Commercial Context of Project Management

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2013

David Aime Masvosvere

Student ID: 1113855

3/24/2013

The Commercial Context

Module: BS3353

Assignment

Case Study: Proposed Thames

Estuary Airport Hub Project

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EXECUTIVE SUMMARY

Calls for a new airport for London and the UK have been heard for decades. Each time a proposal has

been made alternative measures to avoid building an airport in the London Thames estuary have

been sought. Now however, cries to have this airport structure in the Thames have been voiced ever

more loudly by London mayor Boris Johnson, Lord Foster and a few others.

The main issue of contention with the project has been the sketchy financials along with

environmental concerns. These environmental concerns despite having been echoed by many a

British politician pale in comparison to the financiability and logistical matter. As will be noted in this

document in quotes and extracts from BBC articles, Government literature and consultancy reports

by economist firms among others, presently this project is just too risky and lacks detail in areas

where necessary.

A report prepared for the House of Commons Transport Select Committee deals a hugeblow to the project, claiming it would be a risky investment.

It says that because the value of the investment is significantly negative an investor wouldbe likely not to touch the project.

A public subsidy of 10-30 billion would be needed to get the airport built, the report by

economics consultancy Oxera suggests.

The reports authors have calculated the value of a new airport at 15.6 billion bycalculating revenues from passenger charges and taking out operating costs.

In todays money it would have costs of 43.7 billion, leaving a significant gap that would

need to be made up.

If Heathrow were to close as the result of a Thames Estuary airport being built, the final

compensation bill could be as high as 20 billion.

Thomas of Foster + Partners, the architects behind plans for the worlds biggest airport on

the Isle of Grain, will answer questions on the proposal, which has an estimated cost of 50

billion.1

1http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary_airport.aspx

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CONTENTS

EXECUTIVE SUMMARY2

TABLES AND FIGURES USED..4

PART A..5

1. Overview.5

2. COSTS ...7

3. AIRPORT VALUE.8

4. AIRPORT COST9

5. ARR..9

6. IRR9

7. NPV.10

8. PAYBACK PERIOD11

PART B.12

1. PURCHASING AND SUPPLY12

2. COMMERCIAL ISSUES AND RELATED RISKS IN THE TENDERING AND CONTRACT PHASES...16

2.1 IDENTIFYING NEED AND PLANNING PURCHASE.16

2.2 SELECTING TENDERER..17

2.3 CONTRACT MANAGEMENT...17

CONCLUSIONS.20

RECOMMENDATIONS21

REFERENCES21

BIBLIOGRAPHY OF SOURCES CONSULTED BUT NOT DIRECTLY REFERRED TO WITHIN THE

WORK...22

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TABLES AND FIGURES USED

Constrained and unconstrained Demand

Cost estimate

Airport value

Cost forecast

NPV

Cash flow Model

Procurement Cycle

Procurement process

The city of London in 2009 proposed to have the following structure for procurement

Procurement Strategy

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PART A

1. Overview

In assessing whether a new hub airport would be commercially feasible, the first deliberation is the

extent of future demand from passengers and freight. Forecasts estimate the revenue that could be

earned from a new airport, and hence the expected cash flows. The UK Department for Transport

(DfT) published official projections in January 2013 of constrained and unconstrained future UK

aviation demand.

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As seen above forecasts for traffic have been lowered substantially since 2007.

Also it is worth noting that on top of providing services to presently constrained traffic, if all traffic

that would otherwise have used Heathrow Airport were to be moved to a new airport, there would be

an additional 85m passengers per annum (mppa) available for the new hub in 2050 that is with the

assumption that a 100% transfer, from Heathrow happens.

Economics consultancy firm Oxeras analysis, scenarios where Heathrow closed assume 100% from

Heathrow to the Thames Airport hub, whereas if Heathrow remains open no transfer is assumed.

It is also likely that abstraction from Gatwick and Stansted Airports is a concern, which jointly is

projected to provide 70mppa in 2050, though full abstraction is improbable. It is important to notethat, Oxeras base-case scenario has been to assume that there is no abstraction from these airports

and, in a high-case scenario, that there is abstraction of traffic from full-service carriers at Gatwick

(30%) and Stansted (3%) that will transfer to the new hub. These assumptions should cover the fullrange of likely outcomes, with the outturn level of traffic transfer likely to be somewhere in

between.2

2http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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2. COSTS

It is pertinent to note that due to the number of proposal with varying specification (i.e. number of

runways etc) costs estimates vary. Oxera collated cost estimates from a few proposals adjusting for

inflation where necessary as is seam below.

As seen above a new airport in the Thames Estuary would probably cost in the range of 20 billion to

50 billion. The reason for a wide range of cost estimates comes primarily from conflicting estimateswith regard to surface access costs. As most of the proposals outlined are indicative only, it remains

unclear whether this accounts for optimism bias. Repercussions of optimism bias on cost projections

are a great concern as they can result in cost overruns in the order of 50% to 100% for major

infrastructure Projects

Oxeras analysis assumes that a new UK hub airportwould open and be fully functional in

around 2025, which, from the proposals to date, appears to be a reasonable base case,although it is likely that a staged opening would occur in practice.3

An important aspect that most miss to mention and Oxera also noted, was the lack of details on

compensation in the event that Heathrow is closed, this was not addressed in many of the proposals.

With the current value of Heathrows regulatory asset base (RAB) around 13 billion, with pastestimates having suggested that total compensation for the closure of Heathrow could be as high as

20 billion taking into account compensation to airlines, this is a major aspect in regard to the

Thames airport project cost worth noting. The Thames Estuary proposal will not have location

compensation to worry about but there is a prospect for the incurrence of environmental costs as

many have opposed the project on an environmental basis.

3http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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3. AIRPORT VALUE

According to Oxera the resulting figure came about by estimating revenues from forecast passengers

with the assumption that each paid the forecast charges net of operating costs. After this, revenues

are then calculated using todays money with a discount factor reflecting the time value of money

between now and the period when the airport is operational. Then result of this calculation is 15.6

billion.

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4. AIRPORT COSTUsing data from the same Economic consultancy firm the following was discovered. With use of acomparable basis the calculation takes a cost estimate for a four-runway hub which is slated above

70 billion inclusive of compensation, this cost is then calculated in todays money using a discount

factor. If an assumption of an investment programme over time duration of ten years till 2025, with

compensation after the new airport becomes operational, the resultant cost is 43.7 billion.

5. ACCOUNTING RATE OF RETURN (ARR )This is an appraisal technique that considers a simple estimate of a project's or investment's

profitability, subtracting money invested from returns without regard to interest accrual or

applicable taxes. This method is widely used for investment appraisals and capital

budgeting decisions. How to reach a decision is simple, one easy way is to accept projects with an

accounting rate of return that is higher than the cost of capital and reject those that do not.

With regard to the Thames project using ARR is difficult due to the uncertainty of the financials. Theexpected returns and capital investment required are yet to be determined. However it would be a

more than competent technique for a project of this magnitude.

6. INTERNAL RATE OF RETURN (IRR)

This method of appraisal works along with Net Present Value (NPV) as it is the discount rate at

which the NPV of costs of the investment equals the net present value of the of the investment. Hence

it is a method of capital budgeting which can calculate IRR and compare it with cut off rate for

selecting any project. NPV and IRR have been used together as appraisal tools and given good results.

As far as the Thames Airport project is concerned, after looking at the financial forecasts and in

particular the hugely negative NPV it is my assumption that the IRR is lower than Cost of Capitaltherefore is a bad investment.

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7. NPVThis appraisal technique takes into account the present value of net cash inflows generated by aproject including salvage value, if any, less the initial investment on the project. This methods

reliability in capital budgeting is based on accounting for time value of money with the use

discounted cash inflows.

The Net Present Value (NPV) of this project is negative taking into account that subtracting costsfrom the airport value when cost is higher than the airport value renders a negative figure. From a

finance standpoint a based on this NPV value an investor would be unlikely to embark on the

investment. This then implies that the collective investment in a new airport in addition to related

infrastructure is improbable as a commercial investment. However it may still be possible to finance

the projectin the new airport infrastructure of around 20 billion alone, but only through injection

of substantial levels of public subsidy and investment for the surface access and compensation, which

would comprise around 6075% of the total investment cost.4

4http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

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Cash flow Model

8. PAYBACK PERIOD

This appraisal technique is one of the simplest and takes into account the time in which the initial

cash outflow of an investment is expected to be recovered from the cash inflows generated by the

investment.

According to the House of Commons, The ambitious and wide-ranging set of developments intendedto fix Britains creaking infrastructure would cost in the region of 50 billion (20 billion for the

airport and 30 billion for the other infrastructure improvements), though the authors claimed that if

implemented the plan could generate 150 billion - 35bn from the airport, 35bn from road and

rail; 2bn from environmental management and 75bn from growth in the Thames Hub area.5

The main issue with a lot of contention is the time frame needed to recoup the funding and begin

experiencing profitability here. Giving the planning and construction timetables its highly unlikely anew airport could be operational within 25 years. Given the pressing needs of the UK economy to

meet the current demand for international travel, inaction over this period would be highly

detrimental to recovery and growth.6

5http://www.parliament.uk/briefing-papers/SN04920.pdf6 http://eandt.theiet.org/magazine/2013/03/debate.cfm

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PART B

3. PURCHASING AND SUPPLY

Purchasing and supply can be defined as the acquisition or rendering of goods, services or works. It is

complimentary that the goods, services or works are appropriate and that they are availed at the best

possible cost, quality, quantity, time, and location. It important to note that Corporations and publicbodies often define processes intended to uphold fair and open competition for their business while

reducing contact to racketeering and conspiracy.

Due to the magnitude of this project the essential success criterion is the well-timed, precise to excellence

and gainful delivery of supplies, systems and amenities. There are many stakeholders, contractors and

suppliers involved in this kind of project, not forgetting consulting firms. Due to this procurement

methodologies and processes are fundamental to ensuring that project resources are delivered as

requisite.

Procurement Cycle

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The Procurement Process

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The city of London in 2009 proposed to have the following structure for procurement.

As far as Strategy goes I looked at the Just in time strategy used mostly in Japan and despite it being

comprehensive I was not convinced it would serve this project well. As will be seen below I have a

diagram with a strategy proposed in New South Wales that I believe would be suitable to the Thames

project.

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7 http://www.hpw.qld.gov.au/SiteCollectionDocuments/CWMFProcurementStrategy.pdf

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4. COMMERCIAL ISSUES AND RELATED RISKS IN THE TENDERING AND CONTRACT PHASES

2.1 IDENTIFYING NEED AND PLANNING PURCHASE

Potential Risk Probable Effect of risk Action required to Counter Effects

Understatement of the need Purchase of unsuitableproduct or service

Money wasted

Need not satisfied

Analyse need accurately

Overstatement of the need Greater expense

Poor competition

Analyse need accurately

Use functional and performance

requirements

Misinterpretation of user

needs

Totally unacceptable

purchase or not most suitable

product or service

Time lost

Increased costs

Possible downtime

Improve consultation with users

Obtain clear statement of work and

definition of need

Insufficient funding Delay in making the purchase

Additional costs for re-tender

Obtain appropriate approvals before

undertaking process

Improve planning

Impractical timeframe Inadequate responses from

tenderers

Reduced competitionDelivery schedule not met

Improve forecasting, planning and

consultation with users

Improve communication with potentialtenderers

Probity issues Increased procurement costs

Misuse of resources

Most suitable product notobtained

Unethical conduct

Implement best practice policies,

guidelines and practices

Maintain ethical environment

Improve training of personnel

Put suitable controls and reviews in place

Consider using a probity adviser

Improve communication with potential

tenderers

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2.2 SELECTING TENDERER

Potential Risk Probable Effect of risk Action required to Counter Effects

Selecting an inappropriate

supplier

Failure to fulfil the contract Provide staff with appropriate tender

evaluation, financial and technical skills

training and commercial expertise

Improve evaluation procedures

Improve evaluation criteria and clearly

identify them to tenderers in tender

documents

Reject unacceptable offers

Perform financial, technical and company

evaluations before awarding contract

Procurement Review Committee to

review tender and selection process prior

to awarding contract

Selecting inappropriate

productFailure to meet the clientsneed

Ensure users are involved in the

evaluation/selection process

Improve technical evaluation procedures

and train staff as appropriate

Procurement Review Committee to

review tender and selection process prior

to awarding contract

2.3 CONTRACT MANAGEMENT

Potential Risk Probable Effect of risk Action required to Counter Effects

Variations in price and foreign

exchange

Cost overruns Agree on prices and the basis of prices

Agree on a formula for calculating

variations

Unwillingness of the supplier

to accept the contract

Delays in delivery

Need to restart procurement

Seek legal redress if non-acceptance

causes loss

Negotiate but retain integrity of thecontract

Failure of either party to fulfil

the conditions of the contract

Contract disputes

Failure to satisfy needs

Delays in delivery

Downtime

Legal action

Ensure good contract administration and

performance management

Hold regular inspections / meetings and

ensure progress reports

Ensure all staff know responsibilities and

conditions

Ensure good record keeping and

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Potential Risk Probable Effect of risk Action required to Counter Effects

documentation

Inadequately administering

the contract

Cost increases

Failure of contract

Full benefits not achieved

Delivery of unsatisfactory

product

Contract/supply disputes

Maintain up-to-date agency procedures

and practices

Ensure all staff are suitably trained andexperienced in contract planning and

management

Commencement of work by

the supplier before contract is

exchanged or letter of

acceptance issued

Potential liability to pay for

unauthorised work

Possibility of legal action for

perceived breach of contract

Confirm verbal acceptance of contract

with written advice

Accept all contracts in writing

Ensure approvals are received before

allowing work to start

Unauthorised increase inscope of work

Unanticipated cost increases

Contract disputes

Ensure all contract amendments areissued in writing

Record all discussions and negotiations

Confirm instructions in writing

Loss of intellectual property Loss of commercial

opportunity

Unwarranted reliance on

supplier for product support

Ensure suitable clauses are included in

the contract

Failure to meet liabilities of

third parties (eg. royalties orthird party property

insurance)

Legal action

Damage to the agencysprofessional reputation

Check that all obligations are covered in

the contractAgree on responsibilities

Implement appropriate safety standards

and programs

Loss or damage to goods in

transit

Delays in delivery

Downtime

Liability disputes

Include appropriate packaging

instructions in specification

Agree on insurance cover for supplier to

provide

Accept delivery only after inspection

Know when title of goods is transferredto buyer

Fraud Misuse of resources

Legal action

Disruption to procurement

activities

Maintain an ethical environment

Follow and maintain fraud control

procedures

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Potential Risk Probable Effect of risk Action required to Counter Effects

Key personnel not available Progress on project disrupted

Less expertise

Include requirement in specification and

ensure compliance in post-tender

negotiation

Know the market

Accept risk and manage possible delay

Acknowledgment: This checklist is an adaptation of information derived by consultation with a

checklist developed by NSW Department of Public Works and Services.8

8http://www.nswprocurement.com.au/psc/Tendering-Manual/Appendix-3A.aspx

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CONCLUSIONS

Based on the appraisal techniques used it is evident that the project leaves a lot of financial

uncertainties. Based on this reason I do not believe it is a wise investment. The NPV and IRR are a big

factor in this realization as they do not project long term financial viability. It is important to also

note that due to the nature of the project size not all areas have been forecast by the office of MayorBoris Johnson. It can be then concluded that there is a lot of optimism bias with little fact to back up.

As far as the contract and tender phases as outlined in the document, it is very important that these

areas be managed closely as improprieties will prove costly not only financially but time wise and

politically as well as this is highly controversial project.

RECOMMENDATIONS

1. Government regulation to reduce tax improving returns2. Attract investment from development banks that seek returns other than the financial

3. Issuing government guaranteed or backed debt to raise financing changes to the cost structure toreduce cash outflows4. Having supplier credit as it is a good way to improve project performance because one does notpay suppliers immediately freeing up cash for other uses

5. Having strict contract and tender practices that are closely monitored and evaluated6. Having strict in house and outsourced audit systems to reduce improprieties

Word Count (2488)

REFERENCES

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1. http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary_airport.aspx

2. http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/A-new-UK-hub-airport.pdf?ext=.pdf

3. http://www.parliament.uk/briefing-papers/SN04920.pdf

4. http://eandt.theiet.org/magazine/2013/03/debate.cfm

5. http://www.gowerpublishing.com/isbn/9781409425151,http://www.gowerpublishing.com/pdf/SamplePages/Managing-Project-Supply-Chains-

Author.pdf

6. http://www.nswprocurement.com.au/psc/Tendering-Manual/Appendix-3A.aspx

7. http://www.hpw.qld.gov.au/SiteCollectionDocuments/CWMFProcurementStrategy.pdf

8. Baily, P., Farmer, D., Croker, B., Jessop, D., Jones D. (2008) Procurement Principles andManagement,10th Edn. London, FT Prentice Hall (Financial Times). Recommended By The

Chartered Institute Of Purchasing And Supply

7. http://www.cips.org/Documents/Resources/Knowledge%20Now/What%20is%20purchasing%20and%20supply%20management.pdf

8. http://www.cityoflondon.gov.uk/business/tenders-and-procurement/Documents/Procurement%20strategy.pdf

9. http://archive.treasury.gov.uk/pub/html/docs/cup/cup39.pdf

All references accessed between Thursday, January 24 2013 and Friday March 22 2013

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BIBLIOGRAPHY OF SOURCES CONSULTED BUT NOT DIRECTLY REFERRED TO WITHIN THE

WORK

1. http://www.parliament.uk/documents/commons-committees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf

2. http://www.parliament.uk/documents/commons-committees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf

3. http://www.publications.parliament.uk/pa/cm201213/cmselect/cmtran/writev/aviation/m103.pdf

4. http://www.kentonline.co.uk/medway_messenger/news/2013/january/24/thames_estuary_airport.aspx

5. http://www.ciltuk.org.uk/Portals/0/Documents/ProSectors/Aviation/CILT_response_to_DfT_aviation_policy.pdf

6. http://www.parliament.uk/documents/commons-committees/transport/Would_a_new_hub_airport_be_commercially_viable.pdf

7. www.parliament.uk/briefing-papers/SN04920.pdf

8. http://www.bbc.co.uk/news/uk-politics-16606212

9. http://www.purchasing.tas.gov.au/buyingforgovernment/getpage.jsp?uid=07CC4222E4F10F00CA256C8D007F9FC6

10.http://www.bbc.co.uk/news/uk-england-kent-15473914

11.http://media.aerosociety.com/aerospace-insight/2012/09/07/londons-thames-airport-plans-deja-vu-all-over-again/7288/

12.http://www.bbc.co.uk/news/uk-england-london-15817520

13.http://www.bbc.co.uk/news/uk-england-london-20317321

14.http://www.archdaily.com/339271/foster-partners-to-submit-thames-hub-airport-proposal-to-airport-commission/

15.http://thamesestuaryairport.com/pdf/THAMES%20ESTUARY%20AIRPORT%20for%20web.pdf

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16.http://thamesestuaryairport.com/masterplan.html

17.http://www.dailymail.co.uk/news/article-2088376/New-London-airport-Thames-Estuary-favoured-Government-says-Boris-Johnson.html

18.www.fosterandpartners.com/core/pdf/news/?id=494

19.http://www.telegraph.co.uk/finance/newsbysector/epic/bba/9022146/New-Thames-Estuary-airport-could-be-built-in-six-years.html

20.http://www.fosterandpartners.com/news/thames-hub-team-welcomes-consideration-of-thames-estuary-airport-and-re-states-its-vision/

21.http://www.tfl.gov.uk/assets/downloads/corporate/a-new-airport-for-london-part1.pdf

22.http://www.london.gov.uk/sites/default/files/Anewairportforlondon_part2.pdf

All sources accessed between Thursday, January 24 2013 and Friday March 22 2013

THE END