1 Introduction
1.1 Reasons to invest in aviation
There are three main reasons to invest in aviation and these are common to all modes of transport. They are:
Comfort and quality of service are additional sources of value in transport, but are rarely in themselves a reason to invest. Instead, they tend to accompany some combination of the three main reasons. Also, time can be considered a resource, implying that the first reason should be included in the second one. But time is such an important driver of value that it is usually considered separately.
Private sector operators develop their competitive strategies by focusing primarily on the first two reasons, and value the returns on their investment through a financial appraisal. The third reason is mostly relevant for promoters in countries with very poor transport conditions. Public sector investors also base their investment decisions on the very same criteria, although they widen the scope of benefits and costs beyond monetised private flows to include non-monetised private flows, as well as flows to third parties including, ultimately, society at large. Such an exercise constitutes an economic or socio-economic investment appraisal.
The private and public perspectives on investment – the financial and the economic, respectively – are mutually complementary in two respects. First, private financial benefits and costs offer a first approximation to economic benefits and costs. Indeed, the financial appraisal is a subset of the economic appraisal, constituting a partial look at the flows associated with a project. Second, the economic benefits of an investment takes a broader perspective at the sources of value, offering the private sector investor clues about untapped sources of revenue; and economic costs signal potential risks arising from market distortions and badly defined property rights. These issues are explored in section 1.2 of this chapter.
However, the distinction between financial and economic returns is often saddled with confusion, opening the doors to abuse. For example, the projected positive financial profitability of an investment may be touted as proof of the soundness of a project. However, what is advertised as a financially viable investment may in fact not reflect social value or a competitive advantage at all, but rather transfers from other stakeholders. After all, operators and investors may try to influence public policies in order to protect their competitive positions by erecting barriers to competition and, more generally, distorting markets, in extreme cases turning a financially non-viable project into a viable one. In such situations an economic appraisal would show that the proposed investment would be wasteful, despite the positive financial return. A second example is when politicians, for electoral reasons, may want to justify devoting public money to financially loss-making investments with arguments about all sorts of wider benefits to the local economy. On closer examination, a proper economic appraisal may show that many of the alleged wider economic benefits are invalid.
Besides the three fundamental reasons to invest in transport – including time and cost savings and safety improvements, as mentioned above – investment appraisal analysts are continuously confronted with myriad other reasons put forward to justify investments. Some of these reasons are ultimately invalid, but come mixed with elements of the three valid reasons set out above, making it hard to distil the extent to which an investment creates value, and the extent to which it constitutes waste and abuse. Arguments put forward may include the following:
There are also more clearly invalid reasons for investing that are easier to spot in advance:
And even:
To conclude, sound financial returns and arguments with popular appeal are no guarantee that the investment will be worthwhile. The ultimate case is based on saving time, reducing costs, and improving safety in ways that ensure that the benefits outweigh the costs. A project with a positive financial return and a negative economic return is likely to be fully dependent on political patronage.
1.2 Financial and economic returns
The financial appraisal of an investment project involves estimating revenues and costs, including financing costs. Such an estimate constitutes the backbone of any standard business plan. In this regard, there is nothing exceptional in the mechanics of conducting the financial appraisal of an investment in the aviation sector, or in transport in general, relative to a project in any other sector. To simplify, the financial appraisal as presented in this book ignores considerations regarding the capital structure of a project. The focus is on whether the financial resources invested in a project as a whole generate a sufficient cash return to the promoter. Projects can be thought of as being 100 per cent financed with equity capital.
The financial return of a project is a subset of the wider economic returns of the project. Under very specific circumstances the financial return equals the economic return. When markets are competitive, are free from distortions such as taxes, subsidies or price regulations, when there are close substitutes for all goods and services, when an investment project is too small relative to the size of the economy to significantly alter prices, and property rights are well defined, prices reflect the benefits of an additional unit of output produced and costs reflect the resource cost of producing that unit. Private sector investors, in following expected revenues and costs in making investment decisions, will make investments that are in line with maximising not only private profit but also social welfare. That is, the investor will inadvertently be part of the proverbial ‘invisible hand’ whereby the pursuit of private interest leads to an allocation of resources that is socially desirable.
In such circumstances, the financial appraisal of a private sector investment analyst would be sufficient to decide whether the investment should be made from the point of view of society at large, without any need for a public sector economist to carry out any other viability test. However, in reality, prices are often distorted, property rights are not always well defined, and substitutes may be imperfect, giving certain operators a degree of market power. These three distortions are addressed in turn in the following paragraphs.
Firstly, prices may not reflect full resource cost because of the presence of taxes, subsidies, or regulations such as minimum wages or price caps in markets for inputs or outputs. A tax on an input, for example, means that the promoter will pay for the resource cost (the opportunity cost) of the input, plus a transfer (the tax) to the government. The price the promoter pays for the input overestimates the cost of the input to society, and therefore, as far as society is concerned, this price cannot be taken as the basis for making a sound allocation of scarce resources since the taxed input would tend to be consumed less than would be socially desirable. A subsidy on an input would have the opposite effect. Similarly, price regulation, such as price ceilings or floors, may imply that the price does not reflect the scarcity of the input. Prices may instead reflect a market outcome that over- or under-supplies the good.
Secondly, when property rights are not well defined, a market transaction involving a buyer and a seller may interfere with the rights of a third party that does not voluntarily take part in the transaction. These impacts to third parties are called ‘externalities’, in the sense that they are external to the parties that voluntarily agree to a transaction. In the case of aviation the main examples of potential externalities concern the environment, including emissions of greenhouse gases, air-polluting particles, and noise. When the property rights of third parties are well defi...