Why Nacil was a non-starter

The main objectives of the performance audit of civil aviation were to ascertain (1) whether the acquisition of aircraft by erstwhile Air India (AIL) and Indian Airlines (IAL) was planned and implemented with due regard to economy, efficiency and accepted norms of financial propriety, (2) whether their merger into NACIL was properly planned and implemented, (3) the impact of the liberalised policy of GOI on grant of air traffic rights to other countries through Air Service/bilateral agreements and permitting Indian private carriers to fly international routes, (4) the main reasons for the poor financial and operational performance of the pre-merger airlines and the merged entity, and (5) whether MoCA exercised its oversight role effectively.

Acquisition of Aircraft

AIR INDIA: On 30 December 2005, AIL signed purchase agreements for supply of 50 Boeing aircraft (with GE engines) at an estimated project cost of R33,197 crore. But the preceding revision in plan to increase the number of aircraft to be purchased does not withstand audit scrutiny, considering market requirements, forecasts and commercial viability. Many key assumptions underlying the revised project report were flawed, like (1) the assumption that an increase in capacity share would automatically lead to a substantial increase in AIL?s market share, or (2) the assumption of yield increase of 10% (at constant cost) of non-stop US flights, which turned out to be based on a sector that turned out to be a loss-making sector right from the date of commencement.

Note how a programme that was under consideration from 1996 and took eight years to progress up to the Government level for purchase of 28 aircraft suddenly gained momentum. Between August 2004 and December 2005, the proposals were formulated by AIL, approved by its board, examined and recommended by MoCA, the Planning Commission, the Department of Expenditure, PIB, EGoM and also the CCEA. Government conveyed its approval on 30 December and the AIL-Boeing contract was signed on the same day. Within seven months!

The decision to purchase 68 aircraft (50 for AIL and 18 for AICL) on firm basis imposed on AIL an undue long-term financial burden. The fact that the entire acquisition was to be funded through debt to be repaid through revenue generation, except for a relatively small equity infusion of R325 crore for IAL, should have raised alarm signals in MoCA, PIB and also the Planning Commission.

INDIAN AIRLINES: In February 2006, IAL signed purchase agreements with Airbus/CFM for supply of 43 Airbus aircraft at an estimated cost of R8,399.60 crore. The net present values (NPVs) of all the considered sets of aircraft were negative, even assuming constant cost and revenue yield at 2001-02 levels. Consequently, IAL projected an increase of 6% in domestic fares in the first year, with further annual increases of 2% for four years, evidently to make the negative NPV positive?clearly an unrealistic assumption.

The commitments made by the manufacturers to the EGoM regarding creation of maintenance, repair and overhaul (MRO), training facilities, warehouse facilities for aircraft spares etc were quite open-ended. These commitments were not included in the purchase agreements in respect of the IAL fleet acquisition. There has been no tangible progress towards setting up either the MRO or the warehouse facilities.

Merger of AIL and IAL

The initiation of action towards the merger in March 2006, less than a few months after completion of independent largescale acquisition of aircraft by IAL and AIL in late 2005 was ill-timed, with loss of significant synergistic opportunities. Had the possibility of merger with attendant route rationalisation, network integration, common 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. The potential benefits for the merger would have been far higher, had this been undertaken before finalisation of the massive and separate fleet acquisition exercises undertaken by AIL and IAL.

There were huge delays in actualisation of operational integration. The single code passenger reservation system that was a critical element in network integration was activated only in February 2011. HR integration below the level of DGM, representing 98% of the staff, has still not taken place.

Bilateral Agreements

From 2004-05 onwards, there was a substantial liberalisation 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. While this liberalised policy benefited Indian traveller considerably, its timing did not provide a level playing field to AI or Indian Carriers.

The massive expansion of bilateral entitlements has facilitated several foreign airlines in tapping the vast Indian market and funnelling such traffic over their hubs to various global destinations in the US, UK, Europe and elsewhere, through what is termed as 6th freedom traffic, where the entitlements exchanged are vastly in excess of ?genuine? flying requirements between the two countries. For instance, consider the increase in the Dubai sector seat capacity from 18,400 seats/week to 54,200 seats/week between May 2007 to March 2010 accompanied by an increase in points of call in India from 10 to 14. The repeated protests from Air India on the lack of reciprocity and the funnelling of 6th freedom traffic by Emirates through Dubai from interior locations in India were ignored.

It is certainly not our case that AI should benefit from a protected environment but the timing of the liberalisation of bilateral entitlements (notably the Gulf/SE Asia/Europe) from 2004-05 onwards left much to be desired. The delivery of AIL/IAL?s new fleet acquisitions was scheduled only between 2006-11. Giving a reasonable timeframe of 2-3 years post-aircraft delivery for stabilisation of the expanded ?footprint? could have provided AIL/IAL a ?level playing field? for competition.

Financial & Operational Performance

There has been a significant deterioration in operational performance on most parameters for the two airlines (pre/post merger) between 2005-06 and 2009-10. For erstwhile IAL, route economics revealed that most of the services were not meeting cash costs or total costs, both in domestic and international sectors. The performance of IAL vis-?-vis its competitors on various parameters was consistently poor, with a dismally low on-time performance. Further, the market share of IAL in cargo operations dropped dramatically, despite conversion of five B737 aircraft into freighter aircraft.

As for erstwhile AIL, even earlier, most routes were incurring losses; only the Gulf/Middle East and Far East Asia routes made profits till 2005-06. By 2009-10, all routes were loss-making. The single largest loss-making route was the India/US one, which contributed between 41-90% of AIL?s total operating losses between 2005-06 and 2009-10. Assumptions of increased yield on account of non-stop operations (projected in the revised fleet acquisition report) proved to be grossly exaggerated. The liberal increase in bilateral entitlements didn?t help.

PLF of AIL flights in first class and business class declined from already low figures of 14% and 31% (2004-05) to 12% and 28%. Considering the widely recognised view that occupancy of a single seat in business/first class can financially offset several vacant seats in economy class, these abysmally low PLFs in business/ first class are unsustainable. Plus, AIL?s on-time performance for arrival and departure was really low at 62% and 52%, respectively, during 2009-10.

Interest burden, which was nominal in 2004-05, increased 36 times to R2,434 crore in 2009-10. Working capital loan went up nearly 21 times to R18,524 crore in 2009-10. As of 2009-10, the total borrowing was 2.87 times the total revenue. Even the working capital loan was 1.38 times the total revenue. GoI?s equity infusion of R325 crore in 2005-06 into the erstwhile IAL and R800 crore in 2009-10 into AIL represented a mere pittance. Huge amounts continued to be paid to staff as productivity-linked incentive without proper linkage to operational and financial performance, when the entity could ill afford such payments.

Recommendations

HR integration below DGM level (pilots, engineers and other staff) of the erstwhile AIL and IAL needs to be handled swiftly, if the merger is to become a success.

In order to ensure cost rationalisation, AI must ensure a substantial increase in ticket sales through technology-based channels.

Till India has its own hubs and Indian carriers are able to exploit them effectively, entitlements for airlines predominantly dependent on 6th freedom traffic, notably Dubai, Bahrain and other Gulf countries should be frozen by MoCA.

AI?s services are frequently used for VVIP and other Government duties. MoCA should ensure that such dues are paid to AI in a timely manner.

GoI should consider prompt infusion of more Government equity to ensure that the debt-equity ratio reaches levels prevalent in the industry.


How to bring home the barrel

The main objectives of the performance audit of hydrocarbon PSCs were to verify a) whether the systems of MoPNG and DGH to monitor and ensure compliance by the operators and contractors of the blocks with the terms of the PSCs were adequate and effective, and b) whether the revenue interests of the Government (including royalty and share of profit) were properly protected, and whether effective mechanisms were in position for this purpose. Here are the salient findings:

Impact of the profit-sharing mechanism on GoI?s share

The PSC, as it currently stands, is based on a scaled formula for profit sharing between GoI and private contractors. This is based on a critical parameter?Investment Multiple (IM)?which is essentially the amount of ?capex? on exploration and development activities relative to income. The slabs for profit-sharing are so designed that more the capital intensive the project (lower IM), the lower the GoI share of ?profit petroleum?. But private contractors have inadequate incentives to reduce capital expenditure?and substantial incentive to ?front-end? capital expenditure, to retain the IM in the lower slabs or delay movement to the higher slabs.

Operational control of E&P operations is largely with private operators, and GoI?s oversight role is restricted essentially to its representation (through MoPNG and/or DGH) in the Management Committee for the block. Oversight/control of GoI representatives on high value procurement decisions is also very limited in scope (largely restricted to prior intimation of the list of pre-qualified bidders). Therefore, in view of the adverse impact of the profit-sharing mechanism in protecting GoI?s share (linked to the IM), designed in the late 1990s, there does seem to be enough ground to revisit the formula.

We found a number of deficiencies in compliance and control vis-?-vis the PSC provisions by MoPNG/DGH. For protecting the financial interest of the Government, we find it necessary that review and approval of development plans should be considered, not just from a ?technical perspective? but also from a financial perspective?specifically from GoI?s point of view by MoPNG and DGH.

Provisions relating to procurement procedures in the PSCs do not provide for adequate oversight/control by GoI representatives on procurement processes. Given the existing provisions, we recommend that when high value contracts are awarded on the basis of single ?responsive? financial bids, these are awarded without competition, effectively on nomination basis. In all such cases, prior approval of the MC should be necessary for such awards. Post facto approval, with appropriate justification, for emergent procurement decisions may also be considered. Similar provisions would also apply to all procurement decisions involving post-priced bid opening changes to scope, quantities, work, prices, conditions etc.

Independence of Regulatory Body

In view of the fact that the PSC is a contractual document, and compliance with every contractual clause is of utmost importance, we recommend that DGH, and where necessary, MoPNG should put into place adequate and effective measures to ensure that compliance with all provisions of the PSC are fully monitored on a timely basis and appropriately documented, and action taken against operators on a timely and consistent basis, for non-compliance with PSC provisions.

We are of the view that the functions currently discharged by the DGH be clearly demarcated. The technical advisory and related functions should be discharged by a body completely subordinate in all respects to MoPNG. Functions of a regulatory nature such as review of hydrocarbon reserves and reservoir management, laying norms for declaration of discoveries, etc. should be discharged by an autonomous body, with an arm?s length relationship with GoI.

In respect of KG-DWN-98/3 block, the contractor i.e. RIL was allowed to enter the second and third exploration phases without relinquishing 25 per cent each of the total contract area at the end of Phase-I and Phase-II in June 2004 and 2005 respectively as against Articles 4.1 & 4.2 of PSC by treating the entire contract area as discovery area. Subsequently, in February 2009, GoI also conveyed approval to treat the entire contract area of 7,645 sq km as ?Discovery Area?, thus enabling the operator to completely avoid relinquishment of area.

As regards the D1-D3 gas discovery, the operator submitted an ?Initial? Development Plan (IDP) in May 2004 (with estimated capital expenditure (capex) of $2.4 billion). The IDP was followed up with an Addendum to the IDP (AIDP) in October 2006 with an estimated capex of $5.2 billion for Phase-I and $3.6 billion for Phase-II. We found that most procurement activities were undertaken late in line with the schedules of the IDP of May 2004. By contrast, activities in respect of items in the AIDP were initiated even before the submission/approval of the AIDP.

Competition Matters

During 2006-07 and 2007-08, there were large procurement contracts, in respect of which we could not derive assurance regarding reasonableness of costs incurred, primarily due to lack of adequate competition?award on single financial bids; major revisions in scope/quantities/specifications; post-price bid opening; substantial variation orders?with consequential adverse implications for cost recovery and GoI?s financial take. In assessing this, we in no way insisted on application of Government?s procedure.

In the RJ-ON-90/1 block (Operator: Cairn Energy) we found that 13 fresh discoveries were made during or between the appraisal phase and in the development phase in areas already delineated as development areas. Consequently, in our opinion, the declaration of fresh discoveries during the appraisal/ development phases within delineated discovery/development areas amounted to irregular extension of exploration activities, which is not in consonance with the terms of the PSC. This also indicates that the discovery/development areas were not strictly delineated, and included excess area.

Further, there were instances of non-compliance with regard to the PSC provisions for notification of potential commercial interest, appraisal programme, submission of Field Development Plans etc.

The Panna-Mukta and Mid & South Tapti Fields were initially discovered and operated by ONGC. Subsequently these were awarded in 1994 to a consortium of private operators under a JV arrangement with ONGC. Based on the limited records made available to us by the PMT JV, our main findings were that GoI incurred a substantial loss (on account of royalty) by failing to finalise the norms for post-well head costs of gas, and consequentially, gas wellhead prices. Even the norms for post well-head costs notified in August 2007 had significant deficiencies. MoPNG and its nominee for gas purchase (GAIL) failed to comply with the terms of the PSC during 2005-08 with regard to the pre-determined gas pricing formula.