 7.5%, measured on a nominal post-tax
       basis.


6.14   The total of all individual IT leases is then charged to BAA corporate.                              BAA
       corporate then allocates leases to each of BAA’s businesses (including HAL), as

       73
                   Approximately |||||||||| in 2005/06, after deducting the mark-up and correcting for errors. See
       Table 13.
       74
                 Section 4 summarises the work LECG performed to review BAA’s IT lease cost calculations.
       This review identified a number of errors in the calculations.




                                                                                                      CAA|     66
                                                                                              December 2006




       part of the CAS and PLC indirect recharge, using lease specific allocation drivers.
       The allocation of these costs is explained in more detail in Section 5. The effect of
       this process is to create an operating cost in each of the Airports and BAA’s other
       businesses equal to its allocation of the IT lease costs.


6.15   The other impact of this charging process is that HAL also receives inter-company
       income equal to total IT lease costs that are allocated to each of BAA’s
       businesses, including the amount that is allocated to HAL through the CAS and
       PLC indirect recharge mechanism. The relationship between this income, the
       RCV component of the calculation of HAL’s aeronautical revenue requirements
       and the operation of the single till is addressed below.


6.16   To illustrate how BAA calculates IT lease costs, LECG has applied BAA’s
       approach and assumptions described above to calculate the lease costs in a
       hypothetical situation where BAA spends £1,000 on the creation of a new IT
       system with a useful economic life of four years.                      For the purposes of this
       illustration, we assume that the new system will be owned by HAL and that for
       regulatory purposes the cost of this asset is recorded in HAL’s RCV. Under BAA’s
       approach, the annual annuity charge for the asset would be approximately £330.
       Details of this calculation are set out in Appendix 4.1.


6.17   If the annuity charge of £330 was to be allocated equally between three ‘users’ of
       the system (assumed for the purposes of this example to be HAL, GAL and one of
       BAA’s other businesses), each of these users would receive an IT lease cost
       allocation of £110.       As explained above, the transactions associated with the
       allocation of the total IT lease cost (£330) also gives rise to HAL receiving income
       of £33075.

       LECG observations
6.18   We now consider how the calculation and allocation of IT lease costs under BAA’s
       approach compares to a RCV approach.                        First, we consider the level and
       allocation of the IT lease costs under both approaches and assess how this varies
       when changes are made to key assumptions. We then consider how the level of
       costs borne by different users is affected by the operation of the single till. We
       illustrate our consideration of these issues by reference to the hypothetical
       example described above.




       75
               The net effect of this under the single till mechanism is explained later in this section.




                                                                                                     CAA|   67
                                                                                         December 2006




6.19   Finally, before reaching our conclusions on the appropriateness of BAA’s
       approach, we estimate the difference between BAA’s approach and a RCV based
       approach using BAA’s IT asset information.

       Total level of allocated costs

6.20   LECG has sought to understand how the level of the IT lease costs calculated
       under BAA’s approach compares with the costs calculated under the RCV
       approach.      Using the example above, LECG has calculated the costs to be
       allocated to the three users of the asset under the RCV approach.                           These
       calculations have been performed assuming a real pre-tax cost of capital of
       7.75% 76 .   For the purposes of comparison with the nominal lease payments
       calculated under BAA’s approach, we converted the results of our calculations into
       nominal terms assuming a constant inflation rate of 2.5% per annum. Details of
       this calculation are set out in Appendix 4.2.


6.21   The table below compares the total level of costs under the BAA and RCV
       approaches in nominal and in NPV terms77.

       Table 23:      Comparison of BAA and RCV approaches assuming asset lives
                      of four years

        £                            NPV        Year 1      Year 2      Year 3      Year 4       Total

        BAA total                  1,035         330         330           330        330       1,319

        BAA per user                 345         110         110           110        110         440

        RCV total                  1,000         336         324           311        297       1,268

        RCV per user                 333         112         108           104          99        423
                         78
        Difference total             (35)           6          (6)         (19)        (33)        (51)

        Difference per user          (12)           2          (2)          (6)        (11)        (17)

       Source: LECG calculations. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes.




       76
                We understand that this is the rate allowed for when setting the current price control and
       have agreed with CAA that this is an appropriate figure to use for the purposes of this report.
       77
                The NPV of each profile of charges has been calculated by discounting the nominal level of
       charges at a rate of 10.44%, the pre-tax nominal rate equivalent to the allowed real pre-tax rate of
       7.75% assuming a constant inflation rate of 2.5% per annum.
       78
                 In the remainder of this Section, where comparisons are made between costs under the BAA
       and RCV approaches they are calculated as the costs under the RCV approach less the costs under
       the BAA approach. A negative number means that the costs under the BAA approach are higher than
       under the RCV approach, and vice versa.




                                                                                               CAA|       68
                                                                                           December 2006




6.22   LECG’s calculations suggest that BAA’s approach results in a higher total level of
       costs in both nominal (4.0%) and, more importantly, in NPV terms (3.5%)79. The
       year-on-year profile also differs.


6.23   Under the assumptions used in these illustrative calculations, which mimic very
       closely the situation applicable to the shorter life IT assets within BAA’s portfolio,
       BAA’s approach results in a higher overall level of costs (in NPV terms) than
       would be the case under a RCV based approach. This might be a cause for
       concern.


6.24   However, BAA also has a number of IT systems with significantly longer useful
       economic lives. To test whether the conclusion above holds, we have repeated
       the calculations under the assumption that a new IT system had a useful
       economic life of 10 years80. We summarise below the results of these calculations,
       details of which are set out in Appendix 4.3 and Appendix 4.4.

       Table 24:      Comparison of BAA and RCV approaches assuming asset lives
                      of ten years

       £                                               NPV                                Total

       BAA total                                        970                              1,609

       BAA per user                                     323                                536

       RCV total                                      1,000                              1,620

       RCV per user                                     333                                540

       Difference total                                  30                                 19

       Difference per user                               10                                   6

       Source: LECG calculations. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes.


6.25   When a longer useful economic life is assumed, but all of the other assumptions
       remain unchanged, BAA’s approach results in costs that are slightly lower (3%) in
       NPV terms.


6.26   Given the potential offsetting effects between short and longer life assets within
       BAA’s IT asset portfolio, it may be tempting to conclude that the differences

       79
                   In the remainder of this Section we will, when evaluating the effects of alternative
       approaches to the calculation of the IT leases or similar costs, focus on the NPV of the costs over the
       life of the assets. This focus is appropriate because regulators, including the CAA, set price controls
       and compare alternatives by reference to the NPV of costs and revenues, discounted at the cost of
       capital determined to be appropriate for price control purposes.
       80
               In performing these calculations, LECG held constant all of the other assumptions (i.e. the
       BAA and CAA rate of return, tax and inflation assumptions).




                                                                                                  CAA|     69
                                                                                            December 2006




       between the NPV of the allocated costs under the two approaches is unlikely to be
       material when extended to BAA’s actual lease portfolio (assuming the mix of short
       and long life assets where comparable). However, such a conclusion would fail to
       take into account the potential impact of changes to the assumptions used to
       calculate the level of allocated costs under each approach.


6.27   Changes to the inflation rate, tax rate or the rate of return, or any combination of
       these factors, could result in costs under the two approaches differing more
       significantly. We set out below the results of some limited sensitivity analysis to
       illustrate the impact of changing key assumptions. We have assessed the impact
       using the example of the hypothetical IT system with a four-year useful economic
       life described above81. The sensitivities we have considered are as follows:


       •      Sensitivity 1 assumes that BAA changes it’s internal target rate of return on
              investments in IT assets by 250 basis points from 7.5% to 10.0%, on a
              nominal post-tax basis;


       •      Sensitivity 2 assumes that the CAA decreases the Weighted Average Cost
              of Capital (“WACC”) used for the price control by 100 basis points, from
              7.75% to 6.75% on a real pre-tax basis. In order to compare the costs in
              this situation the costs under the RCV and BAA approaches must be
              calculated. In the former case, the change to the rate of return changes the
              nominal level of charges in each year, while under the BAA it affects the
              NPV.


       •      Sensitivity 3 assumes a reduction in the inflation rate of 50 basis points,
              from 2.5% to 2.0% per year.                When costs are calculated under BAA’s
              approach this affects the nominal equivalent of the regulatory rate of return
              used to calculate the NPV, while under the RCV approach the impact is on
              the conversion from real to nominal terms.


6.28   Our analysis is set out in the table below, and further details of our calculations are
       set out in Appendices 4.5 to 4.9.




       81
                  In the interests of limiting the length of the analysis included in this Section, we have not
       included the results of undertaking the same sensitivity analysis using the hypothetical new IT system
       with a ten year useful economic life.




                                                                                                   CAA|     70
                                                                                     December 2006




       Table 25:       Sensitivity analysis

       £                     NPV        Year 1       Year 2      Year 3       Year 4       Total

       Base cases

       BAA – LECG
                              1,035          330         330          330          330       1,319
       calculation

       RCV – LECG
                              1,000          337         324          311          297       1,268
       calculation

       Sensitivity 1

       BAA – 10%
                              1,112          354         354          354          354       1,417
       target

       Sensitivity 2

       BAA - 6.75%
                              1,059          330         330          330          330       1,319
       CAA WACC

       RCV – 6.75%
                              1,000          325         316          306          295       1,241
       CAA WACC

       Sensitivity 3

       BAA – 2%
                              1,048          330         330          330          330       1,319
       inflation

       RCV – 2%
                              1,000          334         321          306          292       1,253
       inflation

       Source: LECG analysis. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes.


6.29   Based on this limited analysis, it appears that the difference in NPV terms of the
       costs under the two approaches is quite sensitive to small changes in the
       assumptions. Larger changes in assumptions or the combination of changes in a
       number of different assumptions could result in differences that are more
       significant.

       Operation of the single till

6.30   When considering the appropriateness of BAA’s approach, it is also important to
       consider how any difference between the two approaches impacts the calculation
       of net aeronautical revenue requirements when a single till is in operation. Under
       the single till, HAL’s revenue requirement is calculated as the allowance for
       operating costs plus an allowance for capital expenditure plus a return on its RCV
       at the allowed rate of return, less its commercial revenues.


6.31   Using the figures calculated for the hypothetical asset with a four year life set out
       in Table 23 above, the NPV of HAL’s net aeronautical revenue requirement can be
       calculated in two steps.       The first step is to calculate the gross aeronautical




                                                                                           CAA|      71
                                                                                December 2006




       revenue requirement, which is equal to the NPV of the returns from holding the
       asset for four years (which in the case of a four year asset is equal to the cost of
       the asset) plus the NPV of the total IT lease costs allocated under BAA’s
       approach.     In the second step, the net aeronautical revenue is calculated by
       deducting the NPV of the income received by HAL (which is equal to the NPV of
       the total IT lease costs allocated to all users) from the gross aeronautical revenue
       requirement.


6.32   This calculation results in a net aeronautical revenue requirement, equivalent to
       net IT lease costs, of £310 in NPV terms.

       Table 26:      Calculation of HAL net aeronautical revenue requirement over
                      the asset life of the lease

                                                                            £

        NPV of return on RCV                                              1,000

        Add: NPV of IT lease costs allocated to HAL                         345

        Gross aeronautical revenue requirement                            1,345

        Less: NPV of total allocated IT lease costs                       (1,035)

        Net aeronautical revenue requirement                                310

       Source: LECG calculations


6.33   The effect of the single till, in the situation in which HAL receives a return on the IT
       assets in its RCV and the IT lease costs are calculated and allocated under BAA’s
       approach, is that the NPV of the net costs to HAL is £310, and not the allocated
       lease costs of £345.


6.34   The operation of the single till has two effects when costs under BAA’s approach
       differ from those under the RCV approach. The first ensures that the NPV of the
       sum of the net IT lease costs allocated under BAA’s approach is equal to the NPV
       of sum of the costs calculated under the RCV basis. Using the example above,
       the NPV of the allocated IT lease costs under BAA’s approach is £1,000 (i.e. £310
       for HAL plus £345 for GAL plus £345 for the other BAA business), which is equal
       to the sum of the costs under the RCV approach (i.e. £1,000).


6.35   The key implication is that the single till ensures that the NPV of the total net IT
       lease costs to the Airports and BAA’s other businesses will always be the same if
       the costs are calculated under the RCV approach. From a regulatory perspective,
       we might therefore conclude that any internal pricing regime that BAA adopts is




                                                                                     CAA|   72
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       unimportant, if all of BAA’s operations are subject to regulation on a system-wide
       basis and a single till mechanism is in place82.


6.36   However, only some of BAA’s activities are subject to regulation and the CAA has
       stated that it intends to adopt a stand-alone approach to the regulation of the
       Airports. It is for these reasons that the second effect of the operation of the
       single till under BAA’s approach is potentially more significant.


6.37   The second effect of BAA’s approach under a single till is that the NPV of net
       allocated IT lease costs may not be in the same proportion as the gross IT lease
       costs or the allocation of costs under the RCV approach. In the example above,
       the NPV of the net IT least costs paid by HAL are £310, where as the gross IT
       lease costs allocated to each of the users was equal at £345. Under the RCV
       approach, the NPV of the costs allocated to each user is equal (i.e. at £333).


6.38   In a situation where the NPV of IT lease costs is higher under BAA’s approach
       than would be the case under the RCV approach, the proportion of total net IT
       lease costs paid by the user who owns the asset (HAL in our example) will always
       be lower than its proportional allocation of gross IT costs. In situations where the
       NPV of costs under the RCV approach is higher than under BAA’s approach, the
       converse will be true.


6.39   It follows that any mechanism used to calculate and allocate IT lease costs, which
       does not result in the same total NPV of costs, as would be the case under the
       RCV approach will, under a single till, result in a misallocation of net costs. This
       could give rise to a cross subsidy.

       Impact on total BAA IT lease costs

6.40   In order to test the overall materiality of the issue it is appropriate to compare IT
       lease costs under BAA’s approach with those calculated on a RCV basis. LECG
       has not had access to the detailed RCV data that would be necessary to calculate
       the costs on a RCV basis. However, we can calculate lease costs that yield an
       IRR equal to the regulatory cost of capital over the useful economic life of each IT
       asset. The NPV of the lease costs calculated on this basis, which is the same as
       re-performing BAA’s calculations but using the CAA’s allowed cost of capital, is




       82
               Assuming that the income derived from the IT leases falls within the definition of the single
       till.




                                                                                                CAA|     73
                                                                                                 December 2006




       the same as under the RCV approach, though the year-on-year profile may not be
       identical83.


6.41   We show the results of our analysis, stated in nominal terms, in the tables below.
       LECG’s calculations are based on the CAA’s allowed cost of capital and are
       compared with the IT lease costs under BAA’s approach, after taking into account
       the corrections summarised in Section 4.

       Table 27:      Total IT lease costs under BAA’s and LECG’s approach using
                      the CAA’s allowed cost of capital

       £ ‘000 (unless stated
                                             2005/06           2006/07           2007/08               2008/09
       otherwise)

       BAA’s approach                         ||||||||||||      ||||||||||||      ||||||||||||          ||||||||||||

       LECG real lease                        ||||||||||||      ||||||||||||      ||||||||||||          ||||||||||||

       Difference £                                233             (700)             (852)                 (908)

       Difference %                              0.6%            (1.9%)           (1.8%)                (1.8%)

       Source: LECG analysis. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes. For presentational purposes, we show only up to 2008/09. Similar
       differences can be observed between 2009/10 and 2012/13


6.42   The differences between overall level of IT lease costs calculated by LECG and
       those calculated by BAA are immaterial. The difference in the level of IT costs
       allocated to each of the Airports is also immaterial, as shown below.

       Table 28:      HAL IT lease costs under BAA’s and LECG’s approach using the
                      CAA’s allowed cost of capital

       £ ‘000 (unless stated
                                             2005/06           2006/07           2007/08               2008/09
       otherwise)

       BAA’s approach                         ||||||||||||      ||||||||||||      ||||||||||||          ||||||||||||

       LECG real lease                        ||||||||||||      ||||||||||||      ||||||||||||          ||||||||||||

       Difference £                                137             (351)             (472)                 (506)

       Difference %                              0.7%            (1.7%)           (1.9%)                (1.9%)

       Source: LECG analysis. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes. For presentational purposes we show only up to 2008/09. Similar
       differences can be observed between 2009/10 and 2012/13

       83
                  LECG’s calculations produce a flat real annuity based over the useful economic life of the
       asset, based on an internal rate of return of 7.75% in real pre-tax terms. The comparability of these
       calculations with those under the RCV approach can be seen by comparing the real terms lease
       calculations in Appendices 4.10 and 4.11 with the results under the RCV approach in Appendices 4.2
       and 4.4. For the purposes of comparison with the information provided by BAA on lease costs
       calculated under its approach, LECG’s lease calculations have been converted to nominal terms
       assuming a constant annual inflation rate of 2.5%.




                                                                                                     CAA|       74
                                                                                               December 2006




6.43   The difference in the level of IT costs allocated for GAL is also immaterial, as
       shown below.

       Table 29:      GAL IT lease costs under BAA’s and LECG’s approach using the
                      CAA’s allowed cost of capital

       £ ‘000 (unless stated
                                            2005/06          2006/07          2007/08                2008/09
       otherwise)

       BAA’s approach                         ||||||||||        ||||||||||      ||||||||||||          ||||||||||||

       LECG real lease                        ||||||||||        ||||||||||      ||||||||||||          ||||||||||||

       Difference £                                30            (242)             (239)                 (224)

       Difference %                            0.3%            (2.7%)           (2.1%)                (1.8%)

       Source: LECG analysis. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes. For presentational purposes, we show only up to 2008/09. Similar
       differences can be observed between 2009/10 and 2012/13


6.44   The difference in the level of IT costs allocated for STAL is also immaterial, as
       shown below.

       Table 30:      STAL IT lease costs under BAA’s and LECG’s approach using
                      the CAA’s allowed cost of capital

       £ ‘000 (unless stated
                                            2005/06          2006/07          2007/08                2008/09
       otherwise)

       BAA’s approach                         ||||||||||        ||||||||||       ||||||||||            ||||||||||

       LECG real lease                        ||||||||||        ||||||||||       ||||||||||            ||||||||||

       Difference £                                56              (34)              (71)                  (60)

       Difference %                            1.6%            (1.0%)           (2.0%)                (1.6%)

       Source: LECG analysis. Note: The figures in this table may not sum correctly owing to roundings
       made for presentational purposes. For presentational purposes, we show only up to 2008/09. Similar
       differences can be observed between 2009/10 and 2012/13


       Conclusions
6.45   We conclude that calculating and allocating IT lease costs on any basis that is
       inconsistent with the RCV approach may result in a different total level of costs.
       Importantly, it could also distort the allocation of net costs of individual assets to
       the Airports and the other businesses.


6.46   Given the current assumptions used by BAA and the CAA and the current IT asset
       mix, the difference in IT lease costs under the BAA and RCV approaches is not
       material. However, should BAA make any changes to the assumptions on which it
       calculates the IT lease costs, or, perhaps more importantly, should the CAA




                                                                                                   CAA|       75
                                                                        December 2006




determine that different cost of capital assumptions are appropriate for setting the
Q5 price control, we believe that our conclusion should be revisited.




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7     Other charges

      Introduction
7.1   In addition to the CAS and PLC, which we described in Section 5, a number of
      costs are charged directly to the Airports from central BAA departments and other
      group businesses. In this section, we set out details of our understanding of these
      costs and the basis on which they are recharged.                          These costs can be
      summarised into the following three categories: (i) Corporate Office direct costs;
      (ii) HEX costs; and (iii) BSC costs.

      Corporate Office direct costs
7.2   There are a number of Corporate Office departments that charge costs directly to
      the Airports and to BAA’s other businesses. The table below provides a summary
      of Corporate Office direct costs for the period 2005/06 to 2008/09.

      Table 31:     Corporate Office direct charges 2005/06 to 2008/09*

      £k nominal              2005/06              2006/07             2007/08              2008/09

      UK airport
      retail                    22,902              ||||||||||||         ||||||||||||         ||||||||||||

      IT                         5,265                ||||||||||          ||||||||||               |||||||

      Property                     937                 |||||||||            |||||||||            |||||||||

      Research                     594                   |||||||              |||||||              |||||||

      Other                        472                   |||||||              |||||||                |||||

      Total                     30,170               |||||||||||         |||||||||||          |||||||||||

      Source: BAA submission BAA/Q5/199-8 – “Interco Income SEA 2005-6.xls", 27 June 2006 & BAA
      submission BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls” 4 July 2006. * Note:
      BAA rolls forward costs from 2009/10 to 2012/13 using inflation and growth assumptions, consequently
      the costs for these years are omitted here.


7.3   We provide a brief description of each activity below:

      •       as noted in Section 5, UK airport retail relates to the sourcing of airport
              specific promotional and marketing materials procured at the group level in a
              central cost centre. These costs are consolidated in the department and
              charged directly out to the Airports based on net retail income.                       Costs
              allocated as part of CAS and PLC indirect costs are those that cannot be
              readily attributed to a particular airport;




                                                                                              CAA|           77
                                                                                       December 2006




      •      IT department direct costs related to Airport and other business specific IT
             projects undertaken by the central department. An example would be the
             Terminal 5 (“T5”) project at HAL. T5 project costs of £4.7m are included in
             the total 2005/06 directly charged IT cost of £5.3m in the table above84. The
             costs relate to resources sourced from the IT department to assist with the
             construction and operation of IT systems at T5. We understand that the
             remainder of the costs relate to ad hoc projects;

      •      the Property department provides the Airports and other businesses with
             investment property management.                We understand that the property
             management team’s work is specific to particular airports. Each airport is
             charged the costs of its specific property team.

      •      the Research department provides research studies and surveys as
             requested specifically by the Airports and other businesses. We understand
             that these are ad hoc services and are invoiced to the Airports when
             incurred; and

      •      Other department costs include a number of smaller Airport specific
             projects, such as security projects and HR training cost initiatives that are
             directly charged to the Airports and other businesses, on a project-by-project
             basis.


7.4   In summary, Corporate Office direct costs are charged to businesses directly in
      relation to the services provided. This approach would appear to be consistent
      with best practice.

      HEX costs
7.5   HEX is a rail service from central London to HAL. HAL owns the assets used in
      this business and they are treated as part of HAL’s RCV in the price control
      calculation. For operational purposes, HEX passes on the revenues of its service
      to HAL, acting as an agent for HAL. HEX is a wholly owned subsidiary of BAA plc.


7.6   The operating costs incurred by HEX, including those charged to it by other parts
      of BAA (e.g. BSC, CAS and PLC costs), are charged directly to HAL with a 10%
      management fee on these costs 85 . HEX’s activities relate entirely to HAL and
      84
               BAA/Q5/185 – “13- March 06 Interco reconciliation 070606.xls”, BAA, June 2006.
      85
                For the purposes of this study and the scope of work agreed between LECG and CAA, the
      conceptual difference between a management fee (the term used by BAA in the context of HEX) and a
      mark-up (the term applied by CAA in relation to CAS and PLC costs and BSC costs) would appear to
      be minimal. We recognise that for legal and taxation purposes the difference may be significant.




                                                                                                CAA|   78
                                                                                         December 2006




      consequently the direct charging of costs to HAL represents an appropriate
      allocation methodology. We discuss the management fee charged by HEX to HAL
      in more detail in Section 8.

      BSC costs
7.7   BSC is a shared service centre located near Glasgow, which provides finance, HR
      and (increasingly) other services to the Airports and to other BAA businesses. We
      understand that many of the services provided by BSC were previously provided
      at individual airports or centrally. BSC is a standalone operation. We understand
      that its assets are not included within the asset base of any regulated airport86.
      The costs incurred by BSC are charged to Corporate (i.e. CAS and PLC
      functions), the Airports and other BAA businesses after the application of a 7.5%
      mark-up. BAA allocates these costs to the Airports and other businesses using a
      range of cost drivers.


7.8   We provide a brief description of BSC activities and associated cost drivers
      below87:

      •       Customer Services provide a telephone contact service to BAA staff and
              suppliers, relating to invoice, payment and payroll queries. These costs are
              allocated on calls per location;

      •       the Purchase to Pay team provides accounts payable and procurement
              support services, processing and paying supplier invoices. These costs are
              allocated based on the number of invoices per location;

      •       the Credit Services department team provides debt management services
              and cash collection and processing for the Airports.                     These costs are
              allocated based on turnover by location;

      •       Invoicing     activities   relate     to   the     processing       of     invoices    and
              telecommunication charges across the Airports and other businesses.
              These costs are allocated on the number of bills per location;

      •       the Retail department is responsible for collecting and processing payments
              and statements for retail concessionaires across the Airports. These costs
              are allocated on the number of concessions per airport;

      86
                BAA has stated it does not believe that there are any assets included in the RCV of any of
      the designated airports that were formerly used to provide services now provided by the BSC, and
      which are now therefore redundant.
      87
                 BAA/Q5/237 – “LECG Corporate Cost Allocations - 5th sub - BSC recharges”, BAA, August
      2006.




                                                                                              CAA|     79
                                                                                    December 2006




       •       the Traffic Charging department collects and processes aircraft charges
               data across the Airports to enable the calculation and generation of invoices.
               These costs are allocated by aircraft charge income per location;

       •       the People Management Administration Team (“PMAT”) department
               provides recruitment, referencing and resourcing services including criminal
               records checking and counter terrorist measures. These costs are allocated
               by the number of employees per location;

       •       the Payroll department administer payroll for the all BAA employees in the
               UK and a number of overseas staff and completion of statutory payroll
               reporting.   These costs are allocated by the number of employees per
               location;

       •       the Accounting to Reporting department provide financial and management
               accounting services to the Airports and other businesses. The department
               records transactions through to preparation of subsidiary and group
               management and statutory accounts and provide tax compliance services.
               These costs are allocated by operating profit and asset net book value per
               location; and

       •       other services include BAA system management, flight information services,
               office facilities and an engineering helpdesk.

7.9    BAA has provided LECG with BSC cost data for the period 2006/07 to 2008/09, as
       shown in the table below:

       Table 32:     BSC charges 2006/07 to 2008/09*

       £’000                             2006/07                2007/08                2008/09

       BSC costs                            ||||||||||             ||||||||||             ||||||||||

       Mark-up at 7.5%                         |||||||                |||||||                |||||||

       Total                                 |||||||||             |||||||||              |||||||||

       Source: BAA submissions “05/06 numbers: CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls” and “06/07 - 08/09 numbers: BAA-Q5-185-14 - Bus Plan Corp Alloc & Inter-co
       06-07 to 08-09.xls”. Note: We have not been provided with 2005/06 BSC data. *Note: BAA
       rolls forward costs to from 2009/10 to 2012/13 using inflation and growth assumptions,
       consequently the costs for these years are omitted here.


7.10   It appears that BSC costs are allocated using a more considered and causality-
       based methodology as compared to that adopted by BAA for CAS and PLC costs.




                                                                                          CAA|         80
                                                        December 2006




Based on our limited review, we believe BAA allocates BSC costs on an
appropriate basis.




                                                             CAA|   81
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8     Mark-up

      Introduction
8.1   BAA allocates certain costs to the Airports after the application of a mark-up. This
      applies to CAS and PLC costs (i.e. indirect charges), and a number of other costs
      charged directly within the BAA group.


8.2   In the context of setting a price control, it is important to ensure that allowable
      costs are set at an appropriate and efficiently incurred level. To the extent that
      costs are being incurred in one part of the business and then allocated to another,
      it is particularly important to consider the impact of mark-ups (either as a cost or as
      income) on the overall cost base and hence the aeronautical revenue requirement
      of each of the designated airports.


8.3   CAA requested that LECG review BAA’s approach and policy in this area. We
      were asked to consider both the appropriateness of allowing mark-ups for price
      control purposes as well as the level of any mark-ups that may be appropriate.


8.4   In this section, we first set out the basis for, and details of, BAA’s approach to the
      application of mark-ups.    We then review the consistency of BAA’s approach
      across different aspects of its operations and different categories of cost. We then
      consider some of the conceptual issues and regulatory precedents we believe are
      relevant when considering the appropriateness of applying mark-ups to centrally
      incurred costs in the context of setting a price control. We then summarise the
      results of a limited benchmarking exercises we undertook to help assess the
      reasonableness of the mark-up applied by BAA.              Finally, we set out our
      conclusions on the application of mark-ups.

      BAA’s approach
8.5   We have identified three main areas where costs are marked-up before being
      allocated to the Airports and to BAA’s other businesses: i) CAS and PLC costs; ii)
      BSC costs; and iii) HEX costs. We discuss BAA’s approach and rationale to cost
      mark-ups in each of these areas below.

      CAS and PLC costs

8.6   In describing the CAS and PLC departments BAA states:


            “…that central functions are strategic centres of excellence that provide
            economies of scale for the business (e.g. one Strategy Analyst for HR




                                                                                   CAA|   82
                                                                                          December 2006




               can review the three airports centrally whereas one analyst at each
               airport would be required if the cost were not incurred at PLC)”88.

8.7   Consequently, BAA believes that it is appropriate to apply a mark-up on the
      majority of CAS and PLC costs, subject to the limitation that the resulting charges
      are not more than the cost of each airport acquiring the services at market prices
      or self providing (whichever is the more efficient)89. BAA states that the mark-up
      on CAS and PLC costs represents:


               “… value added in the provision of technical and professional expertise,
               which could be expected to be delivered from centres of excellence;
               and

               … a financial return to the central organisation, where it could be
               reasonably assumed that if the supplier were a third party, it would be
               expected that a profit would be made.               This accords also with HM
               Revenue and Customs transfer pricing requirements”90.

8.8   BAA applies a mark-up of 7.5% to most CAS and PLC department costs (i.e. on
      average 65% of costs between 2005/06 to 2008/0991) allocated to the Airports and
      to BAA’s other businesses. There are two major categories of CAS and PLC
      costs to which BAA does not apply a mark-up: (i) CAS and PLC Corporate Office
      specific costs which are retained within BAA plc and not allocated; and (ii) IT lease
      costs.    From 2006/07 onwards, BAA has discontinued its previous practice of
      applying the 7.5% mark-up to IT lease costs because a return is already provided
      through the IT lease mechanism, and applying a mark-up on these costs would
      result in a double margin92.


8.9   We understand that the mark-up applied to CAS and PLC department costs was
      set at 7.5% a number of years ago. BAA has not been able to provide LECG with
      any contemporaneous documents explaining how or why this rate was selected.
      With the exception of certain transfer pricing documents summarised below, BAA
      has not provided LECG with any documents supporting the continued
      appropriateness of the 7.5% mark-up. Importantly, BAA has also not shown that



      88
                BAA/Q5/251 – “meeting notes updated 080806 updated JL.doc”, BAA, 23 August 2006.
      89
               BAA/Q5/253 – “Interim Draft Presentation - sent to BAA with initial BAA comments.ppt”, BAA,
      24 August 2006.
      90
                BAA/Q5/54 – “Revenue and cost allocation process”, BAA, 31 January 2006.
      91
                Excluding IT leases, which are not marked up from 2006/07 onwards.
      92
                If the CAA were using BAA’s cost data for 2005/06 as a base year, it would be appropriate to
      deduct the mark-up applied in that year. LECG’s analysis is presented on that basis.




                                                                                                CAA|     83
                                                                                            December 2006




       the resulting charges after application of the mark-up are not more than the cost of
       each airport acquiring the services at market prices or through self-provision.


8.10   BAA stated that the application of a mark-up is required to conform to UK transfer
       pricing rules. Under such rules, intra group services should be provided on an
       “arms length basis” which should include a profit element. BAA has indicated that
       its approach is in accordance with UK tax guidelines:


               “….HM Revenue and Customs (HMRC) guidelines on centrally
               provided services state that cost plus methods are appropriate in most
               instances and that only a modest mark up is necessary”93.

8.11   We understand that HMRC has performed a review, which confirms that the scale
       of mark-up applied by BAA is within the acceptable range for tax purposes and
       that BAA’s approach to transfer pricing was “a low risk area”94, 95. Overall, BAA’s
       management is satisfied that 7.5% remains an appropriate mark up because:


               “… it is only a modest mark up as per HMRC guidance,… it takes into
               account the low level of risk associated with the provision of the
               services,… HMRC did not raise any objections to the 7.5% mark up
               following a recent review carried out by management and shared with
               the revenue (June 2005)… there have been no significant changes in
               circumstances which justify a significant change in approach”96.

8.12   BAA noted that a mark-up of costs of 7.5%, which is equivalent to an operating
       cost margin of less than 7.0%97, is not high for professional services such a those
       provided by the HR, legal, finance and regulation departments. No evidence was
       provided to support this contention.


8.13   The table below details the application of mark-ups for the period from 2005/06 to
       2008/09. For ease of comparison, we have restated 2005/06 to remove the mark-
       up on IT lease costs.




       93
                BAA/Q5/186 – “BAA plc and CAS Departments: Allocations Capping and Pricing Margin”,
       BAA, June 2006.
       94
                 HMRC letter “BAA plc UK/UK Transfer Pricing”, 5 August 2005.
       95
                 The HMRC review did not constitute a formal review of the level of the mark-up, merely that it
       was in the range of acceptability.
       96
                BAA/Q5/186 “BAA plc and CAS Departments: Allocations Capping and Pricing Margin”,
       BAA, June 2006.
       97
                 7.5%/107.5% = 6.98%.




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       Table 33:      Impact of mark-ups on CAS and PLC costs 2005/06 to 2008/09

                                                    2005/06
       £k nominal                 2005/06                             2006/07          2007/08          2008/09
                                                    adjusted

       CAS

       Base costs                   ||||||||||||      ||||||||||||    ||||||||||||||   ||||||||||||||    ||||||||||||||

       Mark-up                        ||||||||||        ||||||||||        ||||||||||       ||||||||||       ||||||||||

       Total costs                 |||||||||||||     |||||||||||||     |||||||||||||    |||||||||||||    |||||||||||||

       Effective mark-up                 7.7%              4.7%             4.7%             4.4%              4.7%

       PLC

       Base costs                   ||||||||||||      ||||||||||||      ||||||||||||     ||||||||||||     ||||||||||||

       Mark-up                        ||||||||||        ||||||||||        ||||||||||       ||||||||||       ||||||||||

       Total costs                   |||||||||||       |||||||||||      |||||||||||      |||||||||||       |||||||||||

       Effective mark-up                 4.5%              4.5%             5.4%             5.2%              5.2%

       CAS and PLC

       Base costs                  ||||||||||||||    ||||||||||||||   ||||||||||||||   ||||||||||||||    ||||||||||||||

       Mark-up                        ||||||||||        ||||||||||        ||||||||||       ||||||||||       ||||||||||

       Total costs                 |||||||||||||     |||||||||||||     |||||||||||||    |||||||||||||    |||||||||||||

       Effective mark-up                 6.8%              4.7%             4.9%             4.6%              4.8%

       Source: BAA submissions “05/06 numbers: CORP OFA STRUCTURE & ACTUALS MAR 06
       SUMMARY.xls” and “06/07 - 08/09 numbers: BAA-Q5-185-14 - Bus Plan Corp Alloc & Inter-co
       06-07 to 08-09.xls”. Note: BAA rolls forward costs from 2009/10 to 2012/13 using inflation and
       growth assumptions, consequently the costs for these years are omitted here.


8.14   The effective mark-up for CAS in 2005/06 (before adjusting for the mark-up on IT
       leases) was greater than 7.5%, as the costs to be allocated in 2005/06 included
       income of |||||||||||||. Removing this income, which was Corporate Office specific
       and was not allocated to the Airports or other businesses, lowers the mark-up to
       7.3%98.


8.15   In general, the effective mark-up is lower than 7.5% because certain costs are not
       marked up. The majority of these costs relate to IT leases99, which are included
       98
                 This income is referred to in BAA’s models as 'Common costs - excptl receipt'.
       99
                 These costs represent on average 27.5% of total CAS plus PLC costs.




                                                                                                        CAA|       85
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       within CAS, with the remainder relating to Corporate Office specific costs which
       are included within PLC. Overall, for the period 2005/06 (adjusted) to 2008/09, the
       effective mark-up for CAS (and total CAS plus PLC) declines to an average of
       4.8% per year.

       BSC costs

8.16   BAA has not provided detailed submissions to LECG supporting its use of a mark-
       up of 7.5% when recharging BSC costs. BAA simply states that these services
       have similar characteristics to those provided by the CAS and PLC departments100.
       Some BSC costs charged to CAS and PLC departments (with a mark-up of 7.5%)
       are subsequently included within the CAS and PLC costs that are allocated to the
       Airports and other business units with an additional mark-up of 7.5%. These costs
       are therefore subject to a double mark-up, however, the amount involved is not
       material (less than £5,000 in 2005/06).

       HEX costs

8.17   BAA has provided LECG with a copy of the contract between HAL and HEX which
       provides for the application of the management fee of 10% on the costs incurred
       by HEX101. However, we have not been provided with an explanation of the basis
       for using 10%, as compared with the mark-up of 7.5% that is applied to CAS, PLC
       and BSC costs. In its regulatory submission, BAA excludes the management fee
       for both HEX revenues and costs, and accordingly we do not consider the issue
       further in this report.

       Consistency of mark-ups across BAA’s departments
8.18   BAA has explained that in addition to the CAS, PLC, BSC and HEX costs there
       are a number of other central costs that are directly charged to the Airports and
       other businesses. BAA does not apply a mark-up to these direct costs.


8.19   BAA has also confirmed that costs incurred centrally that are subsequently
       capitalised in the financial records of the recipient business, are charged without a
       mark-up. This differs from the approach for CAS and PLC operating costs, where
       a mark-up is applied.

       Direct costs applied with no mark-up

8.20   As described in Section 7, there are a number of Corporate Office costs that are
       charged directly to the Airports and to BAA’s other businesses. These Corporate


       100
                BAA/Q5/54 – “Revenue and cost allocation process”, BAA, January 2006.
       101
                BAA/Q5/348 – “Appendix 1 HEX initial service agreement 1998”, BAA.




                                                                                            CAA|   86
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       Office direct costs are charged without a mark-up. The table below provides a
       summary of these direct costs for the period 2005/06 to 2008/09.

       Table 34:      Corporate Office direct charges with no mark-up applied for the
                      period 2005/06 to 2008/09

                                  2005/06            2006/07            2007/08            2008/09

        UK airport retail          ||||||||||||       ||||||||||||       ||||||||||||      ||||||||||||

        IT                          ||||||||||         ||||||||||         ||||||||||            |||||||

        Property                        |||||||          |||||||||          |||||||||         |||||||||

        Research                        |||||||            |||||||            |||||||           |||||||

        Other                           |||||||            |||||||            |||||||           |||||||

        Total                      |||||||||||        |||||||||||        |||||||||||       |||||||||||

       Source: BAA submission BAA/Q5/199-8 – “Interco Income SEA 2005-6.xls", 27 June 2006 &
       BAA submission BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls” 4 July
       2006. Note: BAA rolls forward costs from 2009/10 to 2012/13 using inflation and growth
       assumptions, consequently the costs for these years are omitted here.


8.21   BAA has stated that:


                “…where services are bought in and subsequently charged to group
                companies, unless significant costs are incurred in commissioning and
                overseeing delivery of the service, a mark up may not be required”102.

8.22   BAA notes that where direct costs simply pass through one of the central
       departments, no uplift is applied, as no value has been added103. The argument is
       that the Airports could procure the costs of these services on the same terms as
       the central departments and therefore no mark-up should apply.


8.23   In relation to the T5 project which accounts for £4.7m of the directly charged IT
       costs in 2005/06, BAA stated:


                “…the 7.5% mark-up is not applied to the Terminal 5 project as this is a
                distinct project in the business and that for projects that are not yet
                operational a mark-up would not be charged.



       102
                BAA/Q5/186 – “BAA plc and CAS Departments: Allocations Capping and Pricing Margin”,
       BAA, June 2006.
       103
                 BAA/Q5/171 – “BAA Central Costs Re-charges principles”, BAA, June 2006.




                                                                                             CAA|         87
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               ...an alternative would have been to embed the IT elements in the T5
               project as direct costs in which case BAA argue that the 7.5% would
               not have applied”.

8.24   In some instances, the distinction between the activities that comprise direct costs
       and those that are CAS and PLC indirect costs allocated with a mark-up applied is
       unclear. For example, we understand that the T5 IT costs relate to the provision
       of IT applications, infrastructure and support to the T5 project site. These costs
       appear to be very similar in nature to GPIT costs (which are introduced in Section
       5), which are charged to the Airports and other businesses after application of the
       7.5% mark-up. BAA has accepted that a proportion of these directly charged
       functions could be deemed to add value, in which case an argument (based on
       consistency) could be made for the application of a mark-up on direct costs.


8.25   For illustrative purposes, we consider the impact of applying a consistent mark-up
       of 7.5% to each category of Corporate Office direct costs in the table below.

       Table 35:     Impact of applying a mark-up of 7.5% on Corporate Office direct
                     charges for 2005/06

                                                                                    2005/06 inc
                                         2005/06               Mark-up
                                                                                     mark-up

       UK airport retail                 ||||||||||||            ||||||||||           ||||||||||||

       IT                                  ||||||||||              |||||||              ||||||||||

       Property                              |||||||                  |||||             ||||||||||

       Research                              |||||||                  |||||               |||||||

       Other                                 |||||||                  |||||               |||||||

       Total                             |||||||||||             |||||||||            |||||||||||

       Source: LECG analysis and BAA submission BAA/Q5/199-8 – “Interco Income SEA 2005-6.xls", 27
       June 2006 & BAA submission BAA/Q5/185-14 – “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”
       4 July 2006.

       Treatment of capitalised expenditure

8.26   Where centrally incurred costs incurred are to be capitalised, BAA does not apply
       a mark-up. The costs that are typically capitalised include costs incurred by the
       budget centres within the AMA department, which support capital projects. AMA
       costs relating to the procurement of operating cost items and certain categories of
       capital project costs are included within the CAS and PLC indirect cost allocations
       and are subject to the mark-up of 7.5%.




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8.27   BAA explained it does not mark-up these costs because it would require additional
       consolidation adjustments to ensure that the Group accounts comply with the
       applicable accounting standards104. BAA indicated that this approach is consistent
       with its policy of pragmatism. BAA has also noted applying mark-ups to costs that
       are subsequently capitalised would have the impact of inflating the asset base of
       the airports, and in the case of the Airports would, all other things being equal,
       result in a higher aeronautical revenue requirement.

       Conceptual issues relating to mark-ups
8.28   In the past, the CAA, like other regulators, has set BAA efficiency targets in
       relation to operating and capital expenditure, but has sought not to become
       involved in the management of the regulated business.


8.29   If the management of a regulated company decides that it is appropriate to
       respond to the efficiency incentives by outsourcing functions that historically have
       formed part of the regulated business, or move such activities into a central
       standalone division in order to exploit economies of scale, it is a key regulatory
       principal that the revenue requirement should not increase.              The rewards for
       outperforming efficiency targets flow to the company and its shareholders until
       they are passed on to customers through a change to the allowable cost base.
       Generally, there is no right to claim a margin outside the regulated business just
       because efficiency targets have been met, unless there is an explicit regulatory
       policy to reward outperformance.


8.30   We believe that it is important to consider conceptually whether BAA should be
       allowed to charge a mark-up on costs when it has outperformed efficiency targets.
       This is essentially a policy issue for the CAA.


8.31   A second consideration relates to allowed returns. In accordance with the CAA’s
       statutory duties, BAA is subject to a price control, which is set to allow it to earn a
       rate of return on its RCV plus an allowance for efficiently incurred operating costs
       and capital expenditure.


8.32   The RCV represents the value of all of the functions and activities of BAA’s
       regulated business. These functions will typically vary in terms of capital intensity.
       For example, some central functions, such as HR, will not have a material asset
       base, but they will have a value in terms of their contribution to the operations and
       will contribute to the value of the regulated business as a whole.


       104
                It would be permissible to include the mark-up on costs when preparing the financial
       statements of the individual subsidiary entities, such as HAL.




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8.33   However, as a matter of regulatory policy, in situations where support functions
       are removed from the regulated business, the costs allocated back to the
       regulated business should not include a margin unless there has been an
       appropriate reduction in the RCV of the regulated entity. That is, the RCV of the
       regulated business should be reduced by an amount so that the return foregone
       within the regulated business is equal to the mark-up charged by the new central
       department. If this is not the case, the revenue requirement may be misstated (i.e.
       an element of double return may arise).


8.34   Allowing mark-ups may be more easily justified if support services (e.g. CAS and
       PLC) have never been included within the Airports (and hence never formed part
       of the Airport’s RCV). If these support services have always existed outside the
       scope of the regulated businesses, then the application of a mark-up can be more
       easily justified. We understand that at least some of CAS and PLC departments
       were formerly located at the Airports. However, we have insufficient information
       covering the formation of the CAS and PLC departments and what was (or was
       not) included within the RCV when it was initially set.                     As such, we cannot
       conclude, at this stage, whether there is a case for excluding mark-ups.


8.35   We believe that it is important for the CAA to consider conceptually whether BAA
       should be allowed to charge a mark-up on costs based on the theoretical debate
       above. We note, however, in other regulated sectors the application of mark-ups
       is not generally considered appropriate.

       Treatment of mark-ups in other regulated sectors

8.36   As part of our consideration of the appropriateness, for price control purposes, of
       allowing a mark-up on the costs BAA allocates to the Airports, we have reviewed
       the treatment of similar costs in other regulated sectors.


8.37   In its 2004 Electricity Distribution Price Control Initial Proposals, Ofgem removed
       intra-company margins (e.g. profit margins on charges from related parties) on the
       basis that these were not genuine “costs”. Ofgem stated that if the related party’s
       business was predominantly external to the group (i.e. approximately 75%
       external to the group) then the inclusion of an internal margin could be considered.
       For the purposes of the price control, Ofgem excluded all margins105.


8.38   Ofwat’s Regulatory Accounting Guidelines note that charges paid to central group
       undertakings must be related to the services provided and should be charged at
       cost. Consequently no mark-up is applied in the water industry when determining


       105
               “Electricity Distribution Price Control Initial Proposals”, Ofgem, June 2004.




                                                                                                   CAA|   90
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       the costs incurred in the provision of regulated activities. As an example Ofwat
       states:


              “Management fees should not be inflated by additional costs beyond
              those actually incurred, e.g. where the parent treasury function provides
              a guarantee to the Appointee, a charge should not be made for the
              provision of that guarantee beyond that paid by the parent”106.

8.39   Postcomm ensures that Royal Mail’s overhead business unit profits are eliminated
       through an internal recharge mechanism.                     To the extent that some internal
       recharges are based on prices that are greater than costs, the mechanism
       ensures that the associated profits are removed107. In essence, Postcomm does
       not allow mark-ups on charges from support functions when calculating the
       efficient level of operating costs on which to set the price control.

       LECG benchmarking
8.40   Without prejudice to any conclusions that LECG or CAA may reach about the
       appropriateness of allowing any mark-ups on centrally incurred costs, LECG has
       undertaken some limited benchmarking to assess the reasonableness of the 7.5%
       mark-up applied by BAA.


8.41   With the agreement of the CAA, LECG’s methodology for assessing the
       appropriateness of the 7.5% mark-up was based on a transfer pricing approach.
       This involved reviewing the financial performance of independent companies
       engaged in the provision of similar services to unrelated third parties. It should be
       noted that transfer-pricing studies involve an element of judgement in identifying
       appropriate comparables and hence different opinions may exist as to the
       comparability of particular businesses.


8.42   LECG agreed with CAA that based on the materiality of the costs to which the
       mark-ups are applied and the availability of potentially suitable transfer pricing
       comparables, the scope of the review should be restricted to IT costs 108 . Our
       approach involved three steps:


       •     identify specific functions and activities performed by BAA’s IT department
             through a review of the IT department cost allocation schedules and other
             information provided by BAA and through discussions with BAA staff. This

       106
                 “Regulatory Accounting Guideline v5.04”, Ofwat.
       107
                 “Future Efficient Costs of Royal Mail’s Regulated Mail Activities”, LECG, August 2005.
       108
                 On average over the period from 2005/06 to 2008/09 IT lease costs and Group IT costs
       represent 58% of CAS and PLC before mark-ups.




                                                                                                   CAA|   91
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              step identified four main functions: centralised procurement, software
              development, maintenance and support, and ad hoc project fulfilment;


       •      identify independent companies performing activities similar to each of the
              functions identified.         We identified and reviewed suitable comparable
              companies using the UK industry classification code (SIC code) and the
              FAME database 109 .         We have reviewed the information available on the
              selected companies to remove from the benchmark group those for which
              insufficient financial information is available, those which are loss making110
              and those which are performing dissimilar activities based on the trade
              description provided by the FAME database; and


       •      perform financial analysis to arrive at an arm’s length mark-up of
              comparable companies111.


8.43   We summarise below the results of our benchmarking on the mark-ups achieved
       on arm’s length transactions in each of the four broad areas of IT service provided
       centrally by BAA.

       Procurement functions

8.44   BAA’s IT department performs centralised procurement services in relation to
       airport IT systems and office equipment.                  Our review of the FAME database
       identified the category “Wholesaling activities” as the closest comparator to BAA’s
       IT procurement functions.                Consequently, our search involved identifying
       companies that perform wholesaling of computing, communications and office
       equipment (“wholesaling activities”)112.


8.45   Our analysis of these comparable companies identified an arm’s length mark-up in
       the range of 1.1% to 2.7% for wholesale activities, with a median of 1.7%.
       Consequently, our analysis does not support a mark up of 7.5% on BAA IT
       procurement functions.



       109
                 FAME is a database that contains information for companies in the UK and Ireland. FAME
       contains information on 3.1 million companies, 1.9 million of which are in a detailed format.
       110
                 It is considered that the long run equilibrium profit level cannot be negative and hence
       average loss making companies were excluded from the sample.
       111
                 It is normal transfer pricing practice within the EU to compare cost-plus margins derived from
       the financial statements without making any adjustments that are intended to make the benchmark
       companies more comparable to the entity for which prices are to be set. This is because such
       adjustments are inherently a matter of subjectivity and typically the information is not readily available
       that would allow such adjustments to be made on a consistent basis.
       112
               Companies with a UK SIC code 5184 - wholesale trade and commission trade of computer
       and computer peripheral equipment and software.




                                                                                                     CAA|     92
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       Software development functions

8.46   The software development activities performed by BAA’s IT department are
       embodied in the assets covered by the IT leases and appear to be similar to those
       involved in software development and publishing113. Our analysis of the returns of
       comparable software developers and publishers shows that an arm’s length mark-
       up for these activities would be in the range of 6.4% to 21.0%, with a median of
       15.4%. Accordingly, a mark-up of 7.5% on BAA software development functions
       appears reasonable.

       Maintenance and support functions

8.47   BAA’s IT department performs maintenance and support activities in relation to IT
       equipment at corporate offices, airport facilities and the networks involved in
       linking the different BAA locations. Our review of the FAME database shows that
       companies categorised under maintenance of office, accounting and computing
       equipment 114 provide the benchmarks most closely aligned to the activities
       performed by BAA’s IT maintenance and support functions.


8.48   Our analysis of the returns of these comparable companies suggests a mark-up of
       2.0% to 9.0% for the maintenance and support activities, with a median of 4.8%.
       The 7.5% mark-up suggested by BAA lies within the upper-quartile of the range
       and given the estimation issues involved in transfer pricing we conclude that the
       level of mark-up is reasonable.

       Ad hoc project fulfilment functions

8.49   BAA’s IT department perform ad hoc IT projects. From our review of the various
       projects undertaken by BAA the most appropriate comparable per the FAME
       database appears to be IT consultancies 115 , which include system integrations,
       project management and provision of advice on IT system requirements.


8.50   Our analysis of comparable IT consultancies suggests a mark-up in the range of
       1.7% to 6.6% for these IT consulting activities, with a median of 3.5%. A mark-up
       of 7.5% lies just outside of the upper end of the range. But given the scale of the
       difference, again it is not possible to conclude that the mark-up of 7.5% applied by
       BAA is unreasonable.




       113
               Our search for comparable companies was based on UK SIC 7221 - software publishing.
       114
               SIC 725 – maintenance of office, accounting and computer equipment.
       115
               SIC code 7222 – other software consultancy.




                                                                                           CAA|      93
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       Level of mark-up summary

8.51   The results of our limited benchmarking study suggests that the mark-up on costs
       achieved by companies engaged in the arm’s length provision of IT services,
       similar to those provided internally within BAA, are in the range of 2%-15%, if the
       medians are selected.


8.52   BAA has stopped applying a mark-up on the allocation of IT lease costs from
       2006/07 onwards.     These activities relate to the development of software for
       BAA’s business. On this basis, the mark-ups earned in the market on software
       development and publishing activities, which lie at the upper end of the overall
       2%-15% range, are no longer relevant to the assessment of the appropriateness
       of BAA’s 7.5% mark-up.


8.53   With the exception of Procurement functions, the mark-ups for the other remaining
       groups of activities we have tested broadly lie in a range that incorporates the
       7.5% mark-up applied by BAA. Adopting the median observation would suggest,
       however, that the mark up is towards the upper bound. Our analysis suggests that
       the highest median benchmark on any of the IT activities to which BAA continues
       to apply a mark-up was 5%, however the upper bounds were not significantly
       different to the 7.5% applied by BAA.       Consequently, due to the immaterial
       difference between our benchmark and BAA’s figure and the inherent subjectivity
       of such studies, we cannot conclude strongly that the mark-up is unreasonable.


8.54   As previously mentioned, our analysis has been constrained to benchmarking
       BAA IT costs. In order to identify an appropriate mark-up for all CAS and PLC
       costs a more detailed and wider ranging transfer pricing review would be required.
       It would be inappropriate to speculate here on precisely what such a review might
       reveal. However, we note BAA’s unsubstantiated suggestion that a mark-up of
       7.5% would be appropriate for some of the professional services provided by the
       CAS and PLC departments.

       LECG conclusions and recommendations
8.55   We set out below our conclusions and recommendations in relation to the
       appropriateness of applying mark-ups to CAS and PLC costs and to the other
       costs charged directly to the Airports and other businesses.

       Appropriateness of allowing a mark-up

8.56   There are a number of reasons that can be advanced in support of applying mark-
       ups. For example, the process of applying mark-ups to the costs incurred by
       BAA’s central departments has been in place for many years and hence costs on
       this basis have been incorporated in previous price controls set by the CAA.




                                                                                CAA|    94
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8.57   The argument that centralising overheads leads to greater efficiency (e.g. due to
       economies of scale) is not, in general, a justification for mark-ups. This would only
       be the case if there were an explicit regulatory policy that out performance should
       be rewarded.


8.58   BAA’s assertion that it may be necessary to apply a mark-up to some or all inter-
       company, intra-group, transactions for the purposes of complying with terms of
       transfer pricing regulations does not appear to LECG to be a valid reason for
       accepting, as a matter of principle, that such mark-ups should be included for the
       purposes of setting price controls. We do not believe that the CAA should attach
       much importance to acceptance by HMRC of BAA’s approach. We understand
       that acceptance by HMRC confirms only that the mark-up applied by BAA falls
       within acceptable bounds when calculating arm’s length prices for tax purposes.
       Moreover, the objective of a HMRC review is to identify instances where not
       enough tax is being paid and therefore where inter-company margins are
       understated, rather than overstated.


8.59   The decision on whether to allow any mark-up on allocated and directly charged
       costs is ultimately one of policy. This decision will need to be taken by the CAA.
       When reaching its policy decision the CAA may wish to consider a number of
       factors including whether (i) the CAA intended all regulated functions (including
       overhead and central support centres) to be included within the initial RCV when it
       was set; (ii) whether the RCV has been adjusted over time as functions have been
       outsourced to CAS and PLC, and (iii) any adjustment would fall within the scope of
       materiality. The answer to these questions may be difficult to ascertain as they
       relate, in part, to decisions that may have been taken many years ago


8.60   We recognise that CAA is not bound by regulatory precedent (either that from
       other sectors or the positions and policies it has adopted in previous price control
       reviews116). However, there is strong regulatory precedent to support the exclusion
       of mark-ups. The standards prevailing in the UK water, energy and postal sectors
       would support the exclusion of mark-ups.


8.61   Should CAA conclude that it is inappropriate to include mark-ups in the allowable
       cost base for price control purposes, we believe that it is relatively easy for BAA to
       provide cost information on this basis.               In part, this is because it is already
       required in order to comply with applicable accounting standards. The additional
       compliance costs imposed on BAA would appear to be minimal.



       116
                 Consistency is one of the five key principles originally devised by the Better Regulation Task
       Force in 1997, and subsequently endorsed by Government and adopted by the European Commission.




                                                                                                   CAA|     95
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8.62   We believe the CAA may wish to consider further consultation in this area.

       Conclusions on the level of mark-ups

8.63   LECG’s limited benchmarking analysis does conclusively support a mark-up of
       7.5% on BAA’s allocated IT activities117. However, our analysis has been confined
       to IT activities and has not included some of the professional services provided by
       the CAS and PLC departments to which BAA has suggested a higher mark-up
       may be appropriate. The highest median benchmark on any of the IT activities to
       which BAA continues to apply a mark-up was 5%, however the upper bounds
       were not significantly different to BAA’s figure.


8.64   In order to test the hypothesis that 7.5% as applied by BAA is inappropriate, would
       require a full transfer pricing review118. In determining whether such a study is
       necessary, we would suggest that the CAA have regard to likely time and cost of
       such a study, which may be considerable, and to the potential materiality of any
       change in the mark-up applied. Based on BAA’s projected CAS and PLC costs in
       2008/09 and BAA’s definition of the costs to which a mark-up should be applied, a
       1% change in the mark-up results in a change of ||||||||||| in the level of costs
       allocated to the Airports and other businesses. Approximately £0.9m of this would
       be allocated to the designated airports119.


8.65   In the absence of a full transfer pricing review, and given the level of the effective
       mark-up on total CAS and PLC costs120, we conclude that the application of a 7.5%
       mark-up to the costs to which it is applied by BAA appears to be broadly
       acceptable.


8.66   We do find it unusual, however, that BAA has not been able to support its view
       with more robust analysis such as transfer pricing studies and quotes from third
       party providers and other evidence of market testing. If the CAA decides not to
       proceed with a more extensive study, we believe that in the future BAA should be
       encouraged to assemble documentation and analysis to support its position on the
       appropriateness of allowing mark-ups for price control purposes and on the levels
       at which they should be set.



       117
                On the basis that no mark-up is applied to IT leases.
       118
                The scope of such an exercise should also include the BSC, the costs of which are also
       recharged with the addition of a 7.5% mark-up.
       119
                Should CAA conclude that mark-ups should be applied more broadly, for example, to
       Corporate Office direct costs, the impact of a 1% change in the mark-up may be more material.
       120
                 The effective mark-up on total CAS and PLC costs is forecast to be only 4.8%, on average,
       for the period 2005/06 to 2012/13 as IT lease costs are not subject to a mark-up. In addition, direct
       costs are not subject to a mark-up.




                                                                                                CAA|     96
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       Consistency

8.67   In addition to CAS and PLC costs, a mark-up of 7.5% is applied to BSC costs. A
       significant proportion of the services provided by BSC are transactional in nature.
       Based on our experience we believe that the mark-ups achieved by such
       businesses tend to be low121.


8.68   LECG’s benchmarking exercise did not extend to any of the activities undertaken
       at BSC. Accordingly, we have no market-based evidence on which to base a
       conclusion on whether this level of mark-up appears appropriate. In the absence
       of such data, and based on the materiality of the sums involved, we conclude the
       application of a 7.5% mark-up is acceptable for price control purposes122.


8.69   Even if the CAA concludes that it is appropriate for price control purposes for a
       margin to be earned, it is inappropriate for BAA to earn a double margin on any
       costs. As a matter of principle, we believe that the double margin earned on the
       allocation of CAS and PLC costs originating in BSC should be eliminated for the
       purposes of setting the price control. For the purposes of our report we have not
       made this adjustment as the amounts involved are immaterial (less than £5,000 in
       2005/06).


8.70   As previously mentioned, there are a number of Corporate Office costs that are
       charged directly to the Airports and to BAA’s other businesses. These Corporate
       Office direct costs are charged without a mark-up. BAA states that these costs
       simply pass through one of the central departments and no uplifts are applied, as
       no value has been added. Our review suggests that the distinction between the
       activities that comprise Corporate Office direct costs and those that are CAS and
       PLC costs is unclear.


8.71   Consequently an argument for a mark-up being applied could be made, however
       this a policy decision for the CAA. If the CAA concludes that in general it is
       appropriate for a mark-up to be applied on direct costs charged to the Airports, this
       mark-up should be applied consistently unless there is a good economic reason
       why this should not be the case. A conclusion to include these mark-ups would
       need to be made in parallel with a conclusion on the overall level of mark-ups.
       121
                  Based upon the scope of work agreed between the CAA and LECG, we have not examined
       data related to mark-ups and margins for the services provided by BSC. By way of anecdotal evidence
       we note that on 9 November 2006, Cap Gemini, a leading outsource service provider reported progress
       on its plan to improve the operating margin of its outsourcing division. This division is forecast to
       achieve an operating margin of 4% in 2006, before taking into account corporate costs and
       administrative            expenses.                            Please            refer             to
       www.capgemini.com/m/en/doc/capgemini_Financials_Q3_2006.pdf            and     www.washingtonpost
       .com/wp_dyn/content/article/2006/11/09/AR2006110900283.html.
       122
                The total mark-up on BSC costs of 7.5% amounts to around ||||||||||| for each year between
       2006/07 and 2008/09.




                                                                                                CAA|     97
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       Summary
8.72   The decision to include or exclude mark-ups is one of policy, and hence an issue
       for the CAA. Arguments can be made in support of both approaches. This is an
       issue on which the CAA may wish to seek consultation. In order to conclude on
       the appropriateness of the 7.5% mark-up applied by BAA, we believe that
       additional analysis is required. In the absence of additional information, and given
       that the overall effective mark-up for CAS and PLC is 4.8% over the relevant
       period, a margin of 7.5% on those costs where a mark-up is applied appears
       reasonable, at least on the grounds of materiality.




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9     Capping

      Introduction
9.1   In Section 3 we introduced the concept of capping. This is the process by which
      BAA’s management exercises its judgement to adjust (or ‘cap’) the allocation of
      PLC and CAS costs to particular businesses within the BAA group. An adjustment
      is made in circumstances in which BAA believes that the initial steps of the cost
      allocation process summarised in Figure 4 result in levels of charge in some or all
      businesses which are ‘unreasonable’, ‘inequitable’ or otherwise ‘inappropriate’.123.
      BAA sees this step as being a necessary and integral part of its cost allocation
      process.


9.2   In this section we describe BAA’s approach to capping before setting out our
      observations and conclusions on the appropriateness of capping in the context of
      setting the Q5 price controls for BAA’s designated airports.

      BAA approach
9.3   We understand that BAA introduced a policy of management review and capping
      adjustments some years ago.124.             This was a response by BAA to a recognition
      that its relatively simple and pragmatic approach to the allocation of CAS and PLC
      costs, based largely on the use of passenger volumes and operating profit as
      allocation drivers, might not take adequate account of the specific circumstances
      of individual airports when calculating the amounts to be allocated to each.


9.4   BAA has provided examples of why its ‘mechanistic allocation of costs’ using the
      selected drivers might yield inappropriate results. These include:


      •      the failure of the allocation process to take into account adequately the level
             of costs that the recipient business might reasonably have expected to pay
             for services received had it been a standalone entity able to take



      123
               BAA/Q5/186 – “BAA plc and CAS Departments: Allocations Capping and Pricing Margin”,
      BAA, June 2006.
      124
                We have not been able to confirm exactly when the current practice of ‘capping’ was
      introduced. In paragraph 1.0 of BAA/Q5/186, BAA states “the practice of capping was introduced prior
      to commencement of the last quinquennium”. We interpret this as meaning Q3, and hence that the
      process of capping has been in place since at least 1998. In an email to LECG on 14 July 2006, BAA
      states “caps were introduced many years ago at a time when for example the Stansted terminal had
      recently opened and passenger throughput was well below the terminal capacities and the level of
      operation relatively straight forward compared to the complexities of say Heathrow”. According to
      information contained on BAA’s official Stansted airport website (www.stanstedairport.com), the current
      terminal at Stansted was opened in 1991. It is therefore possible that the policy of ‘capping’ corporate
      recharges have been in place since the early 1990’s.




                                                                                                  CAA|     99
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             independent procurement decisions in relation to source, quality and
             quantity of services consumed125;


      •      how the drivers used in BAA’s allocation process fail to reflect the ways in
             which different airports contribute to CAS and PLC costs through their
             operational complexity. For example, a large, multi-terminal, multi-runway
             airport such as HAL, which is served by flag carrier airlines, affected by
             bilateral agreements and acts as a hub with a large number of transit
             passengers, as compared with a less complex airport such as STAL126; and


      •      the possibility that the level of business activity and the position of the
             business in its development cycle may mean that certain airports cannot
             absorb the level of costs that BAA’s mechanism suggests should be
             allocated to them. BAA has suggested that the position of STAL in the
             years after the opening of the new terminal ahead of passenger demand is
                                                    127.
             an example of this type of failure


9.5   The capping mechanism operates through a process of discussion, review and
      negotiation between the management of each airport/business and BAA centrally
      over the level of corporate allocations.              In reaching conclusions about the
      appropriate overall level of allocations, we understand senior management make
      judgments, which take into account their experience of the level of input provided
      centrally in support of each of the businesses128.


9.6   We understand that the reviews and negotiations are undertaken at an aggregate
      level and do not explicitly consider the appropriateness of the level of the allocated
      cost for a particular department or service provided by BAA centrally.


9.7   The results of these reviews and negotiations have, in the past, resulted in the
      application of two caps. The first involves a reduction in the allocation of corporate
      costs to certain non-regulated airports, with these costs being absorbed by BAA129.
      The second cap is applied to BAA’s regulated airports in the South East of
      England, and has, as shown in the table below, involved capping the level of costs
      allocated to STAL and the reallocation of costs in excess of this cap to HAL and
      GAL.

      125
               BAA/Q5/186 paragraph 2.1.
      126
               BAA/Q5/186 paragraph 2.1 and BAA/Q5/301 paragraph 5.2.
      127
               BAA/Q5/186 paragraph 2.1.
      128
               BAA/Q5/301 paragraph 5.2.
      129
                Given LECG’s terms of reference, we do not consider further the application of this cap in
      this paper.




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      Table 36:       Capping at STAL 2002/03 to 2007/08

      £k (nominal)              2002/03       2003/04       2004/05       2005/06       2006/07         2007/08

      Basic allocation          10,285          9,703       10,720        13,435        ||||||||||||    ||||||||||||


      Less capping               (5,785)       (4,703)       (4,437)       (5,033)       (5,184)         (5,340)


      Net allocation              4,500         5,000         6,283         8,402        ||||||||||      ||||||||||

      Net allocation as
      % of basic                  43.8%          51.5%         58.6%         62.5%          61.8%        63.8%
      allocation

      Heathrow
                                  4,577         3,762         3,591         4,027         4,118           4,328
      reallocation

      Gatwick
                                  1,208           941           846         1,006         1,066           1,011
      reallocation

      Total reallocation          5,785         4,703         4,437         5,033         5,184           5,340

      Source: BAA (BAA/Q5/186)


9.8   We understand that the process of review and negotiation described above
      resulted in decisions to apply caps on the level of costs allocated to STAL of
      £4.5m and £5.0m in 2002/03 and 2003/04 respectively. In 2004/05 and 2005/06
      the review and negotiation process resulted in further adjustments to the
      allocations of CAS and PLC costs. In subsequent years the caps adjustments
      have been calculated by rolling forward the 2005/06 adjustment, increasing it by
      3.0% per annum to reflect inflation.


9.9   The effect of limiting the rate at which the cap increases has been to reduce the
      impact of the cap relative to the total level of the CAS and PLC costs allocated to
      STAL.       In 2007/08, the last year of the current price control period, BAA
      anticipates that STAL will be paying 63.8% of the basic allocation as compared
      with 43.8% in 2002/03. In 2008/09, the first year of the next price control period,
      BAA forecasts that this will increase to 64.6%.130. We understand from BAA that
      this increase is consistent with the growing size and complexity of STAL relative to
      BAA’s other regulated airports in the South East of England131.




      130
                 Calculated as a basic allocation of |||||||||||||| less a cap of |||||||||||| and a resulting net
      allocation of |||||||||||||||| as per paragraph 3.0 of BAA/Q5/186.
      131
                BAA/Q5/301 paragraph 5.3.




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9.10   BAA reallocates the excess charge from STAL to both HAL and GAL on the basis
       of operating profit, which BAA believes recognises the greater complexity of these
       airports compared to STAL132. The use of operating profit as the basis for this
       reallocation introduces a degree of circularity as some of the costs that are
       reallocated on this basis were also initially allocated on the basis of operating
       profit.


9.11   In its Q5 Regulatory Submission, BAA sets out details of its projected levels of
       CAS and PLC costs and their recharge to HAL, STAL and GAL over the period
       from 2006/07 to 2017/18 133 .         These confirm the projected level of capping
       adjustments in 2006/07, 2007/08 and 2008/09 contained in earlier submissions
       and then project no capping adjustments from 2009/10 through until the end of the
       forecast period.


9.12   BAA has explained to LECG that this does not represent any change in its policy
       or approach, but is the output of the same process of review and exercise of
       management judgment that led to caps on the allocation of CAS and PLC costs to
       STAL in prior periods.        BAA has also explained that while it is not currently
       forecasting the use of capping adjustments after 2009/10, in some years a cap or
       adjustment may be needed if circumstances differ from those on which the current
       forecasts are based.


9.13   BAA has provided LECG with some observations on its assessment of the
       situation in 2009/10 and beyond.          BAA has highlighted that by this date it
       anticipates that STAL will have grown further and become appreciably more
       complex as work begins on the Stansted Generation 2 project, while the
       completion of Terminal 5 at HAL is expected to reduce the extent to which HAL
       draws on central resources. In these circumstances, BAA believes that the output
       of its process results in an appropriate allocation of CAS and PLC costs to each of
       the regulated airports134.

       LECG observations
9.14   LECG agrees with BAA that there is no “uniquely correct” way of allocating shared
       costs”135 and that most approaches involve exercising some degree of judgement,




       132
                 BAA/Q5/186 paragraph 2.2.
       133
                 BAA/Q5/300.
       134
                Discussion between LECG and BAA on 12 October 2006 and email from BAA dated
       18 October 2006.
       135
                 BAA/Q5/186 paragraph 2.1.




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       both in their design and in reviewing the appropriateness of the allocations
       resulting from their application.136


9.15   Accordingly, LECG does not object in principal to BAA’s adoption of a relatively
       simple and pragmatic approach to the allocation of CAS and PLC costs, with a
       subsequent stage in which management judgement is exercised to refine the
       allocation of costs. Based on our experience and the explanations provided by
       BAA, we recognise that without adjustment BAA’s approach may not result in
       appropriate or equitable allocations of CAS and PLC costs.


9.16   However, LECG has concerns about BAA’s management review and capping
       process, and about its appropriateness for price control purposes.                               These
       concerns relate to the lack of objectivity and transparency in the process.                            In
       particular:

       •      BAA does not have an accounting or budgeting manual or similar policy or
              procedures document that records and explains the management review
              process. We are not aware of any BAA document that sets out the factors
              which should be taken into account when considering the need for, or the
                                                        137
              scale of, any capping adjustment              ;

       •      BAA does not have any contemporaneous records or analysis supporting
              the derivation of the capping adjustments applied in prior periods or the
              basis for determining the projected levels of capping adjustments in future
              periods138;

       •      the process adopted by BAA does not consider the appropriateness of the
                                                                                                  139
              level of the allocation for any particular service or category of cost                 ; and

       •      BAA has not identified any measurable or otherwise objectively identifiable
              criteria for determining why no capping adjustment is anticipated to be



       136
                 This issue is addressed in greater detail in Section 10.
       137
                 This is consistent with the extent of documentation of the approach and process as a whole,
       as explained in greater detail in Section 3. The documentation provided by BAA in the context of this
       review was produced in response to requests from CAA and/or LECG.
       138
                 LECG requested such documentation, but was informed by BAA that such documentation is
       not available.
       139
                This would appear to be at odds with BAA’s suggestion that one of the weaknesses in the
       BAA’s approach, and hence why it is necessary to apply management judgment, is that it does not take
       account of what the recipient might be willing or able to spend on a particular service in the event that
       these were not provided centrally. It is not clear how one can assess what an individual airport would
       have been willing to pay except by reference to the costs of services.




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             required from 2009/10 onwards and there is not a need for a phased
             removal of the capping adjustment.


       LECG conclusions and recommendations
9.17   We believe that whether to accept the capping adjustments applied and/or
       proposed by BAA for the purposes of setting the price control is ultimately a policy
       decision for the CAA.     However, we do not believe that BAA has produced
       adequate evidence based justification for any of its capping adjustments (including
       those that it has applied in the past, those that it is forecasting will be applied in
       the future and when it believes that no capping adjustment will be required). As
       such, we cannot conclude that it is not appropriate for any or all of BAA’s capping
       adjustments (including the forecast zero values) to be included in the cost base of
       any of BAA’s airports for the purposes of setting the Q5 price control.


9.18   On this basis we have excluded the impact of BAA’s capping adjustments from all
       of our calculations and consider the impact of using alternative drivers on the level
       of costs before application of BAA’s capping adjustments. This does not affect the
       figures submitted by BAA for 2009/10 and beyond.           This is because BAA is
       forecasting that 2008/09 is the last year in which a capping adjustment will be
       appropriate.


9.19   If BAA is to continue with its current approach to cost allocation, and to use
       capping as the basis for submitting information to the CAA for price control and/or
       other regulatory purposes, we believe that it would be helpful if: (i) the overall
       approach and process were more fully and formally documented; and (ii) BAA
       recorded on a contemporaneous basis the rationale for particular allocation and
       capping decisions, and that this documentation included supporting analysis
       wherever possible.




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10     Cost driver analysis

       Introduction
10.1   In this section, we first discuss BAA’s approach to applying allocation drivers to
       CAS and PLC costs. We then provide an assessment of the drivers used by BAA
       in its cost allocation process and consider the applicability of a range of alternative
       drivers. In doing so, we take into consideration the cost drivers applied in other
       regulated sectors. We then set out the results of our modelling work, which shows
       the quantitative impact of adopting alternative cost drivers. Finally, we provide our
       conclusions on the most appropriate basis for allocation of CAS and PLC costs.

       BAA’s approach
10.2   BAA adopts a simple and pragmatic approach to allocating CAS and PLC costs to
       the Airports and to its other businesses.            BAA has not provided LECG with
       detailed documents supporting the original selection of the drivers used. Some
       documents have of course been provided. In relation to its choice of drivers on
       which to allocate costs, BAA stated:

               “Where allocated to businesses (i.e. not retained by BAA plc), costs
               should normally be allocated on the basis of simple ‘drivers’ (or proxies
               for drivers), such as passenger numbers; operating profit; capital
               expenditure and net retail income.”140.

10.3   BAA believes the current process is the most suitable for allocating costs at a high
       level, where this is supported by management review and the use of judgment to
       address any inappropriate results that may arise.                BAA acknowledged that
       alternative drivers might exist and that a more detailed cost allocation system
       might result in a different allocation of costs. However, BAA believes that the
       impact is unlikely to be material141.


10.4   BAA has not completed a formal review of alternative allocation drivers to support
       the contention that an alternative and more detailed methodology would not result
       in materially different cost allocations142.




       140
                BAA/Q5/171 – “BAA Central Cost Re-charges Principles”, BAA, June 2006.
       141
                BAA/Q5/251 – “Response to LECG email 11 August re BAA cost allocation study - meeting
       notes and update”, BAA, 23 August 2006.
       142
                BAA/Q5/253 - “Initial comments on LECG Interim Findings presentation”, BAA, 24 August
       2006.




                                                                                         CAA|    105
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10.5   In order to test the appropriateness of the allocation drivers used by BAA, LECG
       has performed an assessment of the various drivers used and sought to identify
       valid alternatives where appropriate. As a first step, we discussed the selection of
       CAS and PLC cost allocation drivers with BAA’s regulatory team. These drivers
       usually fall under one of two categories: (i) general CAS and PLC allocation
       drivers; and (ii) specific CAS and PLC drivers.


10.6   General (or default) allocation drivers are applied to CAS and PLC costs where
       there is no identifiable causal link between some measure of the level of activity in
       the business and the level of costs incurred by a central department. In this
       section we refer to the costs for which no causal link has been established as
       being common costs 143 . Specific drivers seek to take account of a causal link
       identified by BAA. For the purposes of this study, our primary concern is the
       selection of general allocation drivers, and BAA’s rationale for selecting one rather
       than another as the basis for allocating common costs. However, we also provide
       our observations on BAA’s selection of specific drivers.


10.7   The various drivers used in BAA’s cost allocation process are summarised below.
       We first summarise the drivers applied by BAA to CAS costs. The information
       shown is that for 2008/09144.




       143
                  The common costs to which we refer here are NOT the same as the ‘Common Costs’ listed
       in Table 1 and described in more detail in Section 5 of this report. The ‘Common Costs’ are a category
       of cost identified by BAA, which are not allocated to the Airports and other businesses. The ‘common
       costs’ to which we refer in this paragraph are those CAS and PLC department costs to which BAA has
       applied a default driver.
       144
                 Information for 2008/09 is shown here as it forms the basis for the projection of costs over
       the Q5 price control period, and includes certain categories of costs, which do not arise in 2005/06.




                                                                                                CAA|    106
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       Table 37:       2008/09 CAS departments and allocation drivers

       Department                                                       Allocation Driver

       IT leases                                                             Specific

       Group IT                                                              Specific

       Acquire & Maintain Assets (AMA)                                       CAPEX

       Group Health & Safety                                                   PAX

       Group Security                                                          PAX

       Research                                                                PAX

       Airport planning                                                        PAX

       Airline Relations Team                                                  PAX

       Corporate Responsibility & Environment                                  PAX

       Rail Strategy                                                           HEX

       Managing and Divisional Directors                                       PAX

       Group Marketing                                                         PAX

       Olympic 2012                                                 South East airport’s PAX

       UK Airports retail                                               Net retail income

       Chief Fire Officer                                                      PAX

       Group Services Director                                           Operating Profit

       Airport Operations                                                Operating Profit

       Group Retail                                                     Net retail income

       DEE AOE from 2008/9                                                     DEE

       Common costs                                                     Corporate Office

       Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls “


10.8   In the table below, we show the drivers applied by BAA to PLC costs.




                                                                                            CAA|   107
                                                                                        December 2006




        Table 38:      2008/09 PLC departments and allocation drivers

        Department                                                 Allocation Driver

        Board                                                       Corporate Office

        Finance (including insurance)                                Operating Profit

        Business Assurance                                           Operating Profit

        Human Resources                                              Operating Profit

        Property                                                     Operating Profit

        Corporate Affairs                            50% Operating Profit, 50% Corporate Office

        Economics & Regulation                                       Operating Profit

        Legal                                                        Operating Profit

        Company Secretary                                           Corporate Office

        SMIS & NIC                                                  Corporate Office

        Travelex                                                      Not Allocated

        Source: BAA/Q5185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls “


        General CAS and PLC allocation drivers

10.9    When specific allocation drivers cannot be identified, BAA applies general or
        default drivers to the relevant CAS and PLC departments. BAA allocates the
        majority of CAS department costs using passenger numbers (“PAX”).                        This is
        BAA’s default driver for CAS department costs. BAA believes PAX is a measure
        of airport activity and is therefore an appropriate basis for allocating the cost of
        providing CAS department services, many of which directly support airport
        operations.


10.10   Similar to the allocation of CAS department costs, BAA applies a default driver for
        allocating PLC department costs145. The default driver used by BAA to allocate
        PLC costs is “operating profit”. We understand that the rationale for selecting this
        as a driver is that BAA believes operating profit is a reliable measure of the size
        and complexity of each business, which in turn are reasonable proxies for the
        many individual factors that influence the costs of providing PLC department
        services.

        Specific CAS and PLC drivers
10.11   There are a number of CAS department costs to which BAA applies a more
        specific allocation driver. The use of a specific driver indicates that there is a

        145
                   The costs of only certain PLC departments are allocated. Where PLC department costs are
        allocated, the driver used is operating profit.




                                                                                             CAA|     108
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        causal link between the activities undertaken and the costs incurred. Specific
        drivers are used to allocate the following costs: (i) IT departments; (ii) AMA; (iii)
        Rail Strategy; (iv) UK Airports Retail; and (v) Group Retail.

10.12   The activities of these departments and the services that they provide are
        summarised in Section 5. In Appendix 5 we provide an analysis of the allocation
        of all CAS and PLC department costs to the Airports and the associated allocation
        drivers used by BAA for each year from 2005/06 to 2012/13.

        IT departments (IT leases and Group IT)
10.13   BAA allocates IT costs using a more complex set of drivers than those applied to
        other CAS and PLC departmental costs. The basis of allocation reflects detailed
        consideration by BAA of the use made by different businesses of individual assets
        and services.       IT costs comprise two elements: (i) network, software and
        infrastructure support, maintenance and licensing costs (i.e. Group IT or GPIT
        costs); and (ii) the charges for usage of IT systems and software assets (i.e. IT
        lease costs).

10.14   Where a measure of usage can be identified, BAA allocates GPIT costs on the
        basis of specific drivers, which are applied at the OFA account code level. The
        number of logins is the default driver applied to GPIT costs when no causal link
        can be identified146.

10.15   IT lease costs are allocated on specific drivers identified by BAA at the level of the
        individual asset. Where no clear causal or usage-based drivers can be identified
        for IT lease costs, BAA applies PAX as the default driver.

        AMA
10.16   The AMA department embraces the groups responsible for capital projects, which
        provide strategic direction and advisory services to ensure the effective execution
        of BAA’s capital projects, as well as the supply chain departments that provide
        procurement advice and services.                 BAA allocates AMA costs using capital
        expenditure, arguing that the level of capital investment by each business is
        reflected in the activities undertaken in the AMA department.




        146
                 The login driver used is login numbers, excluding corporate office logins.




                                                                                                 CAA|   109
                                                                                     December 2006




10.17   In order to avoid the potentially distortive effects and volatility of allocating AMA
        costs using annual total capital expenditure, BAA’s capital expenditure cost
        allocation driver seeks to reflect the normal, on-going, level of capital projects.
        Consequently, major projects (such as HAL Terminal 5) are excluded when
        deriving this allocation driver.

        Rail Strategy
10.18   The costs of the Rail Strategy department relate to managing BAA’s rail
        operations, the most significant being HEX. BAA allocates these costs entirely to
        HEX.

        UK Airports Retail and Group Retail
10.19   BAA allocates the costs of the retail departments within CAS on the basis of net
        retail income.     BAA defines net retail income as retail turnover net of any
        commission and discounts.


        Alternative cost allocation drivers
10.20   LECG sought to obtain from BAA information on its selection of CAS and PLC cost
        allocation drivers and its views of the appropriateness of alternative allocation
        drivers. Specifically, we requested details of why BAA believes that its selected
        drivers are the most appropriate and details of BAA’s process for selecting general
        and specific drivers. In order to assist with identification of alternative drivers, we
        also requested that BAA provide detailed descriptions of cost categories and
        departmental activities to supplement the basic definitions provided in its
        submissions.


10.21   BAA provided basic information and such documentation as was available, and
        provided LECG with the opportunity to discuss the activities of certain departments
        with knowledgeable individuals.          However, BAA believes that its choice of
        allocation drivers is the most appropriate consistent with its overall approach, and
        consequently believes that it would not be appropriate for it to propose
        alternatives147.


10.22   In the absence of very detailed information on the activities of individual cost
        centres, we have not been able to perform a bottom-up assessment of the


        147
                  In an email from BAA to LECG on 26 July 2006, BAA rejected a request to engage in
        detailed discussions of alternative drivers. BAA had previously indicated that it had provided
        explanations of the activities performed by the different departments, both in meetings and in
        BAA/Q5/54. BAA also stated that it believes that the cost drivers it has selected are the most
        appropriate given its high level and pragmatic overall approach to cost allocation.




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        appropriateness of each cost driver used by BAA. In general, therefore, we have
        concentrated our analysis on the basis on which common costs are allocated and
        BAA’s selection of default drivers.          Our assessment of BAA’s cost allocation
        drivers is set out below.

        LECG’s assessment of BAA’s drivers
10.23   Based on the information available to us, and our experience of working with
        regulators and companies on other cost allocation projects, our review of BAA’s
        allocation process identified a number of departments to which the application of a
        different allocation driver may be appropriate. The first two are departments for
        which BAA has identified a specific driver, the second two (collectively the IT
        department costs) are departments for which BAA has identified a series of
        specific drivers but has also used default drivers, and the final two are
        departments to which BAA has applied a default driver. These departments are
        summarised below:

        •      AMA (BAA allocates using capital expenditure);

        •      HR (BAA allocates using operating profit);

        •      GPIT (BAA allocates using IT specific drivers);

        •      IT leases (BAA allocates using IT lease specific drivers);

        •      PLC departments (BAA allocates using operating profit); and

        •      other CAS departments (BAA allocates using operating profit or passenger
               numbers).

10.24   We discuss below our consideration of the alternative drivers that may be
        appropriate to departments for which a specific driver can be identified and the
        common costs for which no such causal relationship can be identified. In each
        case we summarise our reasoning and quantify the impact in 2005/06 and in
        2008/09148. Where we have had to make assumptions in order to perform these
        calculations, these are noted.

        Alternatives to specific cost drivers
        AMA

10.25   BAA allocates AMA department costs on the basis of capital expenditure. After
        discussing the activities of the AMA department and its costs with BAA’s
        regulatory team, it was clear that the costs relate in large part to supply chain and

        148
                  We do not show the impact in additional years as in many cases we have not received from
        BAA the information which would be necessary to perform these calculations.




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        procurement activities. We understand that the majority of costs incurred within
        this department relating to capital projects are charged directly to the businesses
        and then capitalised into the relevant projects.


10.26   Consequently, we believe that a more appropriate measure of the level of AMA
        support provided to each of the Airports is the level of directly incurred and
        controlled operating cost. We exclude depreciation from the operating cost values
        used for this allocation as this may include capitalised elements of AMA
        expenditure.


10.27   The tables below show the impact of changing the AMA department cost
        allocation driver from capital expenditure to operating costs. In assessing the
        impact of making this change we have only allocated the AMA costs to HAL, GAL,
        STAL and to BAA’s other UK airports on the basis that the AMA department does
        not, in general, provide support to any of the other businesses149, 150.

        Table 39:      Allocation of AMA costs 2005/06

        Scenario                                    HAL          GAL        STAL        Other            Total


        BAA: Capex                                  6,531       2,126          695       ||||||||||     ||||||||||||


        LECG: Direct operating costs                5,283       1,976        1,005       ||||||||||     ||||||||||||


        % Difference                             (19.1%)       (7.1%)       44.6%       |||||||||||              ||

        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”




        149
                   The ‘Other’ operating costs used in this calculation is the sum of the operating costs of
        Southampton, Aberdeen, Edinburgh and Glasgow airports, including direct intercompany charges but
        excluding allocations and depreciation. For 2005/06, we used the operating cost data from the
        published accounts and direct intercompany charges from BAA/Q5/185 -13 “March 06 Interco
        reconciliation 070606.xls”. For 2008/09, we used operating cost data from BAA/Q5/342 “Response to
        31.10.06. e-mail - operating cost data for LECG.xls” and direct intercompany charge data from
        BAA/Q5/185 – 14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls” and depreciation data taken from
        BAA’s Group Strategic Model.
        150
                  In our calculations we made two assumptions to allow us to calculate the 08/09 depreciation
        charges for the non-regulated UK airports. Firstly, we assumed that the proportion of depreciation to
        operating costs including depreciation for BAA’s non-regulated business was the same as in 2005/06.
        Secondly, we assumed that the proportional split of the non-regulated airport depreciation charge
        between other UK airports and other non-regulated operations was the same as in 2005/06




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        Table 40:      Allocation of AMA costs 2008/09

        Scenario                                   HAL         GAL        STAL        Other             Total


        BAA: Capex                                 3,811       1,322       1,214           |||||||      ||||||||||


        LECG: Direct operating costs               4,248       1,431         804           |||||||      ||||||||||


        % Difference                              11.5%        8.2%     (33.8%)     ||||||||||||||             ||

        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”


10.28   The impact of changing the basis of allocation differs significantly between the two
        years. The primary cause of this is that the distribution of costs under BAA’s
        approach (using capital expenditure as the driver) differs significantly, with a
        marked reduction in the proportion of costs allocated to HAL and an increase in
        the allocation to STAL between 2005/06 and 2008/09. A secondary cause is that
        the operating cost allocation driver we have adopted for 2008/09 allocates a
        higher proportion of costs to HAL than in 2005/06, reflecting the opening of T5.

        HR

10.29   BAA allocates HR department costs using an operating profit driver.                             In our
        experience, staff costs or staff numbers are used commonly as the allocation
        drivers for HR costs on the basis that typically HR department costs are closely
        related to the size of the labour force. This method is consistent with how BAA
        allocates the costs of certain HR activities performed at the BSC.


10.30   We believe that staff numbers would be a more appropriate allocation driver for
        BAA’s HR costs.         The tables below show the impact of changing HR cost
        allocation drivers from operating profit to the average monthly number of
        employees151.




        151
                   This data was taken from the statutory accounts of BAA plc, Heathrow Airport Limited,
        Gatwick Airport Limited, and Stansted Airport Limited. BAA was unable to provide us with forecast
        average employee numbers for 2008/09. Therefore, we have used the 2005/06 allocation percentages
        to allocate the 2008/09 HR costs.




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        Table 41:      Allocation of HR costs 2005/06

        Scenario                          HAL           GAL          STAL          Other             Total


        BAA: Operating Profit              4,007         1,001           457         ||||||||||       ||||||||||


        LECG: Average
                                           2,260         1,042           587         ||||||||||       ||||||||||
        Employee Numbers


        % Difference                    (43.6%)          4.1%         28.4%        |||||||||||||             ||


        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”

        Table 42:      Allocation of HR costs 2008/09

        Scenario                          HAL           GAL          STAL          Other             Total


        BAA: Operating Profit              3,498         1,094           865         ||||||||||       ||||||||||


        LECG: Average
                                           2,240         1,032           582         ||||||||||       ||||||||||
        Employee Numbers


        % Difference                    (36.0%)         (5.7%)       (32.7%)       |||||||||||||             ||


        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”.


10.31   The impact of changing the allocation driver applied to HR departments varies
        between the years. The primary cause of this is the change in the distribution of
        operating profit used by BAA as the basis of allocation of costs between 2005/06
        and 2008/09.        Our analysis assumes the same split of employee numbers
        between the Airports and other businesses for 2005/06 and 2008/09.
        Consequently, whilst BAA’s allocations vary significantly between years, our
        allocations remain relatively constant.

        Alternatives to combinations of specific and default drivers
        IT departments

10.32   Where BAA has not identified specific cost drivers at either the OFA account code
        level for GPIT costs or the level of individual leases for IT lease costs, default
        drivers are used. The default driver for GPIT costs is login numbers and the
        default driver for IT lease costs is PAX. It is in unclear why BAA does not adopt
        the same default driver for GPIT and IT lease costs. We understand, however,
        that the current process represents, in BAA’s opinion, advancement on its earlier



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        approach under which PAX was the default allocation driver for both GPIT and IT
        lease costs.

        Group IT costs

10.33   BAA has undertaken a detailed analysis of its IT costs and seeks to allocate
        individual categories of cost based on usage or some other causally based
        approach where this is possible. We have not been able to obtain sufficient detail
        from BAA to reach a clear conclusion on the appropriateness of each of these
        allocations. However, as noted in Section 5, the detailed approach adopted by
        BAA results in the default driver, logins, being applied to less than 50% of Group
        IT costs


10.34   BAA told us that logins represent access rights, rather than the number of times a
        system is or can be logged onto152. We have a concern with this as a basis for
        allocation because it appears that two airports could have the same level of usage
        of a particular system (and therefore arguably should bear its costs evenly) but
        have a very different number of granted access rights (as a result of, for example,
        different staffing profiles). This could lead to an uneven allocation of costs. BAA
        acknowledged that this is a theoretical possibility, but it believes that the actual
        impact of this would be minimal in practice153.


10.35   BAA acknowledged that all IT costs could be allocated using PAX, particularly
        airport system costs (GPIT costs), where PAX provides a better indication of the
        ‘responsibility’/usage of the systems154. On this basis, and given that we have not
        been able to reach a conclusion on the appropriateness of BAA’s choice of
        specific drivers, we have modelled the impact of allocating all GPIT costs based
        on PAX. This is shown in the table below.




        152
                   BAA/Q5/273 – “Response to further questions in email date 30/08/06”, BAA, 5 September
        2006.
        153
                   BAA/Q5/273 – “Response to further questions in email date 30/08/06”, BAA, 5 September
        2006
        154
                   BAA/Q5/273 – “Response to further questions in email date 30/08/06”, BAA, 5 September
        2006.




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        Table 43:      Allocation of GPIT costs 2005/06

        Scenario                  HAL             GAL            STAL            Other             Total

        BAA: Various              23,965           6,636            3,589          ||||||||||       ||||||||||||

        LECG: PAX                 18,703           9,110            6,160          ||||||||||       ||||||||||||

        % Difference             (22.0%)           37.3%           71.6%            |||||||||                ||

        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”


        Table 44:      Allocation of GPIT costs 2008/09

        Scenario                  HAL             GAL            STAL            Other             Total

        BAA: Various              43,896           7,995            4,342          ||||||||||       ||||||||||||

        LECG: PAX                 29,131          14,328            9,974          ||||||||||       ||||||||||||

        % Difference             (33.6%)           79.2%         129.7%            |||||||||||               ||

        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”


10.36   The effect of changing the basis of allocation from the variety of drivers applied by
        BAA to allocating all GPIT costs based on PAX is very marked, particularly in
        terms of the allocation of costs between the designated airports.

        IT leases
10.37   BAA uses a range of allocation drivers for allocating IT lease asset groups and, as
        outlined and discussed above, applies PAX as a default driver when it is unclear
        which driver is most appropriate for a given asset group.                     When a specific
        allocation driver is applied, the attribution of cost is based on analysis by BAA of
        the estimated usage of the ‘lease’ by the relevant cost centre.

10.38   BAA does not update annually the allocation driver values applied to IT lease
        costs. The values for each driver used is fixed, and then applied in all periods.
        We understand, by way of example, the default driver (PAX) is fixed at 2000/01
        values.     We note that BAA does update the values used for all of the other
        allocation drivers, including those applied to Group IT costs.

10.39   The justification provided by BAA for their use of static driver data, in the context in
        which the other drivers are updated, is that the total cost of a given set of IT lease




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        assets is determined by the assets’ capacity, rather than its actual usage at any
        one point in time. Accordingly, the costs should be charged in constant proportion
        based on some measure of the contribution of each user to the overall design,
        capacity requirements and hence costs of the asset. Under this approach, each
        user is effectively paying for capacity whether they actually use it or not.

10.40   The concept outlined above is one that is applied to the allocation of costs in a
        number of regulated sectors, particularly gas transmission, in which assets must
        be specified to meet conditions of exceptional demand and have significant spare
        capacity. In such situations, the allocation of capacity costs is a significant issue,
        and the contribution of individual customers to peak demand is frequently used as
        a basis for allocation.

10.41   LECG accepts that such an approach may be relevant to allocation of IT system
        costs, but has three principle concerns with the approach as adopted by BAA.
        Firstly, because BAA’s airports are growing, the overall capacity requirement
        placed on any IT system is more likely to be towards the end of the asset’s useful
        economic life. Our understanding is that the approach adopted by BAA involves
        fixing the basis on which the costs associated with a particular asset are to be
        allocated by reference to a current or historical assessment, rather than a forward
        looking one.

10.42   Secondly, whilst it may be appropriate to apply a static driver profile within the time
        horizon of one lease, it does not appear reasonable to fix the values used for a
        particular driver over an extended period of time. On the basis that there is a
        causal relationship between the allocation driver and the level of costs, this link
        risks becoming more remote the longer the time between updates to the driver
        values.

10.43   Thirdly, the concept that is being evaluated would appear to be more consistent
        with physical capacity, and hence IT assets such as the network, than the
        software, coding and other intangible and intellectual property assets to which it is
        being applied under BAA’s approach.

10.44   In order to assess the impact of updating driver values annually, LECG has
        modelled the allocation of costs assuming driver data is updated annually. We
        illustrate in the tables below the impact in 2005/06 and 2008/09.




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        Table 45       2005/06 IT lease charge under static and updated drivers

        Scenario                          HAL           GAL          STAL          Other              Total

        BAA: Static drivers              18,893          8,829         3,401         ||||||||||       ||||||||||||

        LECG: Updated drivers            17,576          8,220         4,952         ||||||||||       ||||||||||||

        % Difference                      (7.0%)        (6.9%)        45.6%           |||||||||                ||

        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”


        Table 46       2008/09 IT lease charge under static and updated drivers

        Scenario                             HAL          GAL          STAL         Other             Total

        BAA: Static drivers                 26,186       12,556         3,703         ||||||||||      ||||||||||||

        LECG: Updated drivers               22,817       11,083         7,451         ||||||||||      ||||||||||||

        % Difference                       (12.9%)      (11.7%)       101.2%         |||||||||||                ||

        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”


10.45   The impact of updating the drivers annually appears to be material. The effect of
        making the change increases in scale and proportion over time. The direction of
        the change at each airport is consistent year-on-year.

10.46   We believe that the cost allocation achieved through annual or periodic updating
        of driver data is superior to BAA’s current approach. Therefore, we incorporate
        the effect of this into the corrected BAA cost allocation position later in this section
        and in LECG’s subsequent consideration of alternative allocation drivers.

        Alternative drivers for common costs

10.47   Common costs are normally defined as those that remain unchanged as
        production of different services varies. That is, costs are said to be common if
        there is no causal link between changes in volume and changes in cost. Such
        costs are incurred irrespective of whether any of the goods or services are
        provided. The nature of common costs is that they result from producing a set of
        different services at the same time and with indivisible use of resources.


10.48   While it is not clear if all of the costs to which BAA applies a default driver – the
        CAS and PLC departments costs for which no causally linked allocation driver can
        easily be identified – strictly meet the definition above, the allocation of these costs




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        is a key component of our study. Accordingly, we have considered the alternative
        approaches that may be adopted allocating common costs.


10.49   There is a wide range of different methods that can be used to allocate common
        costs. The most widely used methods include:


        •      Relative output method.           Common costs are attributed to services in
               proportion to their share of the total output of the firm. The use of this
               method is only possible when all outputs can be expressed in terms of a
               common physical unit (e.g. PAX);


        •      Revenue method. Common costs are attributed to services in proportion to
               their share of the company’s revenues.              Ofwat, states in its regulatory
               accounting guidelines that distributing charges to group companies on the
               basis of profitability or turnover will not provide a proxy for activity, and
               apportionment on this basis should be avoided;


        •      Ramsey pricing.         Common costs should be allocated on the basis of
               relative demand elasticities. Products facing inelastic demand will have a
               higher proportion of common costs allocated to them.                 The idea is that
               consumers with more inelastic demand for particular products should pay a
               higher price for these products.            It is important however, that cross
               elasticities between different products are insignificant, otherwise the
               application of Ramsey pricing principles becomes increasingly complex.
               The Competition Commission rejected the Ramsey-based approach in its
               mobile call termination charges inquiry because it considered the approach
               to be inconsistent with the cost causation principle155; and


        •      EPMU. Under this method, common costs and overheads (which have no
               casual link with BAA activities) to the Airports and other business units
               would be allocated in the same proportion to the Airports and other business
               units as their share of total causally attributable costs.               The causally
               attributable costs used are normally the cash costs, and hence exclude
               depreciation.

10.50   Each method discussed above has its own merits and not one represents best
        practice for every industry or business.          Consequently, the use of any of the
        methods in allocating BAA’s CAS and PLC costs may be justified. In order to


        155
                  “Vodafone, O2, Orange and T-Mobile: Reports on references under section 13 of the
        Telecommunications Act 1984 on the charges made by Vodafone, O2, Orange and T-Mobile for
        terminating calls from fixed and mobile networks”, Competition Commission, paragraph 2.515, 2003




                                                                                            CAA|    119
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        assess the most applicable approach for BAA we have reviewed the approaches
        adopted in other UK regulated sectors.


10.51   Postcomm, the UK postal regulator, believes that EPMU is the most appropriate
        approach to distributing common costs. Postcomm recognises that EPMU has
        been adopted by other regulators in price control reviews, including Ofgem and
        Ofcom, and has been accepted by the Competition Commission156.


10.52   Additionally, Article 14 (3) of the EU Postal Directive states:


               “when neither direct nor indirect measures of cost allocation can be
               found, the cost category shall be allocated on the basis of a general
               allocator computed by using the ratio of all expenses directly or
               indirectly assigned or allocated, on the one hand, to each of the
               reserved services and, on the other hand, to the other services.”157

10.53   Whilst Article 14 (3) may be open to significant interpretation – it appears to imply
        that all costs which have been correctly classified as joint or common should be
        allocated using the EPMU methodology.


10.54   Andersen was engaged by Ofgem to review Transco’s cost allocation
        methodology in relation to Ofgem’s conclusions on cost allocation for Transco and
        British Gas Trading (“BGT”)158. Andersen concluded that a Direct Cost allocation
        method (i.e. EPMU) should be adopted for support costs (e.g. Corporate
        Recharges, Property & Governance, Strategy, Finance, etc). Ofgem accepted this
        recommendation.


10.55   Additionally, Ofcom, the UK telecoms regulator stated in its review of the
        wholesale mobile voice call termination market that the use of an EPMU for
        common costs achieves a more appropriate balance between practicality and
        efficiency than the Ramsey method. Ofcom considered that provided the common
        costs to be recovered are small and/or demand elasticities are not readily
        identified, then the use of an EPMU approach is suitable. Ofcom’s view was in




        156
                   “Royal Mail’s revised Proposals for Size Based Pricing (“Pricing in Proportion)”, paragraph
        4.20, April 2005
        157
                Directive 97/67/EC of the European Parliament and of the Council of 15 December 1997 on
        common rules for the development of the internal market of Community postal services and the
        improvement of quality of service
        158
                  “Report on Transco’s operating costs for the 2002/03 to 2006/07 Price Control Period, Final
        Report”, Andersen, 7 September 2001




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        line with the Competition Commission mobiles inquiry of 2001 that reached similar
        conclusions159.


10.56   Based on precedents from other regulated industries, we believe that the most
        equitable basis for allocating common costs, and by extension, those of BAA’s
        CAS and PLC costs to which a default driver has been applied, is on a EPMU
        basis160. We suggest that when adopting this approach, common costs should be
        allocated on a basis that is equi-proportional to directly incurred operating costs,
        and therefore excludes depreciation and any allocated costs161.


10.57   In light of the above, we evaluate below the reasonableness of the approach
        adopted by BAA and assess the impact of changing the basis of allocation.

        PLC departments

10.58   We do not believe that operating profit is an appropriate driver for allocating PLC
        department costs, particularly in the context of a regulated business in which the
        level of operating profit is a function of allowable revenues and this in turn reflects,
        in part, the level of operating costs. Since the driver will be used to allocate costs
        that will, in turn, impact revenue and profitability, the use of operating profit as the
        basis for allocating operating costs introduces an inappropriate circularity into the
        calculation.


10.59   We believe that a more appropriate approach would be based on EPMU. This
        driver has the advantage of avoiding the circularity associated with the use of
        operating profit while also reflecting the relative size and complexity of each of the
        businesses to which costs are to be allocated.


10.60   In application, we believe that the PLC costs should be allocated across all of
        BAA’s operations, and hence the appropriate derivation of the allocation driver
        would include within ‘Other’ the operating costs of all of BAA’s non-regulated
        activities.    The table below shows the impact of changing the default cost
        allocation driver for PLC department costs from operating profit to operating costs.
        These are costs defined (for these purposes and for subsequent allocations in this
        report we refer to this as an operating cost or EPMU basis) as directly incurred



        159
                  “Equi-proportional mark-ups: regulatory precedents”, Oxera, 1 July 2005
        160
                   We note that BAA is “yet to be convinced that EPMU produces a more reliable measure of
        activity and hence costs associated with the different airport operations” BAA/Q5/358.
        161
                   In the context of BAA, we believe that the relevant costs to be included as the basis for the
        allocation driver are the costs incurred directly by each of the businesses plus the directly allocated
        costs. This is consistent with normal practice.




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        business operating costs plus direct inter-company charges, but excluding
                                                      ,
        depreciation and indirect allocations162          163
                                                            .

        Table 47:      Allocation of PLC costs 2005/06

        Scenario                            HAL                 GAL      STAL         Other              Total

        BAA: Operating profit              11,274                2,816     1,285        ||||||||||       ||||||||||||

        LECG: Operating costs               7,633                2,855     1,452        ||||||||||       ||||||||||||

        % Difference                      (32.3%)               (1.4%)    13.0%       |||||||||||||               ||

        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”


        Table 48:      Allocation of PLC costs 2008/09

        Scenario                            HAL                 GAL      STAL         Other              Total

        BAA: Operating profit              10,475               3,276     2,590         ||||||||||      ||||||||||||

        LECG: Operating costs               9,227               3,108     1,747         ||||||||||      ||||||||||||

        % Difference                      (11.9%)               (5.1%)   (32.5%)       |||||||||||                ||

        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls


10.61   The effect of changing the basis of allocation from operating profit to operating
        costs is to reallocate a material level of PLC costs to the non-regulated
        businesses.

        Non-IT CAS departments

10.62   The majority of the non-IT CAS department costs are allocated based on either
        operating profit or PAX. For the reasons outlined above, we do not believe that
        operating profit is an appropriate basis for the allocation of costs and believe that
        an EPMU based approach is preferable.


        162
                   It should be noted that the numbers in the table do not include those of the HR department.
        Although this a PLC department which BAA allocates using an operating profit driver, we test the
        allocation of this department with an average employee number driver elsewhere in this section and for
        the reasons set out there believe that such costs should be allocated on a basis related to headcount.
        163
                  The definition of ‘Other’ used to allocate PLC costs includes the non-regulated UK airports
        and BAA’s other businesses. We believe that this is appropriate because PLC departments provide
        support for the entire BAA business, rather than just the UK airports. In deriving the driver used, we
        adjusted the costs of ‘Other’ to exclude WDF cost of sales. The basis for this is set out in “BAA-Q5-
        346- Reply to J Lisle email of 17/11/06 re: CAS and WDF allocations”, in which BAA states that such
        costs principally reflect the passenger numbers at the airports and the level of costs incurred in the
        PLC departments are not influenced by the level of activities at WDF.




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10.63   The general situation with the use of PAX is more complex because the non-IT
        CAS departments to which PAX is applied as the basis of allocation vary in nature.
        Based on information and descriptions received from BAA, it appears that some of
        the departments are engaged in activities that are related closely to airport
        operations and hence the level of their costs is likely to be directly or indirectly
        linked to PAX, while in other cases the link to PAX appears more remote. To
        understand precisely which costs fall into each of these categories and hence
        what the most appropriate basis of allocation would be, would require a detailed
        review of the activities undertaken within each of the cost centres that comprise
        the CAS departments. This was not possible given the information to which LECG
        had access.


10.64   To the extent that BAA is correct that non-IT CAS department costs should be
        allocated using a default allocation driver rather than using drivers based on
        causal links, we believe that it would be preferable to allocate these costs on an
        EPMU basis.      Our reasons for preferring EPMU as the basis for allocating
        common costs are outlined above.


10.65   In the tables below we illustrate the impact of allocating the non-IT CAS
        department costs on an EPMU basis rather than the default drivers (operating
        profit and PAX) applied to these costs by BAA. In this analysis we have only
        allocated the CAS department costs to HAL, GAL, STAL and to BAA’s other UK
        airports on the basis that these departments do not, in general, provide support to
        any of the other businesses. To facilitate this, the operating costs included within
        ‘Other’ for the purposes of calculating the allocation driver percentage comprises
        the operating costs of Southampton, Aberdeen, Edinburgh and Glasgow airports.

        Table 49:     Allocation of non-IT CAS costs 2005/06

        Scenario                     HAL         GAL        STAL        Other             Total

        BAA: Operating Profit         6,946       3,211       2,135       ||||||||||      ||||||||||||

        LECG: Operating costs         7,225       2,702       1,374       ||||||||||      ||||||||||||

        % Difference                  4.0%      (15.9%)     (35.6%)      |||||||||||               ||

        Source: LECG analysis and BAA submission “CORP OFA STRUCTURE & ACTUALS MAR 06
        SUMMARY.xls”




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        Table 50:     Allocation of non-IT CAS costs 2008/09

        Scenario                          HAL           GAL          STAL           Other              Total

        BAA: PAX or Operating
                                           8,256         3,783         2,575          ||||||||||       ||||||||||||
        Profit

        LECG: Operating costs            10,127          3,412         1,917          ||||||||||       ||||||||||||

        % Difference                      22.7%         (9.8%)       (25.6%)       ||||||||||||||               ||

        Source: LECG analysis and BAA/Q5/185-14 “Bus Plan Corp Alloc & Inter-co 06-07 to 08-09.xls”


10.66   Allocating the costs of the non-IT CAS departments on an EPMU basis rather than
        the default drivers applied by BAA results in a material reallocation of costs from
        regulated to unregulated airports in 2005/06. This is reversed in 2008/09 as the
        impact of opening T5 increases HAL’s operating costs and results in an increase
        in the allocation of non-IT CAS department costs when these costs are allocated
        on an EPMU basis.

        LECG scenario analysis

10.67   The scope of work for this project required LECG to consider the impact of
        alternative approaches to the allocation of costs when concluding on the
        appropriateness of BAA’s approach for price control purposes.                        As previously
        mentioned, the nature of this study and lack of information provided has meant
        that LECG has been unable to develop a recommended allocation of costs based
        on a detailed, bottom-up review164.


10.68   Consequently, in this section we consider the impact of using alternative drivers
        for the allocation of CAS and PLC costs under eight different high level scenarios.


10.69   The first scenario is LECG’s remodelling of the data submitted by BAA. In the
        second scenario, we correct for all of the errors we identified in BAA’s calculations,
        as described in Section 4 of this report. This scenario also includes the impact of
        reversing BAA’s capping adjustments, consistent with our conclusions in
        Section 9, and the impact of updating annually the IT lease driver. This scenario
        provides a base set of revised costs that we use in the subsequent scenarios
        where we model the impact of changes to the basis on which CAS and PLC
        department costs are allocated.




        164
                 LECG’s model was constructed to allow for this approach.




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10.70   In the third and fourth scenarios, we adopt a high-level approach to the allocation
        of costs, and model the impact of allocating all costs on an EPMU basis and using
        a PAX driver respectively.


10.71   In each of the subsequent scenarios, we incorporate changing the basis on which
        AMA and HR department costs are allocated, as described earlier in this section.
        We then consider, in alternative combinations, the impact of changing the basis on
        which IT costs are allocated and how non-IT CAS and PLC department costs are
        allocated.


10.72   The scenarios are summarised in the table below:




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        Table 51:   LECG scenarios

         Scenario     Description

             1        BAA’s cost allocation assumptions

             2        BAA’s CAS and PLC costs adjusted for all errors identified by LECG

                      BAA’s CAS and PLC costs adjusted for all errors identified by
             3        LECG, all costs (excluding corporate office specific costs) allocated
                      using EPMU

                      BAA’s CAS and PLC costs adjusted for all errors identified by
             4        LECG, all costs (excluding corporate office specific costs) allocated
                      using PAX

                      BAA’s CAS and PLC costs adjusted for all errors identified by
                      LECG, with AMA costs allocated on adjusted operating costs and
             5        HR costs allocated on headcount. All IT costs allocated on PAX.
                      EPMU used in place of PAX and Operating Profit default cost
                      drivers.

                      BAA’s CAS and PLC costs adjusted for all errors identified by
                      LECG, with AMA costs allocated on adjusted operating costs and
                      HR costs allocated on headcount. All IT costs allocated on PAX.
             6
                      EPMU used in place of Operating Profit default cost drivers. BAA’s
                      allocation of non-IT CAS department costs based on PAX is
                      unchanged.

                      BAA’s CAS and PLC costs adjusted for all errors identified by
                      LECG, with AMA costs allocated on adjusted operating costs and
                      HR costs allocated on headcount. IT costs allocated using updated
             7
                      BAA driver data. EPMU used in place of the Operating Profit default
                      cost drivers. BAA’s allocation of non-IT CAS department costs
                      based on PAX is unchanged.

                      BAA’s CAS and PLC costs adjusted for all errors identified by
                      LECG, with AMA costs allocated on adjusted operating costs and
             8        HR costs allocated on headcount. IT costs allocated using updated
                      BAA driver data and EPMU used in place of the PAX and Operating
                      Profit default cost drivers.

        Source: LECG analysis

10.73   The results of LECG’s scenario analysis on the allocation of costs in 2005/06 (the
        base year) and 2008/09 (the first year of the Q5 price control period) are shown in
        the tables below.




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Table 52:      LECG scenario results 05/06

 Scenario             HAL              GAL              STAL             Other                Total


      1               78,051           26,846             7,112           ||||||||||||       ||||||||||||||


      2               71,344           24,498            13,394           ||||||||||||       ||||||||||||||


      3               61,165           22,876            11,636           ||||||||||||       ||||||||||||||


      4               59,523           28,993            19,635           ||||||||||||       ||||||||||||||


      5               58,514           26,125            16,260           ||||||||||||       ||||||||||||||


      6               58,561           26,650            16,980           ||||||||||||       ||||||||||||||


      7               65,040           24,429            13,955           ||||||||||||       ||||||||||||||


      8               64,994           23,904            13,235           ||||||||||||       ||||||||||||||

Source: LECG analysis. Note, the figures shown for Scenario 2 for each individual business do not
agree to those shown in Section 4 as the figures in this table are stated after updating the IT lease
drivers. This updating only affects the allocation of costs, and hence the total level of costs is the
same.




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        Table 53:    LECG scenario results 08/09

         Scenario          HAL           GAL            STAL           Other                Total


             1            100,875        31,875         10,032         ||||||||||||        ||||||||||||||


             2             93,676        29,077         19,363         ||||||||||||        ||||||||||||||


             3             92,838        31,277         17,573         ||||||||||||        ||||||||||||||


             4             75,988        37,375         26,018         ||||||||||||        ||||||||||||||


             5             77,353        34,565         22,874         ||||||||||||        ||||||||||||||


             6             76,412        34,993         23,503         ||||||||||||        ||||||||||||||


             7             91,393        28,626         17,584         ||||||||||||        ||||||||||||||


             8             92,467        28,200         16,892         ||||||||||||        ||||||||||||||

        Source: LECG analysis


10.74   Of the scenarios we have modelled, we do not believe that either Scenario 1 or 2
        are an appropriate basis for setting the price control. We reject the first scenario
        because it incorporates errors and the capping adjustments.                   We also reject
        Scenario 2 as it includes the use of allocation drivers, particularly operating profit,
        which we do not believe are appropriate for price control purposes.


10.75   Scenarios 3 and 4 are also inappropriate for price control purposes, because they
        adopt an overly simplistic approach and would only be appropriate in a situation in
        which all costs were genuinely common.


10.76   Determining the appropriateness of using PAX as a driver for non-IT CAS
        department costs is potentially complex because the costs allocated on this basis
        appear to include some costs that are directly or indirectly linked to airport
        operations, and others that are not. PAX appears to be an appropriate causally
        linked driver on which to allocate the former, but we believe that an EPMU
        approach would be more appropriate for the latter. LECG did not have access to
        sufficiently detailed information to separate the non-IT CAS department costs in
        this way and develop a detailed alternative basis for allocation.


10.77   In the absence of this detail, we believe that it is appropriate to take account of the
        link between many of the non-IT CAS departments and airport operations.




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        Therefore, we do not propose any change to the allocation of these costs to which
        BAA applies the PAX driver, and reject Scenarios 5 and 8 as the basis for setting
        the Q5 price control.


10.78   LECG also considered whether it would be appropriate to recommend a scenario
        under which all IT costs are allocated on the basis of PAX, which is the default
        driver applied by BAA to IT lease costs. Notwithstanding the lack of documentary
        evidence provided by BAA to support the basis on which it allocates IT costs,
        particularly, Group IT costs, we recognise that BAA has sought to allocate these
        costs at a detailed level based on estimates of usage. Therefore, we do not
        recommend that changes be made to the allocation of these costs for purposes of
        setting the Q5 price control. On this basis, we conclude that Scenario 6 is also not
        appropriate for setting the Q5 price control.


10.79   Based on the above, we believe that Scenario 7 is the most appropriate scenario
        that the CAA should consider adopting as the basis for setting the Q5 price
        control. This scenario:

        •     excludes the unsupported capping adjustments;

        •     corrects for the errors identified in BAA’s calculations;

        •     reflects updating annually the values of the drivers used to allocate IT lease
              costs;

        •     replaces the use of a default driver to allocate HR costs with one that is
              causally linked;

        •     changes basis for allocation of AMA costs to a driver which we believe is
              more causally linked than the one selected by BAA;

        •     avoids the circularity implied by using operating profit to allocate costs to
              regulated businesses by adopting EPMU in line with regulatory best
              practice;

        •     recognises that BAA has gone to considerable effort to identify, at a detailed
              level, causally linked approaches for allocating IT costs and does not
              introduce an alternative approach notwithstanding that BAA has not been
              able to substantiate the rationale for its approach; and

        •     recognises that some (but probably not all) of the non-IT CAS departments
              costs to which BAA applies the PAX driver are likely to be related to this key
              measure of airport activity.




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