Annex A - Cost-Benefit Analysis and Commercial Viability Analysis

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Introduction

1. As indicated in "Proving the Economic Case" (paragraphs 51-57 of the guidance on the protection of regional air access to London), it is necessary for Government and regional bodies to work together to provide a robust case for the imposition of a public service obligation (PSO) on a regional air service to London. The guidance in this Annex establishes a common methodology for demonstrating the costs and benefits of the economic case.

2. The Department itself will be responsible for calculating the value of a slot at a London airport, and for providing the direct economic benefits of imposing a PSO, in terms of the savings in overall costs enjoyed by passengers, relative to the costs of travelling by other routes and/or transport modes.

3. The regional body in question will be responsible for demonstrating the wider or indirect economic benefits of imposing a PSO.

4. The Department will take this information into account when deciding whether an air service is vital for the economic development of the region - one of the criteria for imposing a PSO.

A. Cost-Benefit Analysis

Value of a Slot at a London Airport

5. Reserving slots at fully co-ordinated London airports following the imposition of a PSO on a regional route would mean that the slots could not be used for other services. Consideration also has to be given to the fact that, even with new capacity in the South East, excess demand is forecast to grow. Therefore, the opportunity cost of reserving slots will rise over time. This will also be influenced by any changes to the slot allocation regime at European level, such as introducing market mechanisms.

6. Slot values vary by airport (highest at Heathrow, intermediate at Gatwick, and less at Stansted) and by time of day. The slot market is thin, with only a limited number of published trades. The variation in recent slot transactions at Heathrow has been wide.

7. The Department, with the help of the Civil Aviation Authority, will conduct analysis into and justify the specific slot values to be used as a cost in the cost-benefit analysis comparing the benefits of retaining an air service from the regions to London against the foregone value of the slot if it were used for another purpose.

Benefits to the Region

8. The benefits of maintaining a regional link to London are difficult to quantify and need to be judged on a case-by-case basis. They include direct savings to passengers relative to the cost of using alternative routes, coupled with wider regional economic benefits (such as the impact of lower inbound tourism or investment in the region).

Direct Economic Benefits

9. The direct economic benefits of retaining a service to London are the savings in overall or 'generalised' costs enjoyed by passengers, relative to the costs of travelling by other routes and/or transport modes. These savings include the costs faced by passengers who in the absence of the direct service to London would not travel to London at all.

10. Following receipt of a PSO application, the Department will conduct an analysis of the loss of user benefit for passengers to and from the region if that route ceased to exist or materially changed its frequency of service. Once this analysis has been prepared by the Department, it will be shared with the relevant regional body, who will be able to scrutinise the analysis fully.

11. The Department has a passenger allocation modelling suite which assigns passengers to specific routes to and from individual airports. This model is based on minimisation of 'generalised' costs including costs of using surface transport infrastructure as well of using air infrastructure (i.e. the model seeks the lowest cost route to fit the passenger's needs). Forecast throughput on a specific 'thin route' therefore reflects the number of passengers who would prefer to use that route. By removing that route, it is possible to calculate the loss of 'user benefits' as passengers have to choose alternative ways to reach London - including a longer trip by surface transport to another airport or to a continental hub if such routes exist for passengers originally interlining in London - or the loss of welfare if they do not to travel at all. The modelling suite also calculates the loss of benefits to passengers of reduced frequency on that route.

12. The Department's modelling suite generates the change in generalised costs by a range of passenger categories, including:

  • UK business passengers;
  • UK leisure passengers;
  • foreign business passengers; and
  • foreign leisure passengers.

13. It is also possible to derive benefits to passengers who are resident in a specific region, but clearly a region benefits from passengers from other regions and countries travelling to it.

14. The Department's modelling suite also calculates the passenger benefits foregone if a service from a region to a London airport ceases to exist such that interlining opportunities through a UK hub are no longer available. It should be noted that, even where connections are not actively marketed or advertised by the airlines, as at Stansted some passengers may well interline informally using 'no frills' services.

Indirect or Wider Economic Benefits

15. The Government and regional bodies have objectives for the economic transformation of individual regions, and it is important that these are described and taken into account.

16. The Department therefore welcomes the provision of evidence on indirect or wider economic benefits by regional bodies, since this could help provide colour and substance to the case for retaining an air service to London. In doing so, it should however be recognised that it can be difficult to precisely quantify indirect or wider benefits. In part, this is because it is difficult to separate out the importance of air services (or of transport infrastructure in general) from all other factors determining a firm's choice of location or a household's choice of holiday destination. The Department plans to make available an appraisal framework for Route Development Funds in the UK. Regional bodies may find this framework helpful in preparing evidence on wider economic benefits.

17. However, it is important to avoid double-counting, since passenger benefits can serve as a proxy for some indirect or wider economic benefits (e.g. job creation). For example, some of the direct benefits of retention of the regional service to London will accrue to business passengers. This reflects the greater ease with which outbound passengers can do business in London and inbound passengers can do business in the region. Both represent potential benefits for the regional economy through an increase in business efficiency. But these effects cannot be added to the passenger benefits already described, as this would give rise to double-counting. Evidence in terms of wider economic benefits represents an alternative way of describing the benefits of retaining the service.

18. The withdrawal of a regional air service to London will inevitably have a range of impacts on the environment, including the reduction of carbon dioxide emitted throughout the flight, and lessened noise and air quality impacts at the airport level. It is however not proposed generally to quantify these impacts; the slots at London airports currently serving the regional air service would be used for alternative air services through London airports.

B. Commercial Viability

19. Generally, routes to London should not require a specific PSO subsidy. Applications including PSO subsidy will therefore need to be carefully scrutinised since there may be other ways of operating the service (e.g. using aircraft with different 'breakeven' load factors) which may enable a commercially viable solution without subsidy.

20. Regional bodies proposing subsidy in support of a PSO should therefore ask the Department for a 'commercial viability test', which will be undertaken using specialist software that is commercially available, and a standard modelling package used extensively by the industry. This model will be set out in the Department's appraisal framework for Route Development Funds in the UK.

21. The commercial viability assessment will take account of information such as:

  • specific aircraft selection (network analysis if different aircraft types are utilised);
  • estimated yield calculation;
  • full profitability analysis using past passenger performance - contribution, net operating profit, fully allocated profit;
  • breakeven statistics; and
  • route economic assumptions - airport charges, aircraft leasing rates, insurance, overhead contribution etc.

22. Further information relating to this annex can be obtained by writing to:

Department for Transport
Airports Policy Division,
Zone 1/26, Great Minster House
76 Marsham Street
London, SW1P 4DR