Open skies and flights of fancy

Date: 04/10/03

Europe and America began talks this week on liberalising flights across the Atlantic. They could lead to a long overdue rationalisation of the airline industry

THE airline business is an aberration. Distorted by decades of subsidies and international cartels, it has never earned a real rate of return on its investors' capital in its 60 years of existence. Two developments this week give hope that that may be about to change. Negotiators from the European Union and the United States held their first talks in Washington, DC, about liberalising transatlantic aviation, the day after an announcement that Air France and KLM Royal Dutch Airlines are to come as close to a cross-border merger as the industry's arcane rules currently allow. The deal shows the determination of Europe's airlines to consolidate in order to survive; the EU-US talks could lead to the removal of obstacles to a more global consolidation of the industry.

This will have profound implications for travellers. In ten years' time there may be only a handful of multinational airlines left, all of them with seamless networks covering the globe. A visit to the website of one of them will be enough to book any trip in the world to any number of destinations. Beside these global giants will be a number of small airlines running business-only flights to a large number of places. There may also be supersonic Airbuses flying across the Pacific and a new low-cost carrier in Europe called easyAtlantic. Before this can happen, however, the industry will have to go through a period of accelerated evolution.

Manifestly not open

Although the Air France and KLM brands are to remain separate, the partnership between the two promises to become more intimate than any other cross-border deal in the industry. Most airline alliances are little more than joint-marketing exercises, but the Franco-Dutch group plans to integrate its operations more fully.

Moreover, the partnership may not stop there. Alitalia, Italy's flag carrier, has expressed a desire to get closer to Air France, and both members of the new alliance made it clear this week that they would welcome a trilateral grouping. KLM has been seeking a partner for years. An attempt to link up with Alitalia fell through three years ago, just before a planned deal with British Airways was shot down by the Americans. Washington indicated that, if BA took control of the Dutch carrier, the bilateral deal between America and the Netherlands would be cancelled.

The industry is riddled with such bilateral agreements between governments. They control market entry (which airlines can fly) and market access (where they can fly to). Mostly, they also govern frequency and the number of seats per flight. Some of the older ones still give governments power to intervene on prices.

The Americans feared that BA would use its link with KLM to gain more access to American destinations through a back door - ie, by flying direct from Amsterdam's Schiphol airport to, say, New York. In this week's deal, KLM and Air France have come up with an ingenious way by which they hope to circumvent the rules that tie traffic rights between two countries to domestically owned carriers. Although current Air France shareholders will own 81% of the combined holding company, 51% of the KLM subsidiary will actually be owned by Dutch interests for three years.

Clues as to America's reaction to the deal, which has to win clearance from both American and EU antitrust authorities, could lie in the EU-US talks that began in Washington on October 1st. The aim of the talks is to extend the liberalisation of transatlantic traffic. Until last year, such negotiations took place between America and individual European countries. But in 2002, the European Commission won a court ruling that the arrangement was unlawful on the grounds that, for instance, a German-American bilateral deal allowing only Lufthansa to fly transatlantic flights from Germany discriminates against airlines from other EU countries. Subsequently the EU's Council of Ministers voted to give the European Commission power to negotiate with America on an EU-wide deal.

That landmark ruling could change the whole of aviation, moving it from a regulated market of protected national flag-carriers to a truly global business where cross-border mergers and acquisitions are as commonplace as they are for banks.

America's tactic is to build on the bilateral deals it already has with 11 EU countries and to extend them to the whole union, from Greece to Lithuania, via a single agreement forged with the European Commission. Europeans, on the other hand, want a much more ambitious arrangement that would scrap all restrictions, end ownership rules and open access for their carriers to the huge internal American market. The commission wants to create what it calls an “open aviation area” covering Europe, America and the water between them. Under the pugnacious transport commissioner, Loyola de Palacio, the EU has conceived a plan to sweep away all regulations except those on technical and safety matters.

America has some more specific goals too, such as getting more of its airlines into London's Heathrow airport, the biggest international hub in the world. That privilege is at present reserved for United and American Airlines which inherited the rights of PanAm and TWA when those two old brands withdrew as their fortunes waned. But no amount of liberalisation can make that happen on its own; there will be little spare capacity at Heathrow until a fifth terminal and a third runway are built, and both are years away.

It would be a fitting commemoration of 100 years of powered, manned flight if the negotiators at their second meeting, scheduled to take place in Brussels a few days before the historic anniversary on December 17th, could start to untie the knots which have hobbled international air travel ever since it began.

Prussian-style deregulation

The regulatory mess that is international aviation goes back over half a century. At a conference in Chicago in November 1944, governments attempted to lay down the technical and legal rules for the post-war order in international air transport. America had been keen to establish a competitive regime with minimum regulation, not least because it saw the ability of its airlines to dominate such an industry.

But other countries at the conference refused to go along with this. They saw aviation as a matter of national prestige and sovereignty. Thus was born the arcane system of bilateral deals, which not only regulate direct traffic between pairs of countries but also control rights to pick up passengers at a destination and carry them on to a third country. All the various rights were curiously known as the “seven freedoms of the air”, pure Orwell-speak for the exact opposite. In aviation, as in Frederick the Great's Prussia, everything is forbidden that is not expressly permitted.

Alongside this legal bindweed went a tariff-setting arrangement organised through the International Air Transport Association (IATA). For more than 40 years IATA ran a sort of international cartel controlling the price of tickets. Once a pair of airlines had agreed fares through IATA, they had to be approved by both governments involved. Some of this collusion was (indeed, still is) necessary for pooling revenues where a passenger flies one leg of a journey on one carrier and the next part on another. But in practice it amounted to an amazing global cartel that made OPEC look amateurish. Air travel was for a long time limited to the rich because the fares were sky-high.

That first started to change within America itself, when the industry was liberalised in 1978. The federal government withdrew from economic regulation, and any competent airline was free to fly where and when it wanted at prices determined by the market. The result was an explosion in air travel, which rose by 150% over the next 20 years.

The most authoritative studies, done in the mid-1990s, of the effects of liberalisation within America showed that consumers benefited to the tune of $20 billion a year. Fares were 20% lower than they would otherwise have been, and 80% of passengers enjoyed lower fares, especially on routes flown by the new low-cost carriers, such as Southwest Airlines and AirTran (formerly ValuJet).

But the big network airlines gained too. They developed hub-and-spoke systems to suck up traffic from small markets and feed it on to bigger, cheaper flights between hub airports. This system, first developed by American Airlines in the 1980s, led to planes being three-quarters full instead of half-empty.

Europe took nearly 20 years to follow suit, but by 1997 the same rules applied within the EU. Any airline could set up anywhere and fly anywhere within the union's boundaries. At one point, BA was running subsidiaries in both France and Germany, though with little success.

The real achievement of Europe's deregulation was exactly the same as in America: the emergence of low-cost carriers, initially easyJet and Ryanair in Britain and Ireland but with imitators now taking off in Germany, Italy and Spain. The low-cost airlines are on their way to grabbing the same 25% share of the air-travel market in Europe that the pioneers of this approach already have in America.

As Europe liberalised its internal market, America started signing up European countries for bilateral deals, starting with the Netherlands in 1993, but later covering France, Germany and some smaller countries. Although anything but open, these were dubbed “open skies” agreements because they were, at least, more liberal than the old-style arrangements. The country's carriers got to fly to more American cities than before, in return for allowing American carriers to fly from anywhere in the United States to more of its cities.

The two governments in each case dropped all restrictions on flights, capacity and pricing, opening the door to competitive fares. European nations' single flag-carriers were allowed to form alliances with American partners and were given immunity from American antitrust law to fix prices. Indeed, under the first open-skies deal, KLM and Northwest proceeded to pool their transatlantic flights and revenues in a close operating alliance.

The proliferation of such deals, not just with Europe, boosted the revenues of American airlines as the number of international passengers went up by nearly half in the 1990s, while internal traffic increased barely at all. A couple of studies showed that tickets booked through allied airlines on two-stage flights were 18-28% cheaper than separate flights on the same route with non-allied airlines.

But these deals are of more benefit to American carriers than to Europeans. American airlines can fly from anywhere in their own country to European cities, but a European carrier can fly only from its home base. Since the traffic rights they confer are restricted to airlines owned by the European signatory, they inhibit cross-border European integration (or have done so until KLM's attempt to wriggle through this week). No transatlantic merger is possible either, because America limits foreign shareholders to 24.9% of its airlines, while Europe limits non-EU ownership to 49%. Moreover, European carriers are not allowed to pick up passengers in one American city and fly them to another.

If Europe and America can shed these rules and completely liberalise their airspace, the rest of the world will be forced to follow. The two regions together account for well over half the world's air traffic. Global takeovers will then be possible, leading to consolidation and economies of scale. From this, a handful of mega-airlines could come to rule the skies.

The appliance of alliance

This week's Air France-KLM deal indicates how a new global airline industry might emerge. Once the two hook up, KLM's existing American partner, Northwest, will join the SkyTeam alliance, one of the loose international groupings that airlines have formed faute de mieux. It will be followed by Continental Airlines (with which Northwest already does joint marketing inside America), and that will make SkyTeam a close rival to Star, the biggest of the international groupings. Together with oneworld, the three could, in a fully liberalised world, be the kernel of three global mega-carriers.

If the antitrust authorities ever tolerate anything like this, flight costs could come down sharply through economies of scale. Travellers around the world would then routinely enjoy the lower fares that they get now only on off-season deals and low-cost regional flights.

There is always a chance that the talks beginning this week will go nowhere. Although the Americans have been saying for some years that they are looking forward to negotiating with the European Commission on an EU-wide agreement, they might just be aiming to impose the same template of limited open-skies deals already signed with 11 EU countries and with almost 50 others outside the EU. “We sure do like our template,” said one American negotiator ominously when news came through last year of the commission's mandate to negotiate for the EU.

The Americans may prefer to settle for something else, even though there is a feeling in the industry that it is high time to apply free trade rather than just pay lip service to it. The most vocal proponent of total liberalisation of air traffic is Fred Smith, boss of the global air-freight company, Fedex. But leading figures such as Don Carty (until recently chairman of American Airlines) and Rod Eddington (boss of BA) have called for aviation to join the world's free-trading system rather than stay stuck in its time-warp. Even IATA, for long a pillar of the regulated system, is now campaigning for free trade. The danger, as one European airline executive puts it, is that the American airlines “right now have enough on their plate simply trying to survive.” They are set to make losses of around $5 billion this year.

There are plenty of sceptics around. Although BA says it is in favour of the EU's total liberalisation, it might be leery of proposals to open up Heathrow too much. In America, the airlines' unions have great power, and they are sure to oppose the opening of domestic American traffic to foreign airlines. And critics of the EU vision say that such a wholesale re-drawing of the aviation map will stall in disputes over the many intricate details involved, such as concerns about the oversight of safety, technical and security matters.

There are political obstacles too. Ms de Palacio's replacement when she vacates her transport commissioner's chair next year might be some time-server with no drive to push for the same vision. Besides, nothing much can happen before America's presidential election next November.

In the short term, the best that can be expected is for a series of working groups to be set up next spring to find a way to implement an open aviation area. The EU has calculated that such an area across the Atlantic could benefit consumers to the tune of €5 billion ($5.8 billion) a year, and help carriers by stimulating traffic and facilitating consolidation. It will be a long and difficult journey, but consumers should not forget what they have to gain from reaching the destination.

Talks between the European Union and United States on liberalising flights across the Atlantic began in Washington on 1 October 2003. They could lead to a long overdue rationalisation of the airline industry.

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