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MIT-PORTUGAL/IST

From IAB to Terminal 4 Contracts, Agents and PPP´s Francisco Furtado 2/20/2009

The purpose of this report is to develop a structured analysis and evaluation of the decisions taken by each agent in a case study concerning the renewal of the International Arrivals Building of the JFK International Airport in New York. We will do this within the framework provided by papers, handouts and discussions on the Business Models and Contracts course.


Contents Introduction .................................................................................................................................................. 2 What.............................................................................................................................................................. 2 Who, Interests, Goals, Incentives and Decisions .......................................................................................... 3 Port Authority of New York and New Jersey (PA) ..................................................................................... 3 Schipol/LCOR Consortium (Private Bidders) ............................................................................................. 5 Airlines ...................................................................................................................................................... 5 Consultants ............................................................................................................................................... 6 New York City ............................................................................................................................................ 6 Constrains ..................................................................................................................................................... 6 From Decisions to Contracts ......................................................................................................................... 7 Principal´s Strategy and Decision Model ...................................................................................................... 7 Conclusion ..................................................................................................................................................... 9 Bibliography .................................................................................................................................................. 9

Francisco Furtado – CTIS/BMC

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Introduction The purpose of this report is to develop a structured analysis and evaluation of the decisions taken by each agent in a case study concerning the renewal of the International Arrivals Building of the JFK International Airport in New York. We will do this within the framework provided by papers, handouts and discussions on the Business Models and Contracts course. We will start by presenting what is the issue at stake, main course of actions and relevance of this infrastructure. Then we will take a closer look at each agent, their goals, interactions-incentives between the agents and impacts they had in each of them. After we will discuss what were the restriction on their actions and how aligned were the decisions taken, with the goals they had set and how the contracts in place reflected those goals and decisions. Fallowing this we will focus on the Principal strategy, taking in account not only what he knew at the time but also what happened subsequently. In the end we will provide a conclusion underlining the most relevant lessons we can draw from this case.

What The case study addressed in this report is the John F. Kennedy Airport, namely the International Arrivals Building (IAB). The existing Infrastructure (the IAB), built in the 50´s, no longer could provide the services necessary in the late XXth, early XXIst century. Changes in Industry, technology, demand, regulations, and the users’ perception of value made the IAB obsolete. In the early 90´s the Principal, Port Authority(PA)1, decided to update the existing infrastructure. Several options were pursued, remodelling the IAB in several degrees, or have a completely new building. The last option was taken since several studies steered by the PA found that the costs of remodelling the IAB to comply with current and, mainly, future requirements was very high. In deeded Net Present Value analysis showed that in the long run the best alternative was to build a completely new infrastructure. Besides that the services this new infrastructure allows to provide have a good return, both because demand is very high and alternative supply is restricted (the other terminals in JFK Airport cannot capture all the traffic2). The main question was were to get the massive financing for the initial costs (1 Billion dollars). So, after knowing what to do, remained the question now of How? and by Who? The Port Authority knew that it should bring Privates to this project, none the less, it started to develop the new terminal project (and contracted several consultant firms to this task) with considerable detail. 1 2

We will discuss each agent best in the next topic. Estimates were made that in the worst case scenario they would capture 50% of the market share of the IAB.

Francisco Furtado – CTIS/BMC

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After some project “refining”, the PA initiated a bidding process, in the end the project evolved to a Public Private Partnership, were Design3, Building, Finance and Operations were all assignet to the winning private consortium, the Schipol USA/LCOR Incorporated. It was the first time in the US a International Airport Terminal, design, construction, financing and operations, was given to a private, non-airline, entity. We should stress that JFK Airport is a major transportation Infrastructure, this Airport provides 173 000 jobs trough on and off-airport aviation and indirectly related businesses. It contributes 15.8 billion dollars annually in economic activity in New York/New Jersey region. At date the IAB had 45% of the JFK market share and, as mentioned, the other terminals had constrains such that they could at most absorb 50% of the IAB share. If taken alone IAb would be the fourth largest international airport in the U.S.

Who, Interests, Goals, Incentives and Decisions Port Authority of New York and New Jersey (PA) The PA was established by agreement between the states of New York and New Jersey, with the mission to foster trade in the bistate port district. Besides JFK it manages the LaGuardia and Newark airports, bridges, the trans-Hudson tunnels, container ports, industrial parks, bus terminals and the, now gone, World Trade Center. The PA is a financially self-supporting public agency that doesn´t receives any kind of financing from other state entities, and has no power to levy taxes. It relies on his own revenues from tools, fees and rents. In the early 90´s the PA realized it could no longer postpone a grand remodelling of the existing IAB. It´s first goal was to have an infrastructure that could provide an adequate service to Airlines and Passengers, this was to be achieved at the same time that the financing requirements necessary to this remodelling should allow to maintain the pass-through cost to the airlines at reasonable levels and a revenue string to the PA. The first move PA took was an assessment on the main problems caused by the inadequate infrastructure it managed. A list of faults was made addressing both problems from the air and earth side4. After that several solutions were considered. The tenants of the IAB (the Airlines that use it) were involved in these early stages. But, since no consensus was reached between the PA and the 14 tenants,

3

Still the bidding private entities developed their projects in close contact with the PA, meeting the PA requirements, and with complete knowledge of the initial proposal developed By the PA alone. 4 See (Huang, 1997) for details.

Francisco Furtado – CTIS/BMC

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four of them “spined off”, forming a consortium to operate a new terminal, Terminal One, operations started there at 1998. The PA-Airlines joint effort was thwarted, and PA decided to proceeded with preliminary feasibility studies for the IAB. Son some conclusions were reached: •

• •

Costs of incremental changes to the existing infrastructure were very high, and even then adjustments to requirements were not perfect, and as times pass the obsolescence was very difficult to mask; Demand for this service is very high, and competition is constrained, no new Airport is in the horizon and direct competition from the other terminals in the JFK airport is also constrained; Main risk lies with the need for a very large funds for the initial investment.

The PA made the decision then to go forward with the construction of a brand new facility. The private side was to join this effort this way PA would: • •

Minimize it´s financial risks and mobilize private money to the development of this needed infrastructure; It was also pioneering, since in the U.S. there was no tradition of large Airport Terminals being designed, financed and operated by private, non-airline, companies. This was intended to lead to increases in operation efficiency.

Still the preliminary Design was started by the PA (with help from several contracted consultants) alone. At this time there were still some doubts if private partners would come on board, because lack of interest on the private side. There was also mistrust on the quality of responses to a tender process if some base requirements were not pre-established, including a preliminary design. When the tendering process started the Private entities that applied had mixed feelings. To dissolve scepticism PA gave total access to the studies it had already made, laid down preliminary business terms, arranged sessions were the Privates could query the Authority on design, financial, business and operational requirements, and also very important it encouraged the Privates to come with new proposals and not just versions of the draft already made by the PA . With this open book, proactive engagement the PA was able to dissolve fears and demand high quality detailed proposals. When the time to evaluate the proposals came clear goals were set: • • • • •

Develop a new facility capable of addressing XXIst century requirements (the origin of all of this); Keep the Charges to the Airlines; Provide a reliable “baseline” revenue string to the PA (and opportunity to share revenues in very favourable situations); Minimize, eliminate financial risk associated with all aspects of the project; Minimize, or eliminate need to incur in any Capital Costs.

All of this goals were translated to a set of criteria used to evaluate the proposals. Francisco Furtado – CTIS/BMC

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Selecting the team to award the development of this mega-project was the final big decision the PA took in these process. In a way selecting the wining project was only a corollary off all the decisions and option already taken by the PA, so the PA was now only collecting the fruits it had sowed. If serious problems arise with the wining consortium, PA will allegedly have mechanisms to take over and replace it with another company.

Schipol/LCOR Consortium (Private Bidders) This was the consortium that won the bid for the new terminal, Design, Construction, Financing and Operation. It was made up by LCOR (US real estate firm), Schipol (the firm that operates the high rated Schipol airport in Amsterdam), Lehman Brothers (Financial muscle), Morse Diesel International (construction management). This consortium was able to get together a very strong of partners that brought different assets to the team. We should underline Schipol experience in airport management, the design and operations management of the new terminal were modelled on the Airport of Amsterdam a very functional, efficient and profitable infrastructure were revenue from retail activities is maximized. The goals of this consortium were to gain the tender, and to get high profits from the Terminal reproducing the Amsterdam Airport. Another main goal, as the PA, was to minimize the financial risk and don´t incur in great capital costs. The financing strategy proposed by this consortium (combined with the proven design and operations model) was his main strength, actually financial strength and robustness was the main concern of PA that was very well addressed. The option made by Schipol/LCOR was to finance the all operation threw bonds that were assured by the future revenues made in the terminal operation. This way the financial costs they had to bear were minimum, with very small equity financing (just 15 million in a 1.2 billion dollar project). In the end deal a minimum revenue string was awarded to PA, and 60% of the revenues would go to the authority, but up to a limit of 60 million dollars. Besides that costs with some of the accessibility’s were supported by the PA.

Airlines Airlines are the direct clients of the terminals, they also played a major role in all of this. The fact that some of the Airlines that used the IAB got together and developed a terminal for them (TOGA-Terminal One) was a major push/incentive in this process, and on the PA determination. Airlines also had the traditional role of managing terminals (all the other terminals in JFK are managed by Airlines, single or in alliances). One of their goals is to get efficient support for their own operations at the lowest possible cost (low airport charges). So in a way their needs/goals were one of the main drivers to this project, still they were only relevant players in this particular project at the beginning and soon their role was diminished.

Francisco Furtado – CTIS/BMC

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Volatility of the airline industry, long commitment necessary for this project, and achieving a consensus among too many competing players were all reasons why the Private consortiums that rune for the new international terminal weren´t airlines. Actually this provided the new terminal with an edge since the company that operated the terminal was solely focused in it´s operations and it didn´t discriminate against competing Airlines (what usually happens when an airline uses a terminal managed by another airline).

Consultants I also consider the consultants hired to be a player in this game. They worked for PA and didn´t have (or theoretically shouldn´t have) an independent agenda. Still they were a main resource for the PA, and PA was able to set up this project in all of it’s stages and components due to the services provided by their consultants.

New York City It isn’t a major agent, but the land were the JFK Airport is belongs to New York City, and PA as to pay a fee (based on the airport revenues) to the city. In 2015 the land lease agreement will expire, although it´s very unlikely that the Airport will be evicted by the city, the new agreement might be a problem for the new private entity operations and financial sustainability.

Constrains The first constrain to take in account is the financial, it was mainly due to this constrain that the PA embarked in a Public Private Partnership to set up the new infrastructure5. The high initial costs of this project made him financially very risky even if economically very viable. This not only forced the PA to get private money in, it also limits severely the amount of companies/consortiums that can engage in a project like this, even more when we are talking of a very particular industry. On the other hand, once in operation there are other constrains that favour participation in this project. Due to the nature of this market competition is very limited. Since it´s an International Airport/Terminal in the US, focusing in the North Atlantic traffic there is no mode competition. No new airports are expected since PA manages most of these infrastructures, and as mentioned before, the other terminals of JFK have limits and cannot take much of the IAB share. Since we are addressing a major infrastructure in a major Airport the requirements are such that not much players have the Know-how for a project like this. The Airlines would be a easy pick but the fact that this particular terminal as to serve a great quantity of different Airlines and due to his scale demands a long term commitment, makes too hard to create a large and stable alliance to deliver the necessary results. In the end only a combination of financial strength, and Airport highly profitable airport management experience could deliver this. 5

Private sector alleged superior managing skills were also evoked.

Francisco Furtado – CTIS/BMC

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From Decisions to Contracts The decisions/options, goals and interaction among the agents were already exposed. But to what extend did those decisions were successfully translated into the contracts? The main agent, and the one that lead all of the process was the PA, actually since the decision of having a infrastructure ready to provide adequate services, the PA was relentless in pursuing this broad strategic objective. Their end goals were clear and didn´t shift and the tactics were refined along the process. The assessment, preliminary design, bidding process (both assistance to project development and the evaluation of the proposals) was all conducted in way that the results obtained and the stated goals were very aligned. In the final contract the goals of the PA were almost fully accomplished, all the main objectives were achieved6, the main question being could the PA get a bigger share of the forecasted revenues? There was a cap on the PA revenue string, so they are limited to receive 60 million dollars a year. Besides that they are required to spend 80 million dollars in accessibility to the terminal. There are provisions to replace Schipol if problems arise with the operations, but the selection of the new operator rests with the Bank of New York (the bondholders´ trustee), so control on the new infrastructure by PA is very residual... But that wasn´t one of the PA´s top priorities either...

Principal´s Strategy and Decision Model The strategy pursued by the PA was very coherent and robust. We know that for know (until the beginning of the Crisis at least...) operations are going well, although the Terminal 4 accounts are not released everything seems to be happening according with what was expected7. We should stress some key features of the Principal Strategy: • • • • •

Start by making a comprehensive assessment of the situation; Explore alternative options with the closest partners(at the beginning the Airlines); Pursue the best solution even if, for a short period, no partners were on board; Have a pro-active attitude in the Bidding Procedures; Clear evaluation of the different proposals, with criteria aligned with PA objectives.

Having said this two things are important to add, first, although there are few companies with capacity to go forward with a project like this, actually this is a extremely profitable operation. So if no big mistakes were made it would be relatively peaceful to find the right private partner and to be able to 6 7

We will discuss this better in the next chapter See (Karp, 2007).

Francisco Furtado – CTIS/BMC

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minimize the financial risk. So the challenge here wasn´t to avoid financial risks, but to what extend could the state (PA) extract revenues from the project. Second important thing to stress is that in the end deal not everything is perfect for the PA, namely: • • •

It still as to invest 80 million in access; It as limit of 60 Million dollars on revenues, no matter what is the revenue obtained by the Schiplol/LCOR; It loses control of the Infrastructure, and if something goes wrong is the New York Bank that selects the new operator, not the PA.

We don´t have complete information on the contract, and to what extend future events were taken in account when drafting the contract. We know that 2 factors were addressed: • •

First and more important, the increasing demand on air travel; End of the land lease agreement with New York City in 2015.

Other important events were very hard to predict and include in the contract: • •

The 9/11 attack on the World Trade Center that provoked a fall in air travel (in the fallowing couple of years at least); Lehaman Brothers bankruptcy and World Crisis of late 2008 to....;

The effects of the Crisis are still unforeseen, the 9/11 attack had an impact, but it was a short term effect. Tree things are advisable when dealing with uncertainty about the future in contracts of this nature: • • •

Establish several likely scenarios and for each one set what will be each partners obligations (what to do if those scenarios emerge); In the event of some completely unpredictable situation (the current Crisis?) establish a set of guiding principles to renegotiate the contract; Have access to all the raw data from the Terminal Operations (try to even the assimetry of information).

Evaluating the Principals Strategy, and the Contract that framed his decisions, it seems to me that there is only one issue where they should have made other options: •

Have a tighter control on the New Terminal Infrastructure and Operations, PA should have mechanisms to allow her to step in if something goes wrong, should maintain some in-house know-how in Operations, and have a closer monitoring of the project after it passed the key to the Private consortium.

Francisco Furtado – CTIS/BMC

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Conclusion Before starting to make high complements to this project development, the first thing to underline is the nature of this business. Airports, and a major international hub like JFK, are very profitable (and reliable) operations. When there is enough revenue to share between private and state the development of the project, and future relations, are much more peaceful, than when the state decides to bring privates to run financially deficitary infrastructures (some roads, tunnels, rail road...). So it´s easier to make a PPP business like this in face of a Infrastructure like an Airport than with other kind of transport infrastructures. Questions remain if the PA, and State more broadly, couldn´t find similar financing mechanisms without running to the Privates, since the asset that supports the financing, the Terminal revenues, are a very sure income. The fact that the private entity that run the new terminal already had experience, and could maximize revenues in the retail area is significant, and maybe a state run terminal could not perfume as well in that department. Still the current Crisis will change the playing field: • • • •

Private capacity to leverage investment, find financing and raise any type of debt is very low; Project evaluation will be even more tighter; Demand will stagnate and fall in most sectors (maybe public transport will be one of the exceptions); Difficulty to get financing will foster low cost projects with sure revenues, and not mega projects whose viability is based on assumptions that are collapsing...

Probably PPP´s will not vanish, but the scale, framework, and partners involved will change. At least in the short term the need of society (threw the state) to manage strategically important infrastructures will be increasingly underlined. We are in time of changes, and there should be flexibility in the way we manage and utilize those infrastructures to achieve maximum social outcome from them, or at least to minimize the social cost we are all paying.

Bibliography Fuhr, J. (2008). Contract Design, Financing Arragements and Public Ownership-An Assessment of the US Airport Governance Model. Transport Reviews . Huang, M. (1997). International Arrivals Building at JFK International Airport. Karp, A. (2007). New York´s Answer to Privatization. Air Transport World .

Francisco Furtado – CTIS/BMC

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JFK Terminal 4_Public Private Partenerships