19.1 On 31 October 1996, in exchange for a payment to the Crown of $1.5 billion, a substantial legislated monopoly in perpetuity for the operation of Canada's civil air navigation system was transferred to NAV CANADA, a private not-for-profit corporation created in 1995 to receive and operate the system.

19.2 Transport Canada did not fully segregate the air navigation system elements that were to be privatized before entering the sale process. It developed a number of estimates of the system's value, but did not obtain a formal valuation opinion from a qualified independent professional. Nor did it obtain any external assurance as to the reliability of the financial information and results on which it was basing its decision on the sale.

19.3 The Department used both going-concern and net book value approaches to valuing the system. Although the air navigation system was sold as a going concern, the Department reconciled the "purchase price" to a valuation of the system based on an "adjusted" net book value. In our opinion, that was not an appropriate method of valuation in these circumstances. "Due regard to economy" does not mean that the purchase price must equal the valuation; but it does mean that the value must be known and that any difference should be explained.

19.4 The government had directed Transport Canada to receive fair market value for the transfer of the air navigation system to a not-for-profit entity; the Department agreed to transfer the air navigation system for a negotiated payment of $ 1.5 billion, approximately $1 billion less than the entity's going-concern value of $2.4 billion estimated by the Department's financial advisors.

19.5 The costs of transferring the air navigation system to the not-for-profit corporation were significant. Nevertheless, Transport Canada did not identify separately the cost associated with pension transfers, currently estimated at between $145 million and $275 million.

19.6 We are concerned about the Department's lack of justification for entering into a sole-source contract with its principal financial advisor.

19.7 We audited some elements of Transport Canada's oversight of the air navigation system. We did not audit the safety of the system and provide no opinion on it. We found that the legal and regulatory foundations for the regulation of NAV CANADA have been established and the Department has very recently approved its Policy Framework for the Safety Oversight of Canada's Air Navigation System. Nonetheless, there are important matters of risk, data, and audit and inspection that must be resolved before Transport Canada's regulatory regime can be said to be fully operating. The Department is aware of these issues and is in the process of drafting action plans and taking steps to deal with them.

19.8 We are concerned that until Transport Canada makes significant progress in implementing its performance-based regulatory regime, it will not be in a position to have full assurance of NAV CANADA's compliance with the safety regulations governing the air navigation system. Although it has indicated that it would be aware of any problems that existed, the Department has yet to conduct its first audit or inspection of NAV CANADA's operations.

Introduction

19.9 On 31 October 1996, in exchange for a payment to the Crown of $1.5 billion, the operation of Canada's civil air navigation system was transferred to NAV CANADA - a private not-for-profit corporation created to purchase and operate the system. NAV CANADA is to operate independently of the government except for certain clearly defined areas such as safety and services to remote and northern communities, and is intended to become financially independent of the government after two years. This transaction was authorized by the passage in June 1996 of the Civil Air Navigation Services Commercialization Act.

19.10 In the past, two major transportation Crown corporations - Air Canada and Canadian National Railways - were privatized through stock flotations. However, this was the first time that a major operational arm of a government department was transferred by private contract. This was a large and complex transaction involving significant amounts of money and was done in a relatively short time. Given the unusual nature of the transaction and the likelihood that other divestitures may occur in the future, we decided to report on it.

The civil air navigation system

19.11 The civil air navigation system provides civil air traffic control, flight information services such as weather briefings, and a network of navigational aids. Collectively, the various elements of the system provide for the safe and orderly flow of aircraft in Canadian airspace and in those parts of international airspace for which Canada is responsible. Air navigation services are delivered through area control centers, air traffic control towers, flight service stations and a national radar and communications system.

Decision to divest

19.12 On 22 February 1994, the federal Budget included a proposal to study the commercialization of the air navigation system. During the ensuing year, the Department prepared a series of consultation documents and, working with affected government departments, held consultations with all sectors of the aviation community. As the consultations progressed, the option increasingly favoured was the transfer of the system to a not-for-profit corporation that would be created to operate it.

19.13 In the 27 February 1995 Budget, the Minister of Finance announced the government's intent to proceed with the commercialization of the air navigation system. Transport Canada was to achieve this result by as early as possible in the 1996-1997 fiscal year. Initially, 1 April 1996 was set as the target.

Transport Canada's Commercialization Model

Birth of the not-for-profit corporation

19.14 On 26 May 1995, NAV CANADA, a private not-for-profit organization, was incorporated under Part II of the Canada Corporations Act as a non-share capital corporation. By-laws were drafted to establish the new entity's corporate structure and governance requirements following the government's direction. Transport Canada entered into reimbursement agreements with NAV CANADA, specifying that if the transaction was not successful, the government would become liable for the purchaser's eligible expenses. The agreements ended on the transfer date and the costs incurred were borne by NAV CANADA.

19.15 Accountability and corporate governance. NAV CANADA's incorporation documents established the legal and accountability framework for its governance. It was formed with four members: one appointed by the federal government, two appointed by user groups, and one appointed by the unions representing air navigation system employees. Corporate governance is exercised through a 15-member Board of Directors; 10 are nominated by the four appointed members forming the corporation and they, in turn, nominate five more, one of whom is the President. The Board's members cannot be active government officials, politicians, significant suppliers, clients or users of the system.

19.16 Role of the federal government. The Government of Canada continues to have a significant role in the air navigation system. It is responsible for regulating it and overseeing its safety. It may also review changes in revenue structure and rates, and it is responsible for deciding on northern and remote services, and appointing a member to the corporation.

19.17 Monopoly. The Civil Air Navigation Services Commercialization Act provides NAV CANADA with a substantial legislated monopoly over the provision of civil air traffic control services and aeronautical information services in perpetuity, as long as it meets its obligations under the Act. In return, it is expected to offer these services in a safe and efficient manner that meets the needs of Canadians and fulfils Canada's international obligations.

19.18 Financial independence. NAV CANADA is financially responsible for the operation, maintenance and capital requirements of the Canadian air navigation system. To that end, the legislation gives NAV CANADA the right to recover all of its costs through user charges. The primary sources of revenue for the system when it was operated by Transport Canada were the Air Transportation Tax and, since November 1995, international overflight charges. By the end of the second year after transfer, NAV CANADA is to have introduced terminal charges and domestic en route charges in addition to increasing international overflight charges. The government provided for monthly grants to a maximum of $ 1.44 billion to be paid to NAV CANADA during the first two years until it has put its charges in place. These grants are approximately equal to the government's anticipated revenues from the Air Transportation Tax. As NAV CANADA introduces its charges, the government is expected to revise the ticket tax rate until the end of the second year after the transfer, at which time it will be repealed.

19.19 Transport Canada's model is unique. Other countries have moved in the direction of separating the operation of their air navigation systems from government. Some, most notably Australia and New Zealand, have gone so far as to set up the air navigation system operator as an entity similar to a Crown corporation. The United Kingdom has also set up a separate air navigation service organization and plans to privatize it in the near future through a stock flotation.

19.20 At the time of writing, however, Canada is the only major country to have taken the extra step of transferring the operation of its air navigation system to the private sector. The international aviation community is watching the Canadian experience with interest.

Objectives for commercialization

19.21 According to Transport Canada, the government's objectives in commercializing the air navigation system were to have a system able to respond better and more quickly to user needs, to achieve more rapid system improvements in internal and transportation efficiency, to eliminate the system's dependency on taxpayers and to operate the system in a businesslike way.

Timetable for transfer

19.22 In November 1995, following negotiations during the early fall, the government approved the transfer of the right to operate the civil air navigation system to NAV CANADA for a payment of $1.5 billion. A broader agreement-in-principle for the transfer was reached on 8 December 1995 and the agreement to transfer was finalized on 1 April 1996. Although several delays were encountered during the sale process due to the complexity of the transaction, on 31 October 1996 the government received a payment of $1.5 billion and transferred the operating rights and assets of the civil air navigation system to NAV CANADA. Due in part to the speed with which the process was accomplished, a series of undertakings by Transport Canada remained to be done - among other things, to identify and transfer all relevant items of intellectual property, to complete the conveyance of lands, and to complete the assignment of contracts. Exhibit 19.1 shows the timetable of the commercialization process.

Focus of the Audit

19.23 Details on our scope and audit objectives are included in the section About the Audit at the end of the chapter. We did not audit the decision to transfer or look at the negotiation process, but focussed on the implementation of the transfer. We assessed whether Transport Canada exercised due regard to economy in the sale process; established adequate procedures to protect the interests of the Crown during the transfer process; disclosed the full costs of the commercialization; employed appropriate contracting practices in acquiring financial advisory services; and put in place adequate procedures to regulate the safety of the system and receive assurance of its safety.

19.24 The International Organization of Supreme Audit Institutions, through its subcommittee on privatization, has examined the international experience with privatization. Our review of the INTOSAI work and our discussions with others who have experience in divestiture lead us to conclude that in transfers of government services, the risks inherent in these transactions are reduced when the process is done in two phases. First, the operation to be divested is carved out of government operations and commercialized as a government-owned entity. There follows a period of operational stabilization in which the new entity puts in place the management and financial structures it needs to operate on a stand-alone basis. Only when the new organization is clearly defined and operational would a government elect to move the function to a private corporation. Exhibit 19.2 describes the most current and pertinent example, the yet-to-be-completed privatization of the National Air Traffic Service (NATS) in the United Kingdom.

19.25 In addition to privatizing some Crown corporations in recent years, the Government of Canada has also transferred a special operating agency, the Canada Communication Group, to the private sector. In that case, the government followed a two-phased approach. Such an approach was not formally considered by the government in setting out the commercialization options for the air navigation system.

Observations and Recommendations

Valuation of the Air Navigation System

19.26 In any sale, due regard to economy requires that the seller enter the process with a clear understanding of the entity to be sold and its value. This information then becomes a benchmark for reference during the sale, against which the seller can assess the buyer's proposals. Once the sale is completed, the seller can be held to account for the variance (positive or negative) between the sale price and the valuation. We emphasize that "due regard to economy" does not mean that the purchase price must equal the valuation; rather, it means that the value must be known and any difference should be explained.

19.27 Accordingly, in assessing whether the Department exercised due regard to economy in carrying out the sale of the air navigation system to NAV CANADA, we focussed our audit work on what, in our view, was the key issue: valuation.

The entity to be transferred was not fully segregated

19.28 In any such transaction, a clear and comprehensive definition of what is to be sold is important because the usefulness and quality of the valuation depends on how fully the entity is defined.

19.29 Transport Canada conducted a conceptual exercise in 1994 to determine the financial position and financial results for the air navigation system were it to be commercialized. It compiled estimates of the system's expenses and revenues by making a large number of tentative assumptions. However, it did not obtain any independent assurance as to the reliability of the financial figures resulting from the conceptual exercise.

19.30 Transport Canada informed us that it defined several major elements of the sale with NAV CANADA during the negotiation process. Although it may be common to have some of the elements of sale defined at that stage, we found that the impact of many of these elements on the value assigned to the system was potentially quite significant. They included the identification of major revenue streams and of designated employees, the duration of the monopoly right, development of the regulatory framework, assignment of major capital projects, actuarial assumptions for employee severance pay and pension liabilities, and land assessment for ownership and environmental liabilities.

19.31 Transport Canada has made it clear that throughout the sale process the reliability of the inventory and asset management information system was questionable and that any figures provided were always covered by the statement that they were gross estimates. In the spring of 1996, the Department began to execute procedures to improve the accuracy and reliability of the information.

Transport Canada's "lessons learned" study

19.32 The Department conducted a study to identify lessons learned from its own and the government's overall approach to the commercialization of the air navigation system, and to identify key strategic issues for similar undertakings in the future. The Department was to prepare an interim and a final report. On 31 March 1996, it produced an interim report on the lessons learned during the process of negotiating the transfer.

19.33 One of the lessons was the benefit of clearly identifying and segregating assets prior to entering negotiations. The study also concluded that if an entity being sold resides within a larger organization, as was the case for the air navigation system, and if there is time, consideration should be given to separating the entity and having it operate on its own for a certain period of time as this helps to improve the understanding of exactly what is being sold. Although this interim report identified significant lessons that would have warranted a final report upon completion of the transfer, we were informed by the Department that there would be no final report. This is unfortunate because, in our view, the study was a positive step by the Department to identify key lessons from this transfer that could be used in preparing for other government divestitures.

19.34 These lessons were reinforced by the Department's principal financial advisor who wrote indicating that the transfer involved some potential risks, caused in part by the uniqueness of divesting directly out of a government department instead of through a separate government-owned entity. Further, the financial advisor expressed concern that the air navigation system was not a self-contained commercial entity with segregated financial reporting and management information systems, and accordingly there were no audited financial statements upon which the potential purchaser could rely for its valuation and purchase decisions.

Transport Canada's valuation lacked key documentation

19.35 Before the transfer, Transport Canada valued the air navigation system using both going-concern value and net book value approaches.

19.36 We looked at the reliability of the financial information and the documentation for the range of values used by Transport Canada in arriving at the value of the air navigation system.

19.37 We found that many of the key numbers used to determine the going-concern and net book values were based on unaudited historical financial information, on which Transport Canada neither sought nor received external assurance.

19.38 The Department and its financial advisors did extensive analyses in preparing for the sale process and the results of some of this work are contained in documentation made available to us. However, critical gaps in the documentation made it impossible for us to fully review much of this information. For example, many of the underlying assumptions and forecasts used in determining the air navigation system's value were not documented. We requested working papers and analyses for revenue assumptions, operations and maintenance expenditures, capital expenses, financeability, the assumed growth rates and rate charges for the revenue assumptions, assumed efficiency rates, number of employees, salaries and benefits, the forecast capital expenditure breakdowns, etc. The Department was unable to provide us with a sufficient set of working papers supporting the assumptions used in its key valuation models. Such supporting information would have provided, among other things, the details and rationale behind the numbers used in Transport Canada's key going-concern models. The Department has explained to us that because of the way the negotiations proceeded, later changes in the assumptions were not documented.

19.39 The Department was similarly unable to provide us with the rationale and support for the net book value it arrived at, the reasons for excluding capitalized interest and the evidence for other adjustments.

19.40 Due to the lack of supporting documentation, our Office is unable to comment on the reliability of the valuations arrived at by the Department.

19.41 In future divestitures, the government should properly document its key valuation models and maintain a complete set of working papers to support the assumptions used in determining value.

Transport Canada's going-concern valuations

19.42 A going-concern value is generally expressed as a range of values based on anticipated future financial results. This is normally quantified using a discounted net cash flow.

19.43 In the summer of 1994, Transport Canada entered into an agreement with its principal financial advisor for services that included assessing the potential value of the system. Although the financial advisor determined the potential value for different entity types, in this section our discussion focusses on the valuations prepared for the selected form, the not-for-profit entity.

19.44 Initial going-concern valuation. Before entering into the sale process, the Department and its financial advisor developed an initial going-concern valuation of the air navigation system of between $1.0 billion and $1.3 billion. However, this exploratory valuation did not adequately consider, among other things, the full impact of introducing overflight charges, a key revenue stream.

19.45 Subsequent work. During the months that followed, as Transport Canada proceeded to define more precisely the various components of what it was selling, the Department and its principal financial advisor significantly revised the estimates of the value of the air navigation system. Most notably, the planned introduction of the overflight charges in late 1995 increased the revenue potential of the entity by more than $300 million a year. This could, over time, bring the gross revenue potential from about $700 million to over $1 billion per year.

19.46 In assessing an entity's going-concern value, it is important to have the value tested in the financial markets. In this case, because the corporation was intended to be financed entirely through debt, the test of that market was to help determine the amounts investors were willing to risk in the venture. This test of the market, known as assessing the financeability of the entity, provides an additional indication of whether the assessed value is reasonable.

19.47 On 1 August 1995, Transport Canada hired a second financial advisor to review the earlier financial models used to determine the value of the air navigation system and to assess the financeability of the entity, particularly in the United States and international markets.

19.48 The financial advisors' joint valuation: $2.4 billion. In late September 1995, the Department's two main financial advisors made a joint presentation to senior officials of Transport Canada. They presented a number of possible valuations based on differing assumptions about the conditions of sale. The most critical of these was the issue of whether the monopoly on services would be granted for a limited time period or in perpetuity. Accordingly, estimates of value were prepared based on terms of 10, 20 and 30 years. The 30-year term effectively approximates in value a monopoly in perpetuity. These models showed clearly that a grant of monopoly for a more limited fixed term would result in a very sharp decline in estimated value. Ultimately, the Department decided to transfer the monopoly in perpetuity. The estimated value given by the financial advisors for the 30-year (perpetual) monopoly was $2.4 billion. This estimate incorporated both going-concern and financeability considerations.

19.49 To the extent possible, we reviewed the model used to generate this estimate. We found that the assumptions used were conservative (that is, they tended to underestimate the value of the system). For example, the model was based on an assumption that the rates charged by the corporation, and its revenues, would begin to fall as early as the fourth year and would continue to decline thereafter. The model also assumed less-rapid recovery of full costs than is permitted in the legislation or planned by NAV CANADA based on its prospectus. The estimate also assumed that the corporation would be fully taxable; as a not-for-profit corporation, NAV CANADA is not currently taxable. Thus, the estimate of $2.4 billion on a going-concern basis, in light of the actual terms and conditions of the transfer and based on the documentation available to us, could materially understate the value of the civil air navigation system.

19.50 Although the financial advisors did not provide a valuation opinion on that estimate, or any other, based on the documentation available to us the $2.4 billion estimate of value became the figure that was central to subsequent advice provided to the Department.

Net book value, an inappropriate measure

19.51 As early as 1994, Transport Canada had estimated that the net book value of the air navigation system by 1 April 1996 would be $2.6 billion. The net book value of an entity is determined by accumulating all the costs, including financing costs incurred to acquire the assets (such as land, buildings, and systems) that are used in generating revenues, net of depreciation and liabilities.

19.52 The net book value is generally not used to measure the value of an organization to be sold or transferred as a going concern. While the information is useful in preparing for a sale, it provides little or no information about the cash flow generation potential of the assets, which, in a going concern, forms the basis of their value. We reviewed the government's estimate because it was the benchmark against which the Department reconciled the "purchase price", and because of its relevance to the Department's objective of transferring the full cost of the system from taxpayers to the users of the system.

19.53 In October 1995, the Department of Finance informed Transport Canada that it believed that the government should be recovering its investment in the air navigation system by asking for a transfer value equal to the book value. It noted that the financial advisors had stated that it was reasonable and defensible to use a net book value of $2.6 billion, including capitalized interest, as the transfer value of air navigation system assets. In its support for this conclusion, Finance indicated that Transport Canada had used the net book value of $2.6 billion in recent international discussions to justify the introduction of overflight charges. It concluded by saying that in its view the net book value of $2.6 billion, including capitalized interest, should be the basis for further discussions.

19.54 In reply, Transport Canada suggested that in its view the net book value was $1.9 billion. It arrived at this figure by removing from the higher figure the capitalized interest associated with the major Crown projects, such as RAMP (Radar Modernization Project), that had developed the technical infrastructure of the air navigation system. Because the commercialization legislation and applicable ICAO (International Civil Aviation Organization) guidelines enable NAV CANADA to recover all costs including capitalized interest through user fees, and because those interest costs were a real part of the cost of those projects to the Crown, the reduction should not have been made. Moreover, our review of the available documentation leads us to conclude that the adjusted net book value used by the Department is understated by at least $140 million.

19.55 We asked Transport Canada for its rationale for using the net book value as the basis for determining the value of the commercialized air navigation system. The Department informed us that it had focussed on net book value based on advice that ICAO cost recovery guidelines had established this figure as a ceiling on recoverable costs. We have reviewed the applicable ICAO guidelines and cannot find support in them for this conclusion.

19.56 The importance of using going concern as the basis for commercial valuation was further demonstrated by NAV CANADA in its 1996 prospectus, in which it made a preliminary allocation of only $100 million of the purchase price to the air navigation system assets, valued by Transport Canada at $2.6 billion. NAV CANADA also allocated only $36 million of its purchase price to the liabilities it assumed. The remaining $1.481 billion of the purchase price was allocated to the monopoly right or intangible entitled "air navigation rights".

Amount of transfer

19.57 On 31 October 1996, Transport Canada received a payment of $1.5 billion from NAV CANADA for the transfer, after extensive negotiations between the government and the purchaser.

19.58 Exhibit 19.3 shows how the Department compared the price it received with its "adjusted" net book value of $1.9 billion. As we have noted, in our view neither the adjusted net book value nor the net book value of $2.6 billion by themselves represent appropriate bases for valuation in the circumstances of this transaction.

19.59 The more appropriate basis for estimating value is to use a going-concern approach. As discussed earlier, the going-concern estimate of value that was based on assumptions most closely approximating the conditions of transfer was a conservative estimate of $2.4 billion. Additionally, we were informed by Transport Canada that financeability alone suggested that the market would have been prepared to support much higher values.

19.60 The Department did not request or receive from its financial advisors any formal statement of their valuation of the entity, despite the amount of money involved and the government's requirement for assurance.

19.61 As part of a professional and independent valuation opinion, the Department would also have received assurance on the reliability of the financial and other information used in preparing the valuation. However, the Department explicitly specified in the contract with its principal financial advisor that such assurance did not have to be provided. We believe that in a transaction this large and complex, carried out with only one potential purchaser - and where the negotiations were taking place between the Department and an entity represented by some of the same people who had previously advised the Department on how the transfer should be arranged - the Department ought to have sought independent assurance through a formal valuation opinion.

19.62 In making significant divestitures, the government should ensure that prior to entering negotiations, it receives a formal valuation opinion from a qualified independent professional on the value of what is being sold.

Incomplete communication to government on value

19.63 Before the sale process began, the government approved Transport Canada's proposal to commercialize the air navigation system and directed the Department to obtain fair market value, as determined by its financial advisors and approved by the Department of Finance.

19.64 In November 1995, Transport went to the government seeking approval for its agreement-in-principle with NAV CANADA, including approval for a transfer price of $1.5 billion. Although going-concern valuations had been produced, Transport Canada reconciled for the government the value to be received from the transfer (including the price) by comparing that amount to the adjusted net book value (see Exhibit 19.3 ). We received no evidence to suggest that, at that time, the financial advisors supported the adjusted net book value approach, or that they thought that this value in any way represented a proxy for fair market value. No information on the results of the going-concern valuations was formally presented to the government in seeking its approval of the price.

Potential subsidy to aviation industry

19.65 In the making the decision to transfer the air navigation system to a not-for-profit corporation, the government accepted two interrelated financial objectives. First, the government wanted to end dependency on the taxpayer and the objective was to have the users pay the full cost of operating the system. Second, the Department was directed to achieve a price that represented fair market value. In light of these objectives, we believe the negotiation of a purchase price that was significantly lower than the most reasonable valuations (on either a going-concern or net book value basis) represents a substantial indirect subsidy to the aviation industry, which was not properly authorized and disclosed. If one uses either the Department's final going-concern valuation of $2.4 billion or the net book value of $2.6 billion as the best available estimates of fair market value, then the magnitude of the subsidy could range up to a billion dollars.

Lack of due regard to economy

19.66 The Department failed to exercise due regard to economy in determining the value of the air navigation system. Exhibit 19.4 shows basic steps that we believe would contribute to due regard to economy in future government transfers. Further, based on the documentation available to us, we conclude that the Department did not disclose to decision makers information on the potential going-concern value of the air navigation system.

Department's comments: Transport Canada's comments on this section can be found at the end of this chapter.

Significant Costs of Transferring the Air Navigation System

Accountability to Parliament

19.67 Currently, there is no requirement for the government to account to Parliament for the financial and substantive results of divestitures. The costs of transferring the air navigation system to the not-for-profit corporation were significant - we estimate them at between $245 million and $375 million - but were not consolidated and reported to Parliament separately. ( Exhibit 19.5 presents a listing of some of the major costs to the government associated with the decision to transfer.)

19.68 Where major divestitures of government operations are involved, the government should prepare a report for Parliament that sets out the results of the divestiture. This document should include a description of the transaction, an assessment of how the transaction as concluded is expected to meet the government's objectives for entering into it, and a summary report on the costs and proceeds of the transaction.

Severance and pension costs

19.69 In the spring of 1996, the air navigation system employees' pension liabilities to be transferred with them to NAV CANADA were estimated to total up to $1.4 billion. Later estimates reduced this amount to $1.3 billion. Severance payments were estimated at up to $112 million.

19.70 Severance costs. Air navigation system employees transferring to NAV CANADA were paid an additional amount in severance because their employment with the government had been terminated (the entitlement rate for employees whose service is terminated is higher than for those who leave of their own volition). These amounts represent an additional cost of transferring the air navigation system and are estimated by the government to total at least $31.5 million of the estimated total of $112 million.

19.71 Pension costs. Under the agreement to transfer, employees had the option of transferring their pension to NAV CANADA or leaving it under the Public Service Superannuation Account. The government negotiated an amount to transfer to NAV CANADA for pensions that was significantly higher than the actuarial liability for these employees had there been no transfer. The amount to be transferred for each individual is the greater of either the actuarial liability on a negotiated set of assumptions or the result of a contribution test of twice the individual's accumulated contributions, with interest. The negotiated actuarial basis results in a larger actuarial liability than the public accounts assumptions, and the contribution test further increases the transfer amounts. Based on the information for the employees who actually transferred, we and the government estimate that the total liability could be up to $1.3 billion (assuming all of the employees elect to transfer, as approximately 90 percent will). Of that amount, we estimate that up to $275 million represents a cost attributable to the transfer, based on the combined effects on the liability of the negotiated assumptions and the contribution test. While this outcome is not unusual in pension transfer arrangements, in our view this amount represents a cost that should have been disclosed to the government as a separate cost directly related to the transfer. The government now advises us that because of favourable market interest rates, this cost will be partially offset by an amount that it currently estimates at about $130 million.

Other Key Elements of the Transfer

Controls over the transition period

19.72 Although Transport Canada was under some pressure to complete the transfer quickly, it introduced some key controls that are worth noting as significant lessons to apply in future transfers. For example, detailed closing plans were prepared and communicated to ensure that key financial controls were implemented to protect the public purse after the transfer. The financial closing plan included a list of procedures such as the cancellation of credit cards and phone cards, and a series of procedures subsequent to the transfer to ensure that the Department would recover any expenditures it had incurred on NAV CANADA's behalf. Other procedures were put in place to ensure that assets identified in the agreement were transferred. Furthermore, the Department provided for these transition procedures to be managed by employees who had been identified to remain with the Department, to ensure that the government's interest was being taken into account.

Contingent liabilities

19.73 The government is in the process of completing its environmental assessment of the condition of the lands transferred to NAV CANADA. The potential environmental liabilities are estimated by Transport Canada at between $5 million and $20 million.

Contracts for Financial Services

19.74 In the course of our audit of the valuation of the air navigation system, certain concerns came to our attention about the contracting practices used by the Department in the acquisition of financial advisory services. These concerns represent matters that we believe ought to be brought to the attention of Parliament.

The initial contract for financial advisory services

19.75 Following the government's announcement of its intent to study the potential commercialization of the civil air navigation system, Transport Canada decided to contract for financial advisory services. The financial advisor was to challenge the assumptions for building the financial model of the commercialized entity. It was also to focus detailed study on three options for commercialization: a not-for-profit company, a mixed enterprise and a Crown corporation.

19.76 The Department called for bids on this work and a contract for $165,000 was awarded. The contract covered the period from July to September 1994. It was subsequently amended on two occasions to extend the work period to March 1995 and to increase the amount payable to $560,000.

The principal contract for financial advisory services

19.77 Early in 1995, Transport Canada decided that, as the next step in the commercialization of the air navigation services, it would require a financial advisor to assist its negotiating team. The advisor was intended to provide comprehensive financial advice leading up to a transaction, and to perform additional responsibilities in regard to financing the sale.

19.78 Initially, a sole-source oral contract was offered to the winner of the earlier contract. This appointment was confirmed by the contractor in a letter to the Department dated 25 May 1995. The written contract governing the provision of financial advisory services was not signed until after 12 April 1996, almost a year later. Much of the delay in signing the contract can be attributed to a request by the contractor for a revision of the indemnification clause. Ultimately, the contract was signed without the inclusion of the clause.

19.79 On 1 June 1995, the Department prepared a proposal for "Ratification of Contract" and submitted it to Treasury Board. The proposal was ratified on 15 June 1995. Ratification is normally required for contracts let without the required authority from the Treasury Board, as a result of either an administrative error or a pressing emergency.

19.80 In the proposal, the Department asked for retroactive approval of a non-competitive contract based on a transaction fee of 0.4 percent of the final price, not to exceed $4.6 million, and payable in arrears from 1 May 1995. It put forward several points in support of its request.

19.81 The need for sole sourcing. The Department stated that in July 1994, a competitively tendered contract valued at $560,000 had been awarded to the financial advisor for advice in connection with the commercialization of the air navigation system. In fact, the competitive contract had been awarded for $165,000 and was later amended to $560,000.

19.82 The Department pointed out that it was committed to having the terms of the transfer arranged by the fall of 1995, which meant that in its view there was not enough time to call for competitive bids and potentially allow a new firm to familiarize itself with all the complex issues involved. Hence, it concluded that the firm it proposed was the only one ready and able to act as the financial advisor during the time-sensitive negotiations expected with the new entity.

19.83 Transport Canada had known by February 1995 that a financial advisor would be required. We do not have any indication that a competitive process could not have been completed in the time available, or why it was necessary to enter into this contract without first having received the appropriate authorization.

19.84 According to section 6 of the Government Contract Regulations, there are only four exceptions that permit the contracting authority to set aside the requirements to solicit a bid. The information provided by the Department does not adequately explain its reasons for sole sourcing. We are concerned that the practice of sole sourcing based on a contractor having won an earlier, much smaller contract, which was let competitively, circumvents the competitive bidding requirements and is unfair to other firms.

19.85 The basis of payment. In support of its intent to reimburse the advisor using a transaction fee, the Department stated that according to advice received from the Department of Finance, a reasonable transaction fee rate would be between 0.4 percent and 0.7 percent of the negotiated price and that this rate is standard in the industry. Transport Canada has no record of advice received from the Department of Finance on this matter.

19.86 When initial discussions were being conducted with the financial advisor about the second contract, it was contemplated that in addition to providing service of an advisory nature, the advisor might be involved on behalf of the government in arranging (underwriting) debt financing for the new entity. A transaction fee would be usual for underwriting. However, by June 1995 when the request for ratification was sent to Treasury Board, the requirement for underwriting duties had been removed from the draft terms of engagement and no such requirement is to be found in the written contract that was signed. The duties specified in the statement of work, and ultimately set out in the contract, would not normally be paid for on the basis of a transaction fee.

19.87 Payment before written contract. By 22 September 1995, the contract had yet to be signed, due to disagreements about the appropriateness of indemnification clauses as proposed. However, the Department made a decision to pay for services rendered on the basis of an oral contract, and over $1.4 million was paid to the contractor before the contract was actually signed.

19.88 Amendment. On 20 March 1996, the Department submitted to Treasury Board a request for approval to amend the price ceiling in the still-unsigned contract, from $4.6 million to $6.9 million. It stated that this amendment was required to reflect the significant increase in value achieved by the government for the sale of NAV CANADA and for additional services required. The request does not specifically note a decision made nearly a year earlier that services to arrange financing on behalf of the government would not be required of the advisor under this contract, or that a contract had not yet been signed.

19.89 Lack of deliverables. We did not find well-defined deliverables in this contract. Although Transport Canada has advised us that it received the financial advice it needed when it was needed, it is unable to demonstrate whether value for money was received from this $6.9 million contract because it did not keep track of the time its financial advisors spent on the project or request that the advisors provide this information, to which it was entitled.

19.90 Questions about independence of advice. In May 1996, the Department gave permission to its financial advisor to participate in financing activities for the purchaser. The advisor's contract with the Department did not expire until the fall of 1996, at which time a final payment was made. According to NAV CANADA's prospectus, the financial advisor participated in the underwriting syndicate for NAV CANADA and shared in the transaction fee charged to NAV CANADA, which is the usual form of reimbursement for such activities. According to the financial advisor, its involvement with NAV CANADA did not begin until after the transfer had taken place, and its role was limited to the distribution of the securities.

19.91 We did not audit the financial advisor and we offer no opinion on its actions. Where our work touched on that of the financial advisor, we were concerned only with the appropriateness of the government's actions.

19.92 It would be reasonable to expect the government to require that its advisor on price, due diligence and negotiation strategy remain independent from the purchaser all the way through the negotiations, until the commercial closing of the deal and the physical transfer of the air navigation system. Accordingly, the Department should not have released its financial advisor from its exclusive duty to it until the transfer had been fully completed.

19.93 More generally, in many divestitures of government operations it is likely that, as in this case, in practical terms the relationship between the vendor and purchaser will be at less than full arm's-length. Government operations are often sufficiently specific that both management and labour will be a part of the divestiture. In these circumstances, in our view, it is vital that the independence of the financial advisor be fully maintained to ensure that the interests of the Crown are protected.

19.94 In future transfers, to protect the interests of the Crown, the government should ensure that the independence of the financial advisor is appropriately maintained in light of the nature of the transaction and the scope of the advisor's role in it.

The contract for a second financial advisor

19.95 On 19 June 1995 the Department sent out requests for proposals, seeking an American investment banking firm to act as an advisor to it on sale matters such as those related to the United States and international capital markets.

19.96 There were three compliant bidders. Their proposals were evaluated and the contract was awarded. The time taken to process this competitive contract, from the date of issue of the request for proposals to the selection of an advisor, was only 42 days.

19.97 The initial contract with the American advisor was for US $375,000 and covered the period 1 August 1995 to 31 October 1995. There were a number of amendments to the contract, increasing the value from US $375,000 to US $1,050,000 and extending the time for completion to 1 April 1996. This financial advisor was contractually prohibited from participating in the financing activities of NAV CANADA.

19.98 As was the case with the other contract for financial advice, the deliverables were unclear and the Department's records provide no clear link, other than elapsed time, between the work actually done and the amounts paid. Further, the Department has not provided any evidence of the services paid for under this contract for the period of January through March 1996.

Department's comments: Transport Canada's comments on this section can be found at the end of this chapter.

The Regulation of Safety

19.99 The transfer of the air navigation system to a private corporation meant that the Department was no longer responsible for delivering these services. However, in the process it has become responsible for ensuring that NAV CANADA, the new deliverer, does so safely and in compliance with the Aeronautics Act and the Canadian Aviation Regulations, and in accordance with Canada's international obligations. When it becomes aware of a safety deficiency, the Department must attend to it expeditiously. To achieve these goals, the Minister announced, "Transport Canada has established safety regulations and standards that will apply to the new corporation and will monitor its operations to ensure compliance - just as the department now does in the case of commercial air carriers - thus ensuring the continued high level of safety Canadians have come to expect."

19.100 Meeting this commitment represented a formidable challenge for the Department. It was faced with developing and instituting a regulatory regime where previously there had been internal management oversight. This had to be done in a period of about 18 months, without skirting any of the requirements for consultation and notice. This did not mean, however, that the Department was starting from zero. Like all parts of the aviation industry, the delivery of air navigation services is highly structured and disciplined; it is bound by a web of internal procedures and international standards that specify both what is to be done and (often in considerable detail) how to do it. These instruments, particularly the very comprehensive body of International Civil Aviation Organization (ICAO) standards to which Canada subscribes, formed a solid foundation on which to build a regulatory regime.

Transport Canada uses performance-based regulation

19.101 In regulating NAV CANADA, the Department decided to adopt a performance-based approach. In this type of regime, the regulator defines very clearly the results to be achieved (or avoided), and permits the regulated party to decide how it will deliver those results while providing the regulator with the comprehensive data it needs for timely assessment of performance.

19.102 Advantages and risks. This approach has the advantage of being less intrusive and less costly to administer than a prescriptive system. It is assumed that in providing performance data and in assessing its own performance, the regulated party will bear most of the cost of regulation, and the regulator will be able to gain assurance of performance through review of the performance reports and a highly selective program of audits and inspections. However, such an approach is not without its risks. The Department's Safety Review Team noted that setting up the necessary information and performance measurement systems has been an obstacle to success in other attempts at this approach. The team particularly noted the difficulties in doing this in the reform of the rail safety regime, identified by the Railway Safety Act Review Committee in its report.

19.103 The Department has stated that the decision to adopt a performance-based approach to regulation was based on its overall approach to regulation and regulatory reform, which emphasizes the use of performance-based regulations where possible. The decision was made without benefit of an adequate analysis of the appropriateness, including the risks and benefits, of using performance-based regulation for the delivery of air navigation services by a private corporation. Developing a revised regulatory regime, starting from a well-established set of regulations and regulatory procedures in a relatively stable set of relationships, is a task very different from setting up a new regime for a new organization with new senior management. However, the risk was mitigated by the fact that the new regulations were fully reviewed by the Canadian Aviation Regulatory Advisory Council, a group made up of representatives from all areas of the aviation industry.

19.104 The new regulatory program for the civil air navigation system was not developed on the basis of a comprehensive analysis of the risks inherent in it. Although work was done to identify the relative seriousness of the principal hazards in the system, no documented risk analysis was conducted.

19.105 Because it assessed as low the safety risks inherent in NAV CANADA's early operation of the system, the Department's strategy was to start with the minimum number of components for a performance-based program. This decision was based on three assumptions:

that the air navigation system, as provided by the Department at the time of transfer, had achieved an acceptable level of safety;
that the operational environment would remain relatively stable after the transfer; and
that the transfer would be "seamless."

19.106 Our work looked at two issues. First, effective performance-based regulation requires a number of components, which have been identified in the literature and in internal departmental reports. We assessed the extent to which those components are in place. Second, any regulatory regime requires that the regulator undertake a number of tasks in order to have assurance about the level of regulatory compliance. We looked at the Department's activity in this area; that is, at the procedures it had in place to obtain assurance that air navigation services were being delivered safely.

The System Safety Review

19.107 One of the key activities carried out by the Department in preparing for its role of safety regulator was the System Safety Review. This was an ongoing process that began in June 1995 and ended with the final report in July 1996; four interim reports were issued. The purpose of the review was to provide the Department with an ongoing assessment of the risks associated with the transition of the air navigation system from a government operation to a private enterprise.

19.108 The System Safety Review report identified several basic requirements for a performance-based regulatory regime:

identification of regulatory goals;
general reliance on standards of quality and performance measurement;
determination of the most effective means of mitigating and monitoring air navigation system-related risks; and
development of extensive feedback mechanisms to sample, analyze, and evaluate the effectiveness of the risk mitigation.

19.109 These requirements are very close to those we identified in setting our criteria for this part of our audit. We expected that in setting up such a regime the Department would develop:

clear and comprehensive performance objectives or goals for each of the areas subject to regulation;
a formal risk analysis leading to the identification of the key performance goals for which data are to be gathered to monitor performance;
the specifications of the measurement procedures and data to be used to monitor performance;
procedures to ensure timely and unimpeded access to all necessary data;
assessment of the data quality; and
procedures to carry out independent verification of the data.

19.110 We discuss each of these below.

Performance goals for air traffic control

19.111 We found that the Department had established in the regulations the key performance criteria for air traffic control services, in the form of the Canadian Domestic Air Traffic Control Separation Standards. The critical performance goal for this area is the avoidance, through appropriate air traffic control, of losses of separation (distance) between aircraft. In other areas, such as the provision of navigation aids, the relevant ICAO standards have been incorporated into the regulations by reference; however, the ICAO standards are extensive, detailed and largely prescriptive. One area, automated systems, does not appear to be subject to any regulation, nor are there any current ICAO standards that apply, although Canadian air traffic control depends on such systems to a significant degree. In the interim, the Department is working on these issues with NAV CANADA to develop appropriate standards for automated systems performance. Once ICAO has developed standards in this area, they will apply to NAV CANADA.

Need for risk analysis

19.112 In a performance-based system that regulates an area as large and complex as the air navigation system, it is not practical to monitor everything. Risk analysis assists management in identifying the areas that need the most attention, and encourages the most cost-effective allocation of resources.

19.113 The need for risk analysis was identified relatively early in the System Safety Review process. The System Safety Review Team identified and catalogued the risks in the existing air navigation system and those inherent in the new regulatory regime, but it realized that its work was not a substitute for the type of systematic and quantitative analysis that was and is required. Since the transfer, the Department has settled on the methodology it will use for risk analysis and has identified the need for staff training. However, it will be some time in the future before the necessary analysis using the new methodology can be undertaken.

Reporting on performance of the air navigation system

19.114 Once the performance goals to be measured and the indicators to be used to measure them have been defined, the sources of the data used to create the indicators must be identified. For the air navigation system, the principal source of data is an incident-reporting system operated by Transport Canada, called CADORS (Civil Aviation Daily Occurrence Reporting System). Until the transfer, CADORS was an internal departmental management system designed to provide for quick reporting of a wide variety of aviation occurrences so management could identify problems and act quickly when necessary.

19.115 The new regulations have imposed on NAV CANADA the requirement to produce reports that conform with the requirements of the CADORS Manual. The CADORS has the capability to provide relatively complete information on losses of separation - the avoidance of which is the principle objective of air traffic control services. However, while it can and does provide information on other aspects of the air navigation system, such as reporting on identified beacon failures, other sources of information on many NAV CANADA services will have to be identified.

19.116 The requirement that NAV CANADA report in accordance with the CADORS manual should, subject to NAV CANADA's compliance, provide for the timely reporting of key data.

19.117 One of the problems identified in the System Safety Review was whether all incidents that were reportable under CADORS would be reported. This had been a problem and was anticipated to continue after the transfer. Transport Canada needs to work out a means whereby it can gain assurance that the CADORS reports it receives from NAV CANADA are complete. Since the transfer, there have been some problems in this area and the Department has informed us that it has taken steps to gain greater assurance. It compares the reports it receives from NAV CANADA with data from the mandatory incident-reporting system operated by the Transportation Safety Board. We have requested documentation of this process, but the process appears to be relatively informal and no documentation has been provided. While the threshold of seriousness in the Safety Board's system is higher than in CADORS, a proper reconciliation would provide some assurance on the consistency of reporting between the two systems, and at a relatively low cost.

19.118 The Department has indicated to us that it is concerned about the problems of having a number of different systems measuring various aspects of aviation safety, using different definitions and sensitivities. It is considering developing a single system to capture the necessary performance information on a consistent basis. In view of the Department's commitment to increase the use of performance-based regulation, the development of reliable and economical sources of data is important.

Independent verification of performance data

19.119 One of the obligations of the regulator, particularly in a performance-based regulatory regime, is to perform independent tests from time to time to derive the necessary assurance that the information on which it is relying is accurate and complete. In the case of the air navigation system, such verification is made possible by the requirement that recordings of both voice and operational information be made and retained by NAV CANADA. Considerable operational data can also be obtained from flight records and tapes.

19.120 In a new regulatory environment, one would normally expect the level of audit activity to be quite high, declining over time as problems were resolved and assurance of reliability achieved. However, by the end of our audit fieldwork the Department had neither planned nor conducted any audits to verify the quality of the data supplied by NAV CANADA.

Audit and inspections of safety

19.121 One of the key elements in the safety regulatory regime is the requirement that NAV CANADA have a safety management program by which it monitors, inspects and reviews its own operations. Transport Canada believes that once this program is fully operational, it will be able to derive much of the assurance it needs about NAV CANADA's compliance with the necessary procedures by receiving and reviewing the products of that safety program. It should be noted that while NAV CANADA is required by the regulations to develop such a program, the program will not be required to meet with Transport Canada's approval. Nor, it appears, would the absence of that approval bar NAV CANADA from operating the air navigation system.

19.122 Once NAV CANADA's safety program has been completed and put fully into operation, the Department will still need to supplement its receipt and review of NAV CANADA's reports with direct audits and inspections of its own. As noted in our discussion of data verification, we would expect the level of audit to be relatively high until a clear pattern of reliance has been established. In particular, we would expect the effort to be particularly intensive during the period when management's controls and procedures are still being designed and put in place. By the completion of our audit work, however, because it assessed the risks as low, the Department had only limited audit plans to conduct Site Manual validations and had not yet done any safety audits of NAV CANADA.

Safe delivery of air navigation services

19.123 When the government agreed to the transfer of the air navigation system, one of the conditions it established was that the necessary safety regulations and the Transport Canada resources to apply and enforce those regulations be in place prior to the transfer. The Department had the current regulations in place prior to the transfer date, and it had staffed some, but not all, of the positions in the new directorate that is responsible for regulating NAV CANADA. In particular, the Department has stated that all key personnel were in place with adequate resources. However, as we have noted, Transport Canada has some distance to go before it has in place a fully functioning regulatory regime for NAV CANADA. The legal and regulatory foundations have been established and the Department has very recently approved its Policy Framework for the Safety Oversight of Canada's Air Navigation System. Nonetheless, there are important matters of risk, data, and audit and inspection that must be resolved before the regime can be said to be fully operating. Based on the System Safety Review and a consultant's follow-up report for the Department after the transfer, the Department is fully aware of the issues that need to be resolved and is in the process of drafting action plans and taking steps to deal with them. According to the Department's plans, it will take well into the next year to resolve some of the outstanding issues related to risk analysis and performance measurement.

19.124 In discussions with departmental officials we have been informed that there is nothing untoward in this state of affairs; in their view, the risks inherent in the situation are very low. Indeed, the Department has written to us to state that in its view, as at the date of transfer and since then, the necessary safety regulations and Transport Canada resources for the application and enforcement of those regulations have been in place and functioning in all material respects. While the Department has not fully implemented its safety oversight program, and does not have assurance of NAV CANADA's compliance with the safety requirements of the Canadian Aviation Regulations, it points to a number of factors that give it some comfort that it would be aware of any problems that existed. These factors include the view that prior to transfer the system was safe and that it will continue to be operated by NAV CANADA in the same way, including the continuation of all of the system safety oversight activities formerly carried out by Transport Canada; its strong belief that NAV CANADA's management has no incentive to operate in other than a safe manner; the data and information that it currently receives from NAV CANADA, including personal contacts with key NAV CANADA personnel; and, at senior levels in the Department, ongoing contacts with NAV CANADA's clients.

19.125 Comfort, however, is not assurance. Assurance is the result of a planned process of analysis and investigation. Until Transport Canada has made significant further progress in implementing the key elements of its performance-based regulatory regime, it will not be in a position to have full assurance concerning NAV CANADA's operational compliance with the requirements of the Canadian Aviation Regulations and ICAO standards. At the end of our audit, more than half a year had passed since the transfer and no audits or inspections of NAV CANADA's operations had been conducted by Transport Canada.

Transport Canada's comments:

Regulation of Safety

Transport Canada is confident that the new air navigation system provider, NAV CANADA, is committed to highly safe operations and indeed the Canadian Aviation System remains among the safest in the world. This commitment to a high standard of safety is ensured by:

1. the government's regulatory powers under the Aeronautics Act;

2. the authority of the Minister under the Canadian Aviation Regulations to issue an order to NAV CANADA to maintain or increase the level of service in the interests of safety; and

3. the requirement to notify Transport Canada of any occurrences, coupled with the Department's powers to inspect and audit.

The government has authority under the Aeronautics Act over all aspects of aviation including the safety oversight of air navigation system service providers. Part VIII of the Canadian Aviation Regulations (CARs) applies specifically to the air navigation system. The regulations provide for standards to be achieved by NAV CANADA, and the Aeronautics Act provides the authority for audit and inspection of services and facilities. Licensing and training standards for air traffic control are also specified in Part IV of CARs. NAV CANADA must also notify the Minister of the termination or reduction in the level of service and the Minister has the authority to request that the service be maintained or increased in the interest of safety. The Department is vigilant in overseeing operations to ensure that Canada's exemplary aviation safety record is maintained in the new, innovative operating environment.

The Auditor General recognizes that prior to the transfer of the air navigation system to NAV CANADA, Transport Canada had established the legal and regulatory foundation for the regulation of NAV CANADA. Transport Canada had also established a multi-disciplinary team to assess the scope of the safety oversight program, developed a new branch with inspection and audit authority, and completed a comprehensive System Safety study.

Further work has been completed since the transfer, such as the completion of a Regulatory Framework, which includes the program for inspecting and auditing facilities and investigating safety issues and incidents.

It had been more than 50 years from the inception of the air navigation system until its sale to NAV CANADA, at which time the personnel and operating infrastructure were transferred in total. As a result, at the time of the transfer, it was the Department's assessment that the air navigation system had achieved an acceptable level of safety and that the new corporation would assume management of the air navigation system in a responsible, professional and safe manner, given that there was essentially no change in operational staff and that an effective safety program had been established by NAV CANADA.

The studies referred to in the Auditor General's Report were initiated by the Department as a self-assessment of the air navigation system's regulatory safety program and the status of implementation. Both an internal study and a consultant study have been used to reconfirm and refine elements of the program. The self-assessment studies initiated by the Department reflect the philosophy of continuous improvement needed in a highly technical and complex national air transportation system.

Value and Process

The Department is of the view that the price agreed upon for the air navigation system represented the best deal available in the circumstances at the time of the transfer.

Both the purchase price and the choice of a one-phase transfer were appropriate and completely justifiable, given:

the policy decision to pursue exclusively the not-for-profit corporation model with user group involvement;
the economic climate and risks assumed by the purchaser;
the need to move quickly to capitalize on industry and employee consensus; and
the pressing need for a new management model to meet current technological challenges.

One of the government's key objectives was to transfer the air navigation system to a not-for-profit corporation with a suitable balance of stakeholder interests and an acceptable framework for accountability, governance and safety. Considerable time and effort were invested during 1994-95 in working with an Advisory Committee made up of a wide diversity of stakeholders to arrive at such a balance of interests.

Clearly, it was an immense step to move from a departmental program into a private sector corporation. However, a two-phase approach would have delayed implementation of organizational improvements and led to continuing technological and operational delays for air navigation system users. It was also important to seize the window of opportunity presented by the consensus that had been reached in the aviation community and with ANS employees and their bargaining agents as to the direction to be taken.

An extensive study phase preceded the decision to transfer the system, during which various criteria and assumptions were developed and a number of financial models and other equally important aspects of the proposed transfer were examined. Following this study phase, a set of principles to guide the negotiations was approved by Cabinet.

The monetary value was important for the government. However it was not the sole objective. If it had been, the transfer would not have taken place the way it did. This context is ignored in the Auditor General's review of the transaction. It might have been easier to address the value question and other matters through a two-phase process. However, given the opportunity to capitalize on the acceptance of alternative service delivery concepts, the "user pay-user say" willingness exhibited by the aviation industry and the need to move quickly, the government decided to commercialize the air navigation system directly from a departmental program.

There is also an historical context to the negotiations that is ignored in the Auditor General's report. This opportunity was being pursued in a period of considerable economic uncertainty and risks that had to be managed, such as:

interest rates;
the deficit;
credit ratings;
future trends in aviation traffic;
the potential for revenue fluctuations;
uncertain operating and technology system modernization costs;
the challenges of introducing efficiencies to the system while at the same time retaining good relations with a unionized workforce.

All of these factors affected the nature of the transfer of the air navigation system to an entity that had to exhibit long-term viability to lenders. There were legitimate concerns about the ability of a new entity to raise very large amounts of funds at an acceptable cost. It was concluded that these factors contributed to a value that could be represented not only by cash but also by the acceptance by NAV CANADA of these obligations and risks.

The opportunity was seized and the price was negotiated within this context.

With respect to the determination of monetary value, depending on the model and assumptions used, a wide range of values for the air navigation system was generated, varying from approximately $1.1 billion to $2.6 billion depending on the assumptions. Given the decision to use the not-for-profit model, and that negotiations took place between a willing and knowledgeable purchaser and seller, it is the Department's opinion that the $1.5 billion cash proceeds represented the best deal available given all of the circumstances at that time.

It should be recognized that the purchase price or value ultimately has to be recovered from users of the air navigation system. The not-for-profit entity ensures that users are not burdened with the profit- maximizing objective of a for-profit entity that would pass on this additional cost to users.

Transport Canada had to address many of the information requirements to complete this transaction on an ongoing basis. Information to the Treasury Board and other decision makers was disclosed as the data became available for reconciliation and consolidation.

It is true that the Department was unable to identify all of the ultimate points around the transaction until certain building blocks and timing issues were completed. This situation made accurate determination of certain costs impossible until much later, but at no time were decision makers misinformed as to the magnitude and implications of the contemplated transaction.

Contracting Practices

Transport Canada had a short period of time to achieve the commercialization of the air navigation system. Following the Budget of February 27, 1995, the Minister of Finance announced the government's intention to proceed with the commercialization of the air navigation system. The Department was to achieve this result as early as possible in fiscal year 1996-97.

Given the relatively short timeframe to achieve this result, the Department elected to build upon the expertise and familiarity of a financial advisor who had previously assisted in developing appropriate models for the commercialization of the air navigation system. The advisor would be retained to provide a variety of financial services to the Department to implement the "not-for-profit" model. The time required to potentially bring another financial advisor "up to speed" through a competitive contracting process would have severely impeded the Department's ability to meet the expected timeframe for implementing the commercialization of the air navigation system. This exact rationale was provided by the Department in its submission to the Treasury Board to ratify a non-competitive contract with a financial advisor.

The execution of a written contract between the Department and the financial advisor did take several months to complete, as the Department and the financial advisor could not come to a successful resolution on a common understanding of the term "indemnification" in the context of this particular contract. However, all other conditions of the proposed written contract were agreed to by the parties at the very early stages of the contract engagement.

Paragraph 19.86 of the Auditor General's Report makes reference to underwriting duties of the financial advisor being "removed from the draft terms of engagement and no such requirement is found in the written contract that was signed." The Department erred by this omission, as it had been an integral part of the negotiation and contingency planning process with the financial advisor and was included in the agreement with the financial advisor.

Treasury Board Secretariat's comments:

Severance and Pension

On severance, the government's decision was that it would honour its contractual obligations and respect the collective agreements with its unions, i.e. to pay severance at the lay-off rate. This decision was taken with full knowledge of the associated higher costs.

On pensions, the overall potential liability transferable for pensions, estimated at up to $1.4 billion, was fully disclosed to the decision makers, as well as the proposed terms of the agreement. The negotiated actuarial assumptions recognized that NAV CANADA would be investing the transferred funds at prevailing market rates while the government returns were based on investments made over the past 20 years.

In our view, the additional costs in the chapter are overstated and the final amount is expected to be some $100 million to $120 million in excess of the actuarial liability. This amount will reduce the growth in the actuarial surplus in the Public Service Superannuation Account but does not increase the government's expenditures related to pensions.

Contracting

It is the view of the Secretariat that the contract submissions from Transport Canada, as approved by the Treasury Board, were supportable and met the requirements of the Government Contracts Regulations and, apart from the retroactivity involved, conformed to the Treasury Board Policy on Contracting.

About the Audit

Scope

Our audit focussed on the key elements of Transport Canada's implementation of the government's decision to transfer the civil air navigation system. We examined the definition and valuation of the entity to be sold, the controls in place to safeguard government assets during the transition, the compilation and disclosure of the costs to the government of the transfer, the contracting for financial advice and the procedures that Transport Canada had put in place to obtain assurance that NAV CANADA was operating the system safely. We did not audit the safety of the air navigation system and provide no opinion on it.

It should be noted that prior to the decision to transfer, Transport Canada considered several options for the commercialization of its air navigation system. Options such as the establishment of a Crown corporation or a mixed enterprise or the transfer to a not-for-profit private corporation were studied in detail. We have not audited the government's decision to transfer the air navigation system or its decision to transfer it to a not-for-profit entity.

Several other areas were excluded from the audit: Transport Canada's negotiation strategy; review of Transport Canada's overhead, direction and administration costs after the transfer; the impact of the timetable on the quality of the agreement to transfer; the roles and responsibility of Transport Canada after transfer, other than safety; NAV CANADA's effectiveness in meeting the objectives set by the Government of Canada for transferring the air navigation system; minimum levels of service; air navigation system guarantees; and the introduction of NAV CANADA's charges to replace the Air Transportation Tax.

We did not audit NAV CANADA and express no opinion on its actions.

Objectives

Our audit objectives were to assess whether:

Transport Canada protected the taxpayers' interests by following the government's direction to receive fair market value from the sale of the air navigation system, and exercised due regard to economy in the valuation of the entity being sold;
there was full disclosure by Transport Canada to decision makers of information on the value of the air navigation system;
Transport Canada disclosed to Parliament the full cost of commercializing the air navigation system;
Transport Canada put in place the necessary control procedures to safeguard assets and control liabilities during the transition period;
Transport Canada followed the contracting rules in contracting for financial services;
Transport Canada received value for the price paid for advisory services;
Transport Canada has put in place the components necessary to support its performance-based approach to the safety regulation of air navigation services; and
Transport Canada has carried out the various tasks - risk analyses, data analyses, audits and inspections - necessary to provide it with assurance of NAV CANADA's compliance with the laws and regulations governing the operation of the air navigation system.

Audit Team

Régent Chouinard
Charles Gay
Sonja Heikkila
Michelle Lavallée
Rosemary Marenger
Alnoor Nathoo
Nicole Bertrand-Pétrin
Marial Stirling
Cyril Lee-Shanok
Sami Sourani
Jaak Vanker
Judy Wong

For information, please contact Hugh McRoberts, the responsible auditor.

1997 October Report of the Auditor General of Canada

Chapter 19—Transport Canada The Commercialization of the Air Navigation System