By Michael Reddell, October 17, 2016. Link here.

Fairfax’s Hamish Rutherford had a substantial piece in Saturday’s Dominion-Post on the proposed Wellington airport runway extension, under the heading If we build it, will they come? (a rather similar title to my own first post on the airport last year).  It seemed like a fairly balanced article, covering many (but not all) of the key uncertainties about the project.   Most of them wouldn’t be a matter for public concern if this was to be a privately-funded project, but it isn’t –  and everyone agrees on that.

There was an interesting quote to that effect at the start of the article from airport company chair Tim Brown.

As Tim Brown tells it, the first time he discussed a “back of the envelope”-type analysis of the cost to extend Wellington runway with the airport’s chief executive, Steve Sanderson, the conversation was “completely negative”.

…..Brown had just been presented an outline of a $300 million project, aiming to enable non-stop long-haul flights to the capital.

However, the  potential gains to the airport (two-thirds owned by Infratil, the rest by Wellington City Council) were likely to see a boost in profits that would only justify it investing around $100m.

Whatever the final costs of the project might be (and the estimates are unmoved in the years since), Brown was clear about the chances.

“Literally within 10 seconds I said: ‘So what? What do I care? We’re not going to do that, are we?’,” Brown recalled this week.

This isn’t a project that might need the last 10 or 20 per cent of the cost picked up by the taxpayer/ratepayer to make it viable.  Instead it only works –  even on their own numbers –  if the Crown/WCC picks up two-thirds of the capital cost (and ratepayers have already paid millions of dollars to get the proposal this far).  This is a politically-driven project at least as much (and probably more) than it is a WIAL/Infratil one.

The whole process is getting underway again now, both because the airport company (WIAL) has restarted its resource consent application, and because now that the election is past the ability of citizens and ratepayers to hold in check the big spending “boosterish” tendencies of the mayor and councillors is diminished considerably.  It is difficult to tell quite what the balance of the council now is, but the new mayor has been at the forefront of the various “booster” projects the Council is spending money on, and one councillor who was vocally opposed to the extension in the previous term is no longer on the council.  WCC’s track record –  of wanting to “do something”, spend money on big ticket initiatives, often with little or no public scrutiny (sometimes not even with scrutiny from councilors) – is pretty disquieting.

Presumably under some pressure during the election campaign, the new mayor Justin Lester modified his stance somewhat in responding to pre-election candidate surveys.

I have committed to seeking the resource consent for the airport extension project. It’s too early to say whether the project will proceed because the following three caveats will need to be satisfied before it proceeds:

1. Resource consent approval

2. Financial support from Central Government

3. Commitment from airlines to fly direct routes to Asia.

This is a 50 year project and needs careful consideration before any decision is made.

On the face of it, that looks like a fairly insurmountable set of hurdles.  It is very unlikely that any airline is going to give a commitment to fly direct long-haul routes between Asia and Wellington in advance of (multi-year) construction even starting –  they couldn’t know what would happen to fuel prices, the world/regional economy or the like in the intervening period.    That is especially so given the expressed lack of interest in flying long-haul from Wellington from the one airline that always will be flying New Zealand routes, Air New Zealand.

And, to date, central government seems to have been commendably non-encouraging about any suggestion of central government financial support.

So what –  beyond the track record of poor quality secretive spending – makes me uneasy about the Lester-led Council?  First, Lester knows very well that he won’t get commitments from airlines before the Council has to make decisions on whether to fund the runway extension –  but he might get non-binding expression of interests, which could be politically spun to sound a bit like commitments.  Second, the government has a  track record of ending up funding uneconomic infrastructure projects, including ones it initially poured cold water over.  One could think of Transmission Gully, or KiwiRail, or Northland (by-election) bridges or –  perhaps most concerningly – the City Rail Link in Auckland.   With a modest budget surplus to be subject to an electoral auction next year, is it so inconceivable that the government could change tack (government built houses and immigration last week) and throw $100 million in the direction of the runway extension?  Compared to the spending on Transmission Gully, it would be chicken feed.

And while Lester is quoted extensively in the Fairfax article, neither of the conditions in the pre-election quote above (airline commitments, central government funding) is repeated.  [UPDATE: I gather they are still part of his set of pre-conditions]

So ratepayers beware.  Citizens beware.

In the Fairfax article, Lester tries to blunt possible ratepayer concerns by suggesting the bulk of any Council funding should be raised from business rates rather than from residential ratepayers, because “the majority of the benefit would go to the business sector”.  That might sound superficially plausible (if there were material benefits at all) but the mayor seems unaware of the notion of tax incidence: that the party who writes the cheque to pay a tax or rates bill isn’t typically the party that bears the economic cost.   Much of any company tax is actually borne, over time, by workers –  because less investment occurs than otherwise, and wages are lower as a result.  Just as renters bear some/much of the incidence of rates bills paid by landlords, we should expect that the wider pool of Wellington citizens would bear much of the economic cost of higher business rates to fund an airport extension, even if no non-business ratepayer ever has to increase their direct rates bill.  This is an issue that should bother all citizens, not just business ratepayers.

A lot of the decision-making should turn on a robust cost-benefit analysis of the proposal.  WIAL and the Council have commissioned their own analysis, which suggests large positive national benefits.  Not many people who have looked carefully at the numbers have found their numbers persuasive.  Justin Lester seems to suggest this is all about self-interest

“I’m not going to have people telling me and telling Wellington and telling our council what we should be doing because of their own interests.”

If one wanted to descend to a similar level, one could ask about the incentives on and interests of councillors –  spending other people’s money on big ticket projects.  But, perhaps more importantly, advocates like Lester would do better to front up and explain why they disagree with specific points raised by critics –  whether those critics are representatives of the airline industry, or other commentators and economists.

In the last few weeks, questions have begun to surface about the estimated cost of the runway extension itself.  In a private sector project, citizens wouldn’t need to worry too much.  After all, if the company proposing the development gets it wrong, its own shareholders will be the ones who lose money.  But this is a project where large amounts of ratepayers/taxpayers money will be at stake, and where it isn’t clear how well aligned incentives really are.  The construction estimates are being done for WIAL, which has already concluded that it would only be worth them putting in around $100 million.  If the project is to proceed central or local government will be on the hook for the rest.  Mightn’t the incentives at present be to keep the construction estimates to the low end of a possible range?  Doing so might (a) increase the chances of getting a resource consent (since, sadly, the Environment Court needs to do an economic appraisal) and (b) increase the chances of getting central and local government approval to proceed, with political commitment to the project, with any later cost-overruns perhaps largely falling on those parties.

My own unease has been around three main points; developed in earlier posts:

(a) the large assumed increase in long-haul visitors to New Zealand, simply because of an option to fly long-haul into Wellington (rather than Auckland or Christchurch.

(b) the very large assumed “wider economic benefits” assumed to flow from such increases in visitor numbers, even if the passenger projections were accurate, and

(c) the discount rate being used to evaluate such gains (many of them decades into the future).

I dealt with the visitor number points in this post late last year.   The WIAL cost-benefit analysis uses passenger projections which assume an increase of 200000 visitors to New Zealand (building up over time) simply because it becomes physically possible to fly long haul into Wellington.   That seems implausible.  In his own look at the passenger projections, Ian Harrison of Tailrisk Economics, noted that the numbers assumed that within 20 years 30000 more Americans a year will come to New Zealand simply because they can fly directly into Wellington.   One can imagine a few more might want to arrive via Wellington, but is it really credible that so many more will come to New Zealand as a whole?  Perhaps more startling were the assumptions for “other Asia” (ie other than China and Japan).  At present, only around 30000 people come from those countries to Wellington in a year.  The projections assume that putting in a runway allowing long-haul flights will provide a boost of an additional 105000 visitors annually within 20 years.  Were Wellington Florence, perhaps it would be a credible story.  As it is –  and even with some more marketing spending and a heavily subsidized new film museum – it just doesn’t ring true.  Long-haul passengers don’t come to New Zealand for its cities –  the cities are mostly gateways, and in the case of the lower North Island, Wellington isn’t the gateway to much.  (And yes, I can see the South Island as I type, so perhaps there is a small “gateway to the South, by slow ferry” market).

I touched on the “wider economic benefits” and the discount rates in this post. Here are some extracts from that post:

But much the biggest issues relate to the possibility of benefits to New Zealand from additional foreign tourists buying real goods and services in New Zealand.  Sapere appear to have estimated a total for the likely increase in tourist spending in New Zealand and then subtracted an estimate for the cost of providing those services.  For that they have assumed that 45.5 per cent of the expenditure is domestic value-added (ie returns to labour and capital).  That approach doesn’t seem right and generates highly implausible estimates.

The producer surplus is the gain to the provider of a good or service over and above what he or she would have been willing to provide that service at.   The cost of providing the service includes the cost of intermediate inputs (materials etc) but also the cost of the labour and the cost of capital (a normal rate of return).  If the producer sells product at that cost, there is no producer surplus. In this context, there is no net economic benefits –  economic costs have just been covered.

Over the long haul, in reasonably competitive markets, producer surpluses should be very small (in the limit zero).  For a hotel that budgeted on 80 per cent occupancy, a surprise influx of visitors for the weekend will generate a producer surplus –  the windfall arrivals add much more to revenue than they do to costs of supplying the service.  But over the long haul –  and the airport project is evaluated over the period out to 2060 –  it is fairly implausible that there will be any material producer surplus resulting from well-foreshadowed increases in visitor numbers.  Most of what tourists spend money on in New Zealand are items such as accommodation, domestic travel, and food and beverage.  In all those sectors, capacity is scalable.  One would expect new entrants just to the point where only normal costs of capital were covered.  In the long run, supply curves for most of these sorts of services/products should almost flat.

My proposition is that there are few or no producer surpluses likely to arise from a trend increase in foreign tourism as a result of extending Wellington airport.  But even if there were, any such gains would have to be offset against the loss of producer surplus for New Zealand producer (to foreign producers instead) from New Zealanders taking more holidays abroad.  It makes little difference to the hoteliers if I take my holiday in London instead of Queenstown, while at the some time someone in Manchester takes his in Queenstown instead of taking it in London.

Even if the consultants are right that there would be more additional inward visitors than outward, any producer surpluses from either set of numbers should be small.  And the net of two small offsetting numbers is even smaller.

The safest assumption, in evaluating the WIAL proposal, is to assume that the economic benefits of the proposal all accrue to users, and that there are no material net economic benefits (or costs) to the rest of the community.  Perhaps there is a small amount in the net GST flow, but it is hardly worth focusing on given the scale of the other uncertainties.

Perhaps this point will seem counterintuitive to lay readers and city councillors.  Surely “Wellington” or “New Zealand” is better off from having more foreign visitors (assuming the numbers outweigh the increased outflow of New Zealanders)?  And if so, shouldn’t we –  Councils, government –  be willing to spend money to get those benefits?   The short answer is no.    Good and services cost real resources to provide, and in a competitive market simply providing more goods and services won’t make the city or country better off –  you need to be able to sell stuff that generates more of a return than it costs to provide (including the cost of capital).  Vanilla products and services typically don’t do that.  After all, labour that is used to provide services to tourists is labour that can’t be used for something other activity.  And over a horizon of 45 years we can’t just assume there are spare resources sitting round unused.  Spending public money to generate this economic activity will come at a cost of some other economic activity being displaced (as well as the deadweight costs of taxation, which are allowed for in the cost-benefit analysis).

If, to a first approximation, there are no “net incremental economic benefits” for the “rest of the community” then even if the WIAL/Sapere passenger number estimates are totally robust, the net benefits of the project drop from $2090 million to $954 million.

It is not as if the new visitors – even if they eventuate –  are likely to be top-end exclusive customers.  Business and government travel –  a significant part of the Wellington market –  is unlikely to be much affected, and any boost to overall visitor numbers seems likely to be mostly tourists, consuming fairly vanilla, easily replicable, goods and services.

And what of the discount rate?

It is very unlikely that any private company (or shareholder) would evaluate such a risky project using anything as low as a 7 per cent real cost of capital.  On the WIAL/Sapere numbers, even raising the discount rate to 10 per cent –  a fairly typical cost of capital for Australian companies according to a relatively recent survey by the RBA –  roughly halves the value of any net benefits from the project (even if all the other assumptions about passengers numbers, and “wider economic benefits” are in fact well-founded).  But this runway extension seems much riskier than the typical investment project –  it is location-specific, not usable for anything else, and relies on assumptions that involve transforming the nature of the business (ie there is no long haul capacity at present, and no one can know with any confidence how much demand there might be for the service).  It would be enlightening if Infratil/WIAL told us what cost of capital/discount rate assumptions they would use in evaluating such a project if all the risk were on them?  I’m sure, for such a hard-nosed bunch of operators, if would prudently be more than 10 per cent real.

The Fairfax article picks up a number of other points, including some comments from me. In some of those comments, I probably wasn’t as clear as I might have been.

A few weeks ago, Singapore Airlines –  assisted by a non-transparent Wellington City Council subsidy –  began flying several times a week between Singapore and Wellington, with a stopover in (of all places) Canberra.  No one know whether those flights will succeed (SIA reportedly wants to move to daily), and become viable without ongoing Council subsidies.  That uncertainty is reflected in the article.  Tim Brown from WIAL seems to believe that if the route succeeds, and attracts a larger proportion of foreign passengers, it would tend to support the case for the runway extension.  Justin Lester seems a bit nervous

Like the airport company, Lester also appears to concede that if the Singapore Airlines flights do not show the demand its supporters hope, it would be bad news for the runway extension.

“People are getting on and off these planes four times a week and if the demand doesn’t go up to seven times a week, you know, we won’t need to do it,” he said, quickly adding that this would be a “strong indicator” rather than proof the runway extension was not worthwhile.

I was quoted along similar lines

Would strong success of Singapore Airlines’ new route, with a high proportion of visitors, help prove the case of the missing passengers?

For a man who freely admits he is naturally sceptical about most public infrastructure projects, Reddell is surprisingly open to the idea.

“If they can make that route viable without larger public subsidies than they’ve got then I think that would be interesting”, especially given that passengers face being “stuck in Canberra for a couple of hours”.

But with several caveats.  First, even if the Wellington-Canberra-Singapore route proves viable, it only offers any insight on the long-haul issue if a material proportion of the passengers in and out of Wellington are not just Wellington-Canberra passengers (although it seems unlikely that a daily 777 flight just Wellington/Canberra would be economic).

Second, if such flights prove viable with the current runway, that is great. All involved are likely to gain.  But that is different proposition than spending  (an irreversible) $300 million on a new runway.  As I noted

However, Reddell adds, this may only prove Brown is right about the problem being a lack of marketing, without proving the airport extension itself was needed.

“I would open up the argument, [of] let’s subsidise some more flights, and if they don’t work we can shut them down, whereas with the $300m runway extension, it’s a sunk cost,” Reddell said.

“The great thing about marketing is you can shut it off. You can’t do much with a runway extension” that doesn’t work out.

In the cost-benefit analysis, one of the options they looked at was a big increase in marketing expenditure.  It produced net benefits not that much smaller than those purportedly on offer from the runway extension, and could be re-evaluated constantly, rather than being irreversible.

If central and local government do go ahead and fund the extension, it wouldn’t surprise me if 10 years hence there were a few long haul flights in and out of Wellington.  But, of itself, that would prove nothing about the economics of the project.  The financial contribution of central or local government would, no doubt, be treated as a bygone –  with no direct financial returns, and arguable and uncertain indirect ones –  and with a runway in place, and only its own capital contribution to cover, perhaps WIAL could attract a few flights.  That might leave today’s councilors feeling better, as they show the extension to their grandchildren, but is no reason to think that Wellington citizens and ratepayers will have been made better off as a result.

I’ve not touched at all on issues like the possibility that future carbon charges make long haul travel less attractive than it is today, or that rising sea levels might raise questions about Wellington airport more generally.  But they all should bring us back to Justin Lester’s point

This is a 50 year project

and

His “gut instinct” was that the case would eventually be proven, but it could be soon, or it could be decades away.

The costs of waiting simply aren’t that large.  If the proponents are right, the case will look that much more compelling  –  and less risky –  10 years from now.  If they are wrong, (lots of) real resources will have been irreversibly wasted –  and that burden will be felt not just by Wellington businesses, but by all citizens and ratepayers of Wellington.   I’d urge the incoming Council to reflect on that choice, and to take seriously what decisionmaking under uncertainty should mean.