08 September 2011

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Complete CAG Report - AIR India the Ministry of Civil Aviation (MoCA) and the Bilateral Agreements – Part One

Complete CAG Report - AIR India the Ministry of Civil Aviation (MoCA) and the Bilateral Agreements – Part One

1. The Report is a Performance Audit of civil aviation sector in India which includes NACIL (Air India Limited as it is known today), the Ministry of Civil Aviation (MoCA) and the Bilateral Agreements concluded by Government of India with other governments on entitlements for international operations between India and their countries, as well as permissions given to private Indian carriers to operate on international routes.

2. The Performance Audit was commenced in September 2009 and would have concluded in 2010, but for the fact that reasons for non-performance/losses incurred by Air India Limited were inconclusive without examining the role and extent of support/control by MoCA.
3. Air India repeatedly stated that the government's decision to award profitable routes to private Indian carriers and international carriers vide bilateral agreements also adversely impacted their commercial viability. Hence, to ensure a holistic study, we had to examine the open sky policy of the government which also included bilateral agreements with other countries. This examination was carried out in late 2010 and early 2011.
4. At each stage of the audit process, our findings have been shared with AIL and MoCA. The first draft of the performance audit was issued to the Ministry in November 2010 and a second draft report in March 2011. The final draft incorporating the results of the audit of bilateral agreements was issued to the MoCA in July 2011. The replies received from the AIL and Ministry have been incorporated in the Report. Deliberations held in the exit conference on 3 August 2011 have also been addressed adequately.

5. Air India Limited (AIL) and Indian Airlines Ltd. (IAL) dominated the Indian aviation industry till the mid-1990's, when as part of the open sky policy, the Government of India (GoI) ended their monopoly in air transport services, and allowed private operators to provide air transport services.

6. After IAL and AIL (as well as Air India Charters Ltd. (AICL), the Low Cost Carrier subsidiary of Air India) undertook massive fleet acquisitions of Airbus and Boeing aircraft respectively in 2005, a proposal for merger of the two airlines was initiated and completed in August 2007 with their amalgamation into the National Aviation Company of India Ltd. (NACIL); this Company was subsequently renamed as “Air India” in November 2010.

7. Almost immediately after the merger, NACIL faced significant financial problems, which continued to multiply manifold, resulting in acute cash flow and working capital problems. This forced Air India (AI) to approach the GoI repeatedly for financial support. Further, the actual merger of the operational activities of IAL and AIL took unduly long, and is still not complete in many respects.

8. On 30 December 2005, AIL signed purchase agreements for supply of 50 Boeing aircraft (with GE engines) at an estimated project cost of Rs. 33,197 crore.CAG Found Following –

9. The AIL's aircraft acquisition process had taken an unduly long time. The initial proposal was made in December 1996 and examination continued in fits and starts till January 2004. Once AIL revisited their earlier proposal and sent a plan for acquiring 68 aircraft (53 firm and 15 optional) the process gained momentum culminating in the contract being signed in December 2005.

10. AIL's project report of January 2004 proposed acquisition of 18 small capacity short range aircraft (B737-800) and 10 medium capacity long range aircraft (A340-300) with a positive Net Present Value (NPV) on stand-alone basis. However, by November 2004, the AIL Board changed their fleet acquisition plan and submitted a revised proposal for acquisition of 50 medium capacity long range/ ultra long range aircraft (in addition to 18 small capacity short range aircraft for its subsidiary, Air India Charters Ltd. (AICL)). The sequence of events upto November 2004 clearly demonstrates that the erstwhile AIL hastily reworked its earlier acquisition plan and expanded its requirement. The revised plan saw a dramatic increase in the number of aircraft to be purchased in the period between January 2004 and November 2004. This increase in numbers does not withstand audit scrutiny, considering the market requirements obtaining then or forecast for the future as also the commercial viability projected to justify the acquisition. The acquisition appears to be supply-driven.

11. Audit is constrained to comment on the speed at which the acquisition process proceeded. A programme which was under consideration from 1996 and took eight years to progress upto the Government level for purchase of 28 aircrafts suddenly picked up speed. Between August 2004 and December 2005 the proposals were formulated by AIL, approved by its Board, examined and approved by MoCA, the Planning Commission, the Department of Expenditure, PIB, EGoM and also the CCEA. Government conveyed its approval on 30 December and the Contract was signed by AIL with Boeing on the same day. From receipt of the proposal by the government to the signing of contract with government approval, by AIL with Boeing took seven months.

12. Many of the key assumptions underlying the revised project report (for 50 long range aircraft) were flawed. The assumption that increase in capacity share would automatically lead to a substantial increase in AIL's market share, was not adequately validated. Similarly, the assumptions of yield increases (at constant cost), especially the yield increase of 10 per cent (at constant cost) of non-stop USA flights, were unduly optimistic. This sector on which American/Canadian airlines were already operating non –stop flights and based on which fact AIL was made to reconsider its fleet requirement, turned out to be a loss making sector right from the date of commencement of such services.

13. The entire acquisition (for both AIL and IAL) was to be funded through debt (to be repaid through revenue generation), except for a relatively small equity infusion of Rs. 325 crore for IAL. This was a recipe for disaster ab initio and should have raised alarm signals in MoCA, PIB and the Planning Commission.

14. In February 2006, IAL signed purchase agreements with Airbus/ CFM for supply of 43 Airbus aircraft (with CFM engine) at an estimated cost of Rs. 8399.60 crore. CAG found that

15. The Net Present Values (NPVs) of all the considered sets of aircraft (including the L-1 combination of Airbus aircraft) were all negative, even assuming constant cost and revenue yield at 2001-02 levels. Consequently, IAL projected an increase of 6 per cent in domestic fares in the first year, with further annual increases of 2 per cent for four years, evidently to make the negative NPV positive. This unrealistic assumption of dramatic increases in yield at constant costs (i.e. while assuming costs – fuel, staff, interest and other costs etc. to be constant throughout the project life) was critical to projecting an optimistic picture of positive project cash flows on NPV basis, and to the approval of the acquisition project.

16. If indeed, GoI/ MoCA was keen on, or agreeable to, a full-scale aircraft acquisition by IAL in the public/ national interest, it should have acknowledged that such an acquisition would involve substantial negative cash flows (based on realistic and reasonable assumptions) and considered and approved appropriate arrangement(s) for funding the resulting cash deficit

17. Concerns regarding potential difficulties of IAL in successfully funding the acquisition process with a positive NPV had been raised within MoCA, but were ignored. The file notings indicate an undue haste to push through the pre-PIB meeting. Such haste evidently rendered it difficult for MoCA officials to express their concerns or reservations.

18. The Planning Commission and the Department of Expenditure, MoF raised concerns on several key and critical issues at different stages, but finally oncurred with the acquisition proposal. The subsequent AS&FA, MoCA repeatedly expressed serious reservations about the acquisition proposal. However, his views did not cause a re-think on the aircraft acquisition process.

19. Based on available records, we are unable to ascertain the detailed justification for, or the background to the 'in principle' approval of GoI for 'working towards the merger' of AIL and IAL.

20. Inexplicably, synergised / integrated operation between AIL and IAL (even though this was recommended / recognised in 2004) was not factored in as part of the acquisition project analysis either for AIL or IAL. The initiation of action towards the merger in March 2006, less than a few months after completion of independent large scale acquisition of aircrafts by IAL (Airbus) and AIL (Boeing) in late 2005 (after long drawn out procedures/ negotiations) appears somewhat ill-timed, with loss of significant synergistic opportunities. Had the possibility of merger (with attendant route rationalization, network integration, common maintenance/ overhauling facilities and other synergies) been considered – even at a late stage – in the process of fleet acquisition, the underlying economics could have been significantly altered; perhaps, even a common acquisition process for AIL/ IAL could well have been considered. In our view, the potential benefits for the merger would have been far higher, had this been undertaken before finalization of the massive and separate fleet acquisition exercises undertaken by AIL and IAL.

21. The financial case for the merger was not adequately validated, prior to the merger. Detailed item-wise financial analysis was not available, so as to assess the reasonableness and robustness of the projected benefits (on account of revenue synergies and cost and capital productivity synergies). The proposed revaluation of fixed assets had no operational or cash flow benefits

22. There were huge delays in actualization of the merger/ operational integration. The single code passenger reservation system (which was a critical element in network integration) was activated only in February 2011.

23. HR factors in any merger process are the most complicated. Even in March 2006, apprehensions with regard to HR problems due to a potential merger were expressed. HR integration below the level of DGM, representing 98 per cent of the staff, has still not taken place.

24. Even four years after the merger, AI is yet to join the Star Alliance, mainly due to the delay in setting up a single code passenger reservation system. In fact, as per the press release of 31 July 2011 available on the Star Alliance website, AI's application for membership of the Star Alliance has been “put on hold”, and the integration of Air India into the global airline alliance “will be suspended”. This raises the likelihood of indefinite delays as also serious uncertainties on AI's prospects for joining the alliance.

Role of MoCA –
Liberalized policy towards bilateral agreements on international entitlements
From 2004-05 onwards, there was a substantial liberalization by the Government of the policy on bilateral agreements on entitlements for international operations between India and other countries, as well as in allowing private Indian airlines to operate on international routes. In our view, while the liberalized policy towards bilateral entitlements benefited the Indian traveler considerably in terms of choices (and lower tariffs), the timing of the liberalization (given the timing of AIL/IAL aircraft acquisition, upgraded Indian airport with infrastructure with hub-spoke capabilities etc.) did not provide a level playing field to AI (and to a lesser extent other Indian private airlines). At this stage, Indian carriers (including
AI) will have to tackle renewed and serious challenges to compete effectively with established international “mega carriers” specializing in 6th freedom traffic.
The massive expansion of bilateral entitlements in respect of several countries (notably in the Gulf, South East Asia and Europe) has facilitated several foreign airlines (predominantly Emirates) in tapping the vast Indian market and funnelling such traffic over their hubs (e.g. Dubai) to various destinations in the USA, UK, Europe and elsewhere, the through what is termed as “6 freedom traffic”. Although the bilateral agreements do not the explicitly provide for exercise of 6 freedom rights, the entitlements exchanged are vastly the in excess of “genuine” flying requirements between the two countries (termed as 3 / 4 freedom traffic based on Origin-Destination data) and implicitly allow “mega-airlines” with the giant hubs to exploit 6 freedom traffic.

As an illustrative case of the liberalization of bilateral entitlements, the sequence of
events relating to the Dubai sector, covering the period from May 2007 to March
2010, (when the seat capacity was increased from 18,400 seats/ week to 54,200
seats/ week and points of call in India were increased from 10 to 14), clearly
demonstrates the one-sided nature of benefits to Emirates/ Dubai (through
enhancement of entitlements and additional points of call in India). This evoked the repeated protests from Air India on the lack of reciprocity and the funnelling of 6 freedom traffic by Emirates through Dubai from interior locations in India. Even change of gauge facility at Dubai International Airport, which would at least have provided an opportunity for Indian carriers to funnel traffic in smaller capacity aircraft from interior Indian locations and take them onward to UK/ USA/ Europe and other destinations in larger capacity aircraft was not adequately pursued, nor linked to grant of additional benefit. Repeated requests from AIL resulted in vague commitments from UAE Authorities for such facility, not at Dubai Airport but at the upcoming Jebel Ali Airport (an impractical option for AIL and other Indian carriers) and that too with distant timeframes between 2012 and 2018! Clearly, while Dubai actively protected the commercial interests of its airlines, MoCA failed to obtain appropriate quid pro quo while granting concessions.

The notings on MoCA files while processing proposed entitlement liberalization refer
to the demand from the “labour class/ working class” Indians for more seats to/ from
India (as projected by several agencies – Ministry of External Affairs (MEA), Ministry of Tourism (MoT), Ministry of Commerce and Industry (MoCI)). These, however, are in a sense, misleading, since the “labour class/ working class” Indians would be interested only in point-to-point connectivity, largely to the Gulf/ Middle East It is certainly not our case that AI should benefit from a protected environment, cloistered from competition from foreign airlines (and other Indian carriers), especially in the current era of economic liberalisation. However, the timing of the The delivery of AIL/ IAL's new fleet acquisitions, approved by GoI in December
2005, was scheduled only between 2006 and 2011. Giving a reasonable
timeframe of 2 to 3 years post-aircraft delivery for stabilisation of the expanded
“footprint” could have provided AIL/ IAL a “level playing field” for competition.
Substantially enhanced fleet acquisition, in fact, justified AIL to operate larger
number of routes liberalisation of bilateral entitlements (notably the Gulf/ SE Asia/ Europe) from 2004-05 onwards left much to be desired:

It is only now (November 2010 onwards) that India finally has an international
class airport terminal at Delhi capable of large scale hub and spoke operations
(domestic/ international and international/ international); large scale
development of other international airports in India facilitating hub and spoke

operations (at the minimum where domestic and international terminals are co-located) will follow later. Again, giving a reasonable timeframe of 2 to 3 years
after full-scale operationalisation of Delhi would have provided a level playing
field to all Indian airlines (not just AIL/ IAL) to compete with the mega carriers
specializing in 6th freedom traffic

Many of the countries in the Middle East have only one, or maybe two major
airports or “points of call” to offer, while the vast Indian market has numerous
attractive interior locations with good commercial potential. The element of
“reciprocity” or “give-and-take”, if any, in exchange of bilateral entitlements,
except to an extent in the case of Qatar, which was apparently guided by
politico-economic considerations), could not be ascertained

Suggested Reading – Rs 10,000 crore loss Unnecessary Purchases by Govt brought
Air India into financial mess – CAG report finding

Reality views by sm –
Thursday, September 08, 2011

Tag-News CAG Report on AIR India Purchase Loss


iffatali July 28, 2012  

Yes, and imagine a world where there were no hypothetical situations.
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Unknown January 04, 2013  

this blog is very informative for me....its a great work from ur side....thanks and congrats...
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