Looking Beyond UDF

Is our fixation with user development fee (UDF) as the funding workhorse for our airports causing us to overlook other more efficient and social benefit-maximizing funding options?

V Ranganathan, Indranil Guha, Manuj Sethi & Reema Mahajan

Indian airports are in the throes of modernization. With work complete or nearing completion in four major ones — Delhi, Mumbai, Hyderabad and Bangalore — and tier II city airports queued up already, India’s airports liberalization process has progressed briskly. But is there more to it than what meets the eyes? Replacing our creaky airports with glitzy glass and mortar structures is one thing; transforming them into thriving international aviation hubs is quite another.

For that to happen, robust governance is a fundamental pre-requisite — an area that is the Achilles heel of our bureaucracy and political establishment. For example, before the airports privatization got underway, there seems to have been very little deliberation in our policy circles with respect to regulation of user charges to be charged by these new airports. No wonder, this issue has become one of the stickiest bones of contention since the opening of the new Bangalore and Hyderabad airports.

Under the proposed user development fee (UDF) regime, Bangalore International Airport Ltd (BIAL) has proposed a user charge of Rs 675 for domestic passengers and Rs 1,070 for international passengers. So how likely is it that such a UDF regime, which is slated to become the funding workhorse of most of India’s major greenfield and brownfield airports, would in fact end up becoming a major drag on the growth potential of India’s civil aviation sector?

The success of most of the leading airports around the world has been largely due to their ability to diversify their revenue streams and draw a larger share of their income from nonaeronautical revenues (that is, commercial activities like retail revenues and office rentals) vis-a-vis aeronautical revenues.

Singapore’s Changi International Airport earns 60% of total revenue from non-aeronautical charges, up from 40% in 1981. Non-aeronautical revenues help Changi cross subsidize its user charges and landing fee, which in turn helps the airport attract an ever increasing base of carriers and passengers from around the world to fly to Changi. The increased footfall thus generated drives retail spending at Changi’s many retail outlets and hotels, thereby covering for under-realization of user charges. To support this strategy, Changi has a conscious policy of investing in capacity well ahead of demand. Changi today has the capacity to handle 70 million passengers per annum (mppa) against an actual demand of 37 mppa (2007 figure). So successful has this strategy been that the tiny city state with a population of just 4.5 million manages to attract nearly eight times as many travelers to its airport.

Just like Changi, a CRISIL study has shown that the British Airport Authority earns 72% of total revenue from non-aviation activities; Toronto earns 62%; while Indian airports earn no more than 10-30%.

For Changi’s model to be successfully replicated in India, it’s imperative that Indian airports attract more passengers by rapidly adding capacity, lowering landing fee and eliminating UDF. Currently, our leading airports serve no more than one-sixth to one-fourth the passenger numbers served by the likes of Changi and Heathrow. For a city with a GDP half the size of Singapore’s, Bangalore’s airport for example, serves a paltry 10 mppa (against 37 in case of Changi).

Such measly scale of operation means that there is hardly any cost efficiencies associated with scale. Furthermore cost of capital for airport financing typically tends to be on the higher side, because of the plethora of operational, financial and political risks they entail. Besides, India’s upcoming airports have to contend with high operating expenses, owing to very high debt service obligation. Therefore, they seem to have little choice but to charge rather steep user charges to bridge the gap between revenue realization and debt obligations, more so during the initial years when the optimal revenue potential of the airport has not yet been realized.

So is there an alternative funding model that can help Indian airports lower their user charges? This is where some financial ingenuity and smart leveraging of funding opportunities provided by multilateral agencies like International Bank for Reconstruction and Development (IBRD) and Multilateral Investment Guarantee Agency (MIGA) can do the trick. Both IBRD and MIGA are part of the World Bank Group and help promote investments in developing countries by providing insurance cover against political and other non-commercial risks for projects in the developing world.

Now this is how it works: An airport first secures IBRD/MIGA’s backing which enables it to raise debts, whose repayment is structured such that repayment obligation during say, the first 10 years of operation is negligible. At the end of 10 years, the entire original debt is retired through a lump-sum ‘bullet’ payment, which in turn is refinanced through a new loan. The benefits of this model are two fold. Firstly, the cost of capital at the time of refinancing is much lower, given that the airport would have been in operation for 10 years by then and that most of the risks would have been mitigated over this period. Secondly, the ingenuity of the debt structuring ensures that interest payment obligation in the first 10 years is very low, thereby eliminating the need to charge high user fee to fund debt service obligation.

This model can be a very effective alternative to the UDF-based funding structure for India’s upcoming airports.

For the next Changi to emerge out of India, what we need is not just brand new terminal buildings replacing the old ones, but a change in mindset and a concerted strategy — both at the level of individual airports as well as at policy formulation level. It’s going to take some doing and out-of-the-box thinking to bring about a shift in the centre of gravity of Asian civil aviation from the Asia Pacific region to the subcontinent.

(Prof V Ranganathan is the RBI Chair Professor at Indian Institute of Management, Bangalore. The others are second year MBA students at the institute)

Source : The Times of India

About Devesh Agarwal

A electronics and automotive product management, marketing and branding expert, he was awarded a silver medal at the Lockheed Martin innovation competition 2010. He is ranked 6th on Mashable's list of aviation pros on Twitter and in addition to Bangalore Aviation, he has contributed to leading publications like Aviation Week, Conde Nast Traveller India, The Economic Times, and The Mint (a Wall Street Journal content partner). He remains a frequent flier and shares the good, the bad, and the ugly about the Indian aviation industry without fear or favour.

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