VIRGIN ATLANTIC’S RESPONSE NATS (EN ROUTE) PLC
CAA PRICE CONTROL PROPOSALS (2011‐2014)
27TH AUGUST 2010
1 Introduction 2
2 Scope of Price Control/Structure Price Control/Compatibility SES 3
3 Traffic Forecasts 7
4 Service Quality and Environmental Performance 8
5 Operating Costs/Pensions 14
6 Capital Expenditure 18
7 Price Controls 20
8 Conclusions 22
Virgin Atlantic welcomes the opportunity to comment on the CAA’s price control
proposals for NATS (En Route) plc for the period 2011‐2014 (CP3).
The setting of the price controls applicable to NERL during CP3 takes place against the
context of NERL’s general out‐performance during CP2. NERL’s performance during CP2
has been characterised by an improving credit rating A+/A2, a maintained safety risk
index, improving service quality, reducing delays, out‐performance relating to OPEX
costs and overall financial out‐performance during the first three years of CP2. In each
of the first three years of CP2, NERL has earned a profit before tax of £86.3m, £62.5m
and £77.6m respectively1. This evidence suggests a more stringent approach to the CP3
assessment should be taken by the CAA.
Against this backdrop, during CP2 Virgin Atlantic and other airlines have been required
to take difficult decisions to dramatically reduce costs (for example during 2009/10
Virgin Atlantic reduced its airline operating costs by 8%)2 and change their business
models in response to the recent downturn in traffic. Monopoly providers such as NERL
should not be immune from the same challenges. Whilst we recognise that CP3 will
deliver its own challenges, the CAA needs to ensure that the right incentives are in place
to ensure that NERL provides safe, high quality service and additional capacity at the
lowest possible costs and charges.
The CAA’s current proposals permit NERL to charge £53.78 per CSU in 2011 ‐ a 6.2%
increase on the 2010 Eurocontrol price/CSU. Whilst over the CP3 period the CAA’s cap
proposes a 1.725% reduction/CSU, we consider that the price cap applicable to NERL
should be more challenging. Whilst in certain respects the CAA’s proposals do challenge
NERL’s March 2010 Business Plan, in particular Virgin Atlantic considers that there are
greater opportunities for improved operational cost efficiency and more stretching
service quality measures.
1 “CP3 Baseline Business Plan Overview and Context – NERL Performance in CP2” Presentation to CCWG, 29 April
2 “Virgin Atlantic Airways accelerates out of recession with strong Q1 sales” 30 July 2010 http://www.virgin-
2. SCOPE OF THE PRICE CONTROL, STRUCTURE OF THE PRICE CONTROL AND
COMPATIBILITY SINGLE EUROPEAN SKY
Scope of the price Control
Virgin Atlantic supports the continuation of the single till approach to setting the
Eurocontrol price control for CP3
As set out in Virgin Atlantic’s response to the CAA’s February Consultation, Virgin
Atlantic supports the inclusion of the approach services to Luton and London City
Airports within the London Approach service, permitting that this does not place
additional costs on users. Virgin Atlantic considers that the CAA should ensure that the
treatment of approach charges in the UK is consistent with European counterparts.
As set out in the response to the CAA’s February consultation, Virgin Atlantic does not
accept that civil aviation should absorb or subsidise the costs of service or facilities
necessary for the safety of general aviation (GA) on the basis that the creation of
controlled airspace is primarily a necessary measure to protect the safety of commercial
aviation. In our view these measures are safety and compliance issues necessary for GA,
for which the CAA and Government has responsibility.
The CAA states in its May 2010 document that it has seen no persuasive evidence that
would overcome the policy or practical difficulties with the creation of a separate
charging scheme for small aircraft. However, EU regulation 550/2004 Article 15 3(b)
states: "Exemption of certain users, especially light aircraft and State aircraft, may be
permitted, provided that the cost of such exemption is not passed on to other users".
For Virgin Atlantic this is clear – other users should not be required to pay for services of
light aircraft. Whilst the CAA states that following a review during 2009 the Department
for Transport concluded that the UK was meeting its obligations under the EC Charging
Regulation to ensure that costs of services to exempt traffic were not met by other
users, Virgin Atlantic has not seen the evidence to support this conclusion. Nor does
Virgin Atlantic accept that policy or practical difficulties should prevent the
establishment of a separate charge.
Structure of the Price Control
Compatibility Single European Sky Charging Regulation
Volume risk sharing
Virgin Atlantic acknowledges that the SES Charging Regulation permits a volume risk
sharing arrangement on the basis of:
• Where the actual number of service units are higher or lower within +/‐ 2% of
the forecast, the volume risk is borne by the air navigation service provider
• Where the actual number of service units is higher by >2%, 70% of the
additional revenue in excess of 2% is returned to users in the following year
• Where the actual number of service units is lower by >2%, 70% of the loss in
excess of 2% is borne by users
• Where the actual number of service units is less than 90%, the full amount of
loss in excess of 10% is borne by users no later than year n+2
• Where the actual number of service units are higher than 100%, the full amount
of additional revenue in excess of 10% shall be returned to users no later than
However, as set out in Virgin Atlantic’s response to the CAA’s November 2008 and
February 2010 consultations, we do not believe that the volume risk sharing
arrangements should continue. The existing 50/50 risk sharing arrangement was
implemented at a time when, in its infancy, NERL suffered significant financial distress
due to an unprecedented downturn in traffic following the events of September 2001.
Since then, NERL has established itself as financially robust and profitable organisation.
Given this financial stability and based on usual practice in the regulation of monopoly
companies, Virgin Atlantic believes the arrangement should revert to NERL bearing
100% traffic volume risk, to ensure ongoing incentives are placed on NERL.
Virgin Atlantic disagrees with the CAA’s conclusion that the SESII risk sharing
arrangements do not point unequivocally in one direction as to its impact on the overall
profile of risk to NERL. Virgin Atlantic notes that whilst these arrangements imply less
protection for NERL within a narrow range of volume volatility, as stated by the CAA,
outside of this range NERL’s risk is lower under the SESII scheme than under CP2. This is
particularly so on the downside of traffic volume risk, where users bear a greater burden
of risk during times of a significant reduction in traffic. As stated by CAA, over CP1 and
CP2 NERL would have benefited from the SESII risk sharing scheme. Therefore, Virgin
Atlantic considers that the SESII arrangements actually benefit NERL implying a positive
impact on NERL’s risk profile.
Measure of traffic
Virgin Atlantic recognises that the CAA must assess how the change from distance to
CSUs (in order to remain consistent with the SES Charging Regulation) might affect
NERLs exposure to traffic risk.
However, Virgin Atlantic considers that thorough and reliable data should be available
prior to drawing the conclusion that there could be implications for equity returns and
the cost of capital movement from distance to CSUs. For example, whilst the standard
deviation of CSU growth is higher than that for distance growth, we note the CAA’s
recognition that this is based on only a few data points and there is no certainty this will
be sustained into future years. In addition, whilst the basis of measurement may
potentially impact NERL’s exposure to traffic risk, in Virgin Atlantic’s opinion the SESII
volume risk arrangements reduce NERL’s exposure to traffic risk, thus diluting any
potential increase in traffic risk as a result of the altered measurement basis.
Until robust and reliable data can be established on which to base assumptions, Virgin
Atlantic considers that no presumptions as to implications on equity returns and cost of
capital should be made, nor should users be required to pay the cost of these
Treatment of inflation
Overall, Virgin Atlantic supports the CAA’s proposals relating to the treatment of
inflation in CP3 to ensure consistency with the Charging Regulation. However, Virgin
Atlantic does not consider that the movement from RPI to CPI should present NERL with
any material additional risk that it could not manage through its ongoing contract
management and/or through hedging to account for any inflationary discrepancies.
Virgin Atlantic considers that NERL should bear the risk for the actual difference
between RPI and CPI.
We support the CAA’s view that these adjustments are transitional for CP3 only and that
NERL’s Business Plan for CP4 should be on the basis of the SES arrangements.
Virgin Atlantic notes that the Charging Regulation makes no provision for the
adjustment of charges during the course of the control period, but does allow for the
accumulation of variances to be passed through at the next control period.
Virgin Atlantic does not support the CAA’s proposal to pass through 80% of any variance
in real spectrum costs at the end of RP1. In our view, as previously stated, NATS is
involved and well aware of the processes for allocation of frequencies for ATM purposes
and better placed than the airlines to be able to judge the efficiency of this allocation
and use. In our view treatment of spectrum costs as a pass through, even on an 80%
basis, would discourage effective management of this issue and would also dilute the
incentives placed on NERL.
Impact of Volcanic Ash
Virgin Atlantic agrees with the CAA’s assessment of the impact of volcanic ash risk is not
an issue for the cost of capital, nor does Virgin Atlantic consider that an allowance
should be made within the traffic forecast which would be merely speculative. In Virgin
Atlantic’s opinion the volume risk sharing arrangements are designed to address this
circumstance which in any case ‐ as a result of the SES Charging Regulation ‐ now
provides NERL greater downside protection.
3. TRAFFIC FORECASTS
Virgin Atlantic is reasonably satisfied with NERL’s forecasting methodology. However,
Virgin Atlantic maintains that NERL’s modelling and forecasts may understate traffic.
This concern is increasingly apparent following publication of the CAA’s May 2010
proposals, which following NERL’s March 2010 traffic forecasts implied a ‐2.4% decrease
in total forecast traffic volumes.
Despite NERL’s claims that its forecasting accuracy had, aside from the economic
downturn, been within +/‐2%, there has been significant volatility (c. 6%) in the NERL
forecasts over a relatively short period of time, in particular the further 2.4% reduction
in traffic forecasts based on the March 2010 Business plan. In addition, Virgin Atlantic
has been told by NERL that there is potential for a further reduction in forecast traffic
volumes based on the September 2010 forecast that NERL intends to produce. Virgin
Atlantic would like the CAA to confirm how it intends to deal with this additional
information that may come to light after the regulatory consultation process has ended.
In addition, at the time of submitting its response to the CAA’s February 2010
consultation, Virgin Atlantic requested that “NERL should be required to provide a
commentary on the anticipated impact of any significant changes to the forecasts on the
remainder of the Business Plan.” As far as Virgin Atlantic is aware, no information has
been forthcoming from NERL regarding the assumed impact of this further reduction in
traffic volumes. For example, no changed assumptions as to the level of OPEX required
or improvements as to the achievability of the service quality metrics have been made.
Virgin Atlantic welcomes the pressure that CAA has exerted on NERL’s Business Plan,
however Virgin Atlantic considers that based on reduced traffic volumes the CAA should
go further – particularly in relation to OPEX projections and more challenging service
4. SERVICE QUALITY AND ENVIRONMENTAL PERFORMANCE
Virgin Atlantic considers that NERLs performance in CP2 provides helpful context for the
establishment of robust and challenging CP3 metrics, targets and financial incentives.
CP2 has been characterised by reducing delays (despite strong traffic in the early part of
CP2) and during CP2 NERL has consistently outperformed in relation to the delay
performance par value, earning bonuses of £5.6m, £6.0m and £6.9m in 2007, 2008 and
2009 respectively. Virgin Atlantic considers that NERL should be progressively and
continuously incentivised to improve service quality.
We urge the CAA to review the requirements under this section to ensure adequate
pressures are brought to bear on NERL to enable improved service quality at reasonable
cost and subsequent price to the airlines.
Relationship of delay performance to SESII
Virgin Atlantic agrees that the structure of metrics put forward as part of the CCWG
brings a level of sophistication to the measurement of NERLs service quality provision
and allows consistency with the requirements of SESII.
Virgin Atlantic agrees with the CAA that the CP3 measures should be in addition to any
required under the SES II regime. Whilst the T1 metric is similar to the KPI specified in
the Performance Scheme, we welcome the CAA’s proposal to set an explicit target for
ATFM delay per flight in the National Performance Plan (consistent with the SESII KPI)
and require NERL to report if the KPI is not met, in addition to the specific provisions
regarding T1. Whilst we recognise that SESII does not require a direct financial incentive
in RP1 and acknowledge that the T1 metric is similar to the KPI specified in the
Performance Scheme, we agree with the CAA’s assessment that attaching a financial
metric to T1 will incentivise NERL to control the delay per flight.
Basis of measurement
Virgin Atlantic questions the logic of remaining with enhanced CFMU data during CP3.
Whilst Virgin Atlantic accepts that using CFMU data which has not been cleaned up for
potential anomalies is suboptimal (although Virgin Atlantic is not clear of the extent to
which this will affect the data), failing to use CFMU data will reduce the ability of users
and the CAA to make comparative assessments of the performance of NERL during CP3,
particularly given that the SESII performance regime will use data supplied directly by
Eurocontrol CFMU. While recognising the CAA’s motives for keeping the NERL adjusted
data for CP3, Virgin Atlantic considers it would be of benefit to operators if a parallel set
of data using unadjusted CFMU data could be produced during CP3 in order to establish
the comparable figures prior to a possible full use of the unadjusted CFMU data for the
The CAA proposes to use NERLs enhanced CFMU data, however Virgin Atlantic would
wish to clarify how the CAA audits such data and NERL’s calculation of the delay
performance based on NERL’s enhanced data.
Virgin Atlantic accepts the CAA’s proposal to allow for exemptions to the T3 metric
when major changes to systems are implemented. Whilst we recognise the CAA’s
proposal to limit exemptions to periods when major changes are being implemented to
10 days per year, we question if 10 days is excessive and sufficiently incentivises NERL.
In addition, we would welcome more clarification as to the provisions regarding this
exemption i.e. through what forum users are consulted, the amount of time in advance
that users are consulted, maximum time period of single exemptions and restrictions
regarding extension to exemptions should service not revert after the length of time
Principles for calibrating delay performance
Virgin Atlantic disputes that the maximum values at risk in CP2 (£24m) is deemed
appropriate by the CAA going forward into CP3, as it is claimed to have adequately
incentivised NERL to keep downward pressure on delays. VAA believes that bearing in
mind the potential effect of ATC delays on the airlines’ costs, the maximum amount at
risk should be increased from the CP2 level of 24m in order to provide greater incentive
to NERL to reduce delays (in particular with changes in traffic volumes).
If the CAA is not minded to increase the maximum amount at risk, as a minimum more
stretching targets on the metrics should be put in place during CP3 to ensure continuous
improvement in performance. Whilst we recognise that the CAA’s May 2010 proposals
challenge NERL to go further in relation to the par values set, we consider that given the
generous OPEX allowance projection and further reduced traffic forecasts accepted by
the CAA, the par values should be significantly more challenging.
We welcome the CAA’s consideration that there is no strong case for the maximum
bonus to be as large as the maximum penalty based either on principle or practical
Weighting of money at risk
Virgin Atlantic agrees a greater weight should be assigned to the T2 metric given that T2
reflects the disproportionately significant impact of extended delays during the morning
and evening peaks.
Virgin Atlantic welcomes the CAA’s commitment that the par values proposed for the
delay metrics should be consistent with the forecasts for traffic and operating
expenditures set within the price control. Virgin Atlantic asserts that the par values
should also be set cognisant of NERL’s historical out‐performance in relation to delay
metrics, recent performance given the downturn in traffic and combined with the
relatively modest level of traffic growth anticipated during CP3. It is also important to
recognise the impact of any capacity enhancing capital projects or investments during
the period such as iFACTS.
In relation to the par values, we welcome the CAA’s recognition that it would expect a
significant increase in expected performance given the 2.4% revision downwards in
traffic and in the absence of any reduction in operating expenditure since the November
2009 Business Plan. However, it is important to note that airlines did not agree that
NERL’s November 2009 par values were appropriate or consistent with the underlying
November Business Plan in the first place. Nor did we consider that the underlying
operating cost base represented an efficient level. Since then, whilst NERL’s traffic
forecasts have reduced and the CAA has set more challenging operational cost and
service quality assumptions, Virgin Atlantic still considers that NERL should be required
to achieve more challenging delay performance and this should be consistent with what
it is currently achieving – to do otherwise would in Virgin Atlantic’s opinion be counter
intuitive to what the scheme is intending to achieve.
In addition, we agree that the performance metrics should reflect at a minimum a
constant standard throughout CP3, if not improving. Virgin Atlantic considers that a
relaxed profile again seems counter intuitive to what the scheme is intending to
Whilst Virgin Atlantic accepts that there should be some degree of modulation to the
par values dependant on traffic volumes, Virgin Atlantic does not accept that there
should be an asymmetric level of gearing whereby the modulation to the par value is
much higher where annual traffic volume exceeds the threshold, compared to a
reduction in traffic volumes.
Proposed Par Values
Term 2009 Bonus Par Penalty Commentary
Performance Payable Value Payable
T1 4.5 10 12.5 15 The par value and deadband
ranges proposed by CAA in its May
T2 11.2 30 35 40 2010 proposals implies that based
on last year’s performance NERL
currently has significant headroom
within the par value range.
Virgin Atlantic considers that the
CAA’s proposals represent a step in
the right direction. However, CAA
should go further given NERLs
current performance against these
metrics, reduced forecast traffic
volumes, modest traffic increases
anticipated over CP3, a generous
OPEX allowance and CAPEX
investments including iFACTS.
T3 1.3 1050 1200 1350 Whilst Virgin Atlantic accepts the
T3 metric is driven by random
events e.g. equipment failures
rather than traffic, it is important
to note the additional contingency
built into the CAPEX programme,
the allowance for exemptions
when major changes to systems
occur and the apparent improved
performance in project
management capabilities identified
by NERL, should all assist NERL to
secure appropriate performance.
Virgin Atlantic does not accept NERL’s suggestion that the CAA’s proposals and changes
to the delay metrics put at risk NERLs ability to deliver service quality. In particular, we
do not consider that NERL’s targets were already sufficiently challenging nor based on
an efficient operational cost assumption. In regards to service quality metrics, we
consider that the CAA can and should go further than the above proposed par values ‐
to ensure ongoing and continuous improvement of NERL from the current basis of
performance, particularly given the relatively modest increase in traffic assumed
Virgin Atlantic supports the maintenance of the incentives mechanism during the
Olympics. We agree that the par values for the Olympics should be adjusted, whilst
leaving the par values for 2012 to be equivalent to other years as a whole.
However, Virgin Atlantic notes that the revised par values for the Olympics period are
somewhat generous. Virgin Atlantic considers that CAA must ensure that NERL make
every effort to adequately manage traffic and minimise delays during this period and
not allow a significant reduction in service delivery standards which might otherwise
affect the overall delay performance statistics.
Flight Efficiency and Environmental Performance
As set out in Virgin Atlantic’s response to the CAA’s February consultation along with
delay performance, flight efficiency is vital for the airline community and the
corresponding reduced user impact on the environment. As such, Virgin Atlantic
believes that flight efficiency metric should be incorporated into the incentive scheme
from the outset of CP3.
We welcome the progress that NERL has made in developing a metric for inclusion
within CP3, particularly given the challenges in terms of managing the trade‐offs
between the needs of different airspace users, securing the most efficient routings, the
complexity of UK airspace and avoiding any unintended consequences.
Virgin Atlantic recognises the desire to assess both horizontal and vertical flight profile
inefficiencies. Since the publication of the May 2010 consultation document, proposals
have been drafted that describe a 3D Inefficiency score. Virgin Atlantic welcomes this
approach, but is concerned that the suggested methodology for vertical efficiency is
overly complex and potentially difficult to manage.
Aircraft climb and descent profiles will be governed by a number of factors including;
aircraft weight, climatic conditions and airline operating speed schedules. When we
then apply the ATM factors of route and altitude restrictions, adjacent traffic and ATC
sector capacities, it is difficult to interpret the meaningful measures that can be utilised
on a daily basis. Notwithstanding the above challenges, VAA remains supportive of all
the efforts to arrive at a workable solution in order to enable a flight efficiency metric(s)
to be in place at the beginning of, or very soon after, of the commencement of CP3.
VAA recognises the challenge in delivering a financially incentivised metric given the
maturity of the metric and confidence in the track record of the metric. The approach
taken by NERL in its latest proposals may be prudent and we look forward to assessing
what further progress NERL has made and commitments it is able to offer in its response
to the CAA’s price control proposals.
However, given the significant cost implications to airlines of flight inefficiency it is
essential that the CAA recognises the value to the airlines in enabling this incentivised
measure and incorporates this into CP3 as soon as practicable. Whilst we welcome the
commitment and progress made by NERL thus far, we are concerned that once the price
control decision is set this progress may falter without financial incentivisation or a
requirement within the price control decision to deliver a flight efficiency metric within
5. OPERATING COSTS/PENSIONS
Defining a baseline and adjusting for efficiency
In regards to the operational expenditure requirements it is well recognised that the
CAA needs to make an objective assessment of the level of OPEX that an efficient, well‐
managed company would require. Virgin Atlantic does not consider that the CAA’s
approach to establish a baseline, removing one‐off/atypical costs, then rolling this
forward taking account of volume growth and expected efficiency savings achieves this
Taking this approach assumes that the current operational cost base of the provider is
incurred at an economically efficient rate. Virgin Atlantic does not consider this is the
case for NERL. Therefore, extrapolating current performance will not permit the CAA to
reach an objective or efficient view of the operational expenditure requirements of
NERL, as the baseline will exceed the requirements of what could be expected from an
Adopting the CAA’s approach means that users will continue to bear the cost
consequences of NERL's failure to pursue more cost efficient methods of service
delivery. Such an approach simply rewards NERL with increasing levels of OPEX without
fundamentally challenging the way that these costs are incurred or could be delivered
This is particularly important in relation to items such as labour productivity which
constitute a significant proportion of the OPEX cost base, for example staff costs
currently account for £216m of NERLs actual OPEX. Virgin Atlantic considers more
challenging OPEX targets can be set, deliverable by alternative working arrangements,
practices, more innovative ways of rostering or peak period deployment, HR
arrangements and systems management.
In addition, it is unclear as to the appropriateness of a roll forward mechanism in
relation to items such as Other OPEX and Intercompany costs as it is unclear as to what
constitutes these costs. Alone these two cost elements jointly represent over 15% of
NERLs OPEX cost base.
In addition to the concerns associated with rolling forward the 2009/10 costs base,
Virgin Atlantic considers that that applying NERL’s assumed 2% efficiency factor is
insufficient. As set out in the joint trade association letter and Virgin Atlantic’s response
to the CAA’s February consultation, airlines are dubious of the comparative efficiency
studies published by the CAA to date which we believe should be considered
comparisons with a historic industry average. In the view of airlines, they do not identify
a true benchmark which NERL should strive to achieve and give us little evidence of
NERL’s efficiency potential either today or during CP3. As such, whilst the Helios study
concluded that “NERL’s cost effectiveness performance had improved over the five
years to 2007, and was now better than the average of the European comparators
chosen” – this gives us little insight into how much further NERL can and should be
expected to go in terms of cost effectiveness during CP3.
The reduction in underlying operating costs should be significantly more challenging
than NERL’s proposed 2% per annum for CP3. CAA’s proposed reduction in real unit
operating expenditure over CP3 is insufficient in relation to the far more robust and
challenging efforts by airlines (Virgin Atlantic recently reported its airline operating costs
had reduced by 8%) in response to the economic climate and does not adequately
consider the need for far greater performance driven efficiency from infrastructure
providers within the value chain. In addition, Virgin Atlantic considers that the CAA
proposals should be scrutinised in light of NERL’s historical outperformance in terms of
OPEX, particularly during CP2. On operating costs over the CP2 period as a whole NERL
expects to under spend against the CAA determination by around £82m (4%).
Virgin Atlantic believes that without a more stringent efficiency target NERL
management will not be incentivised to deliver additional savings.
Adjusting for volume
Virgin Atlantic questions if the 30% cost of volume elasticity assumptions is still valid. It
is unclear if during the downturn airlines saw evidence that NERLs cost base reduced by
a third of the reduction in the volume of flights. In addition, we question how as, NERL
becomes more technologically advanced e.g. iFACTS, what the impact on the
Virgin Atlantic maintains the view that NERL’s application for an allowance of
contingency of £13m pa (3%) is wholly inappropriate, although we welcome the CAA’s
proposal to only allow 50% of the level proposed by NERL we remain of the view that an
allowance for OPEX contingency appears inappropriate. Virgin Atlantic remains unclear
as to what contingency has been historically used for, how NERL has managed this and if
this was effective and incurred at an economically efficient rate. In addition, Virgin
Atlantic questions the appropriateness of an allowance for OPEX contingency from the
outset of CP3, contingency in the short term should be mitigated by the greater ability
to plan in the short term. In addition, with a truncated period for CP3, Virgin Atlantic
questions if even 50% of the NERL request is appropriate. Finally, the availability of
OPEX contingency will reduce NERL incentives to manage OPEX efficiently and
effectively, how can airlines have some comfort as to how this contingency will be
Virgin Atlantic notes with concern that the key driver of OPEX increases relates to
increasing pension costs. In particular, the share of OPEX relating to pensions is
expected to double from 11% to 21% from 2008/9 to 2015/16. Whilst we recognise that
NERLs March 2010 Business Plan updated the pension costs to reflect the conditions as
at 31 December 2009 and this reduced the projections for pensions costs by £112m
(26%), we remain concerned that overall CP3 pension costs in CP3 are projected to be
£313m and considerably greater than in CP2. The pension costs and their impact on
users are clearly critical and unacceptable. It is difficult to accept the CAA view there is
little more that NERL can do to reduce pension costs. In this regard it is important to
look at the remainder of the industry, other industries and even the Government’s own
radical approach to this issue. Other companies/industries have taken alternative
approaches to addressing such issues and NERL/CAA should ensure that the due
diligence to review all approaches to address the issues as conducted by other
companies/industries has been carried out.
Virgin Atlantic considers that given the significant reduction in NERLs March 2010
assessment arose in part as a result of a slightly better investment return than
previously assumed at the end of 2009, consideration of a further valuation needs to be
undertaken. Given the significant movement in the markets, particularly as of late, the
valuation is central to the issue.
Given the scale of the increased pensions cost projections, Virgin Atlantic does not
believe that 100% pass through of cost for pensions is appropriate. NERL should be
liable/responsible for some of the risk. Allowing a full cost pass through reduces
incentives on NERL to manage its pensions costs, perhaps evidenced in the late closing
of the defined benefits scheme.
Virgin Atlantic requests that Table 9‐3 should be extrapolated so there is visibility of the
projected pensions cost over a 15 year period. In addition, the CAA should seriously
consider how pensions costs are managed going forward. For example, consideration of
a CP4/CP5 pensions costs projection cap, which if exceeded becomes NERLs own risk to
manage should be undertaken.
6. CAPITAL EXPENDITURE/COST OF CAPITAL
Capital Expenditure Plan
As set out in our response to the CAA’s February consultation, Virgin Atlantic believes
that NERL should be challenged to deliver the capital investment plan for the low case
GBP 620m expenditure, in response to the significantly lower forecast traffic. We
therefore challenged the CAA to scrutinise the proposed plan.
Virgin Atlantic is disappointed that the CAA has not challenged NERL to deliver the
CAPEX plan within the lower capital expenditure envelope of £620m as requested by
airlines. Instead the base case plan remains at £650m with NERL having failed to find
any additional efficiencies in the capital plan. Whilst NERL had during CCWG reduced the
size of the capital investment envelope, it is important to note that this was not
delivered through achieving efficiencies per se, rather through deferral of various capital
projects due to the lower than anticipated traffic forecasts. Meanwhile, whilst NERL
claims that it had reduced its planned investment costs by around 10% prior to the
March 2009 baseline Business Plan, Virgin Atlantic queries if it has seen evidence of this
publicised efficiency saving. Despite claims that NERL has improved capability to plan
and deliver, there is limited visibility of these efficiencies demonstrated in the
development of the CAPEX plan.
NERL’s plan to invest £30m in Information Systems (IS) has been challenged by the
airlines through the CCWG process. Virgin Atlantic remains of the view that this should
be further challenged and remain under review by the CAA, as a measure to contain or
potentially trim capital expenditure still further. Whilst we acknowledge Logica’s review
of NERL’s proposed IS investment plan, we query if this review sought to establish the
amount necessary for the basic sound running of the NERL business, rather than an
amount which may be more closely linked with historic practices of NERL.
Risk and contingency
A very significant allowance for risk and contingency has been made in the above plan
and following both an internal review and a study by Logica, the total risk and
contingency amount is now proposed to be increased still further by £20m, up to a
stated total of £120m, or some 18% of the investment total. Virgin Atlantic is
disappointed that the CAA has permitted NERL an additional allowance for contingency.
Whilst Virgin Atlantic recognises the advice CAA has received from Logica, Virgin Atlantic
questions the appropriateness of this increased contingency allowance particularly
given Logica’s identification that NERLs capability to plan and deliver investment
projects efficiently and effectively has improved significantly since CP2 and NERLs own
identification of their improved project management capability rating (up from 1.8 in
2004 to 3.7 in 2008)3.
Finally, Virgin Atlantic questions what assessment has been made given the truncated
nature of CP3 and its associated impact on the risk and contingency requirement.
Set in the context that regarding CAPEX NERL has under‐spent in the first two years of
CP2 but is expected overall to exceed the CP2 projections by some 5% (approx £29m),
by the end of the control period, Virgin Atlantic welcomes the CAA’s proposals for
enhanced CAPEX reporting and monitoring. Broadly, Virgin Atlantic supports the
approach to increasing transparency set out by Logica. In addition, Virgin Atlantic
supports the further suggestions put forward including preparation of a business case
for each major project, improved governance process and transparency on the use of
contingency. In addition, Virgin Atlantic considers that an understanding of the
efficiency assumptions should be set out in the business case and any impact of the
investment plan on service (and where appropriate, the mitigating measures necessary)
should also be outlined.
To ensure ongoing improvements in the transparency, monitoring and delivery of capital
projects, Virgin Atlantic considers that there should be consideration of capital triggers
in future reviews.
Cost of Capital
Virgin Atlantic has not undertaken its own cost of capital analysis, however we welcome
and support IATA’s analysis of this topic.
Virgin Atlantic is not persuaded that the SESII arrangements (in particular regarding the
volume risk sharing arrangements and movement from distance to CSU’s as a basis of
measurement) substantially alters NERL’s risk profile. Indeed, in relation to risk sharing
Virgin Atlantic considers the SESII arrangements will benefit NERL, substantially reducing
its exposure to downside risk.
3 “CP3 Baseline Business Plan Overview and Context – NERL Performance in CP2” Presentation to CCWG, 29 April
7. PRICE CONTROLS
En Route Price Control
Virgin Atlantic is extremely concerned that the CAA’s current price control proposals
imply a price per CSU in 2011/12 of £53.78, a significant increase of 6.2% on 2010’s
price/CSU. Such an increase will occur at a time when airlines’ recovery from the recent
economic downturn will still be delicate. In addition, we do not consider that a price
control which proposes only an average 1.725% reduction in chargeable service units
over CP3 is sufficiently challenging.
Whilst Virgin Atlantic acknowledges the additional pressures that the CAA proposals
have brought to bear on NERLs March 2010 Business Plan, we consider that:
• NERL should be challenged to deliver greater OPEX efficiencies than set out
in the CAA’s proposals. Virgin Atlantic does not consider the 2009 /10 OPEX
cost base represents an efficient level or that the 2% efficiency factor
assumed by CAA is sufficiently challenging. In addition, alternative pensions
arrangements should be considered.
• NERL should be challenged to deliver greater efficiencies in relation to the
capital investment programme.
• The SESII arrangements does not substantially alter NERL’s risk profile.
Whilst we recognise that the spike in 2011 is driven by lower traffic in 2010 and a
substantial increase in the level of pensions costs, Virgin Atlantic believes that greater
consideration as to the appropriateness of smoothing the price control profile should be
given. Whilst we accept that strong arguments are required to divorce prices from costs,
Virgin Atlantic reiterates that the recent economic downturn was unprecedented and
airlines’ recovery, in particular in 2011, is likely to be extremely delicate, where a
£3.16/CSU or 6.2% price increase will have a significant increase on an airline’s cost
Oceanic Price Control
Whilst Virgin Atlantic acknowledges that the Oceanic element of NERL’s business is
small, the market remains uncontested. Thus, the CAA needs to ensure sufficiently
challenging price controls are applied to NERL’s monopoly provision of the service.
In this regard, we are concerned that the CAA’s proposals imply a significant increase
(18.6%) in the first year of CP3. Again, Virgin Atlantic considers that CAA should set
more challenging OPEX efficiency assumptions and consider further the appropriateness
Revised Traffic Forecasts
In particular, Virgin Atlantic is concerned that NERL anticipates a further reduction in
traffic volumes based on its September 2010 traffic forecasts and the subsequent
impact this may have on the price control proposals. Virgin Atlantic would like the CAA
to confirm how it intends to deal with this additional information that may come to light
after the regulatory consultation process has ended.
Virgin Atlantic is extremely concerned that the CAA’s price control proposals imply an
increase in 2011 of 6.2% in En Route charges and an increase of 18.6% in Oceanic
charges. Such increases come at a time when airlines’ recovery from the recent
unprecedented economic downturn will be delicate. In addition, Virgin Atlantic does not
accept that a price profile which implies an average reduction in price per CSU of
1.725% for En Route Charges and 1.425% for Oceanic charges, is sufficiently challenging.
In particular, Virgin Atlantic considers that the CAA should revisit its proposals to:
• ensure NERL is incentivised to deliver greater OPEX savings and efficiencies,
including reconsideration of the treatment of pensions costs;
• ensure NERL is required to deliver greater efficiencies in relation to the capital
investment plan; and
• strengthen service quality targets to ensure NERL is progressively and
continuously incentivised to improve service quality.
Without challenging NERL’s cost base further and requiring NERL to deliver in
accordance with more stretching service quality targets, Virgin Atlantic considers the
CAA’s CP3 price control proposals risk repeating the inadequacies of the CP2 price