This presentation aims to discuss the:
- business models used by airlines today;
- international regulatory framework governing airlines; and
- relevance of the regulatory framework to emerging business models
SMU DEDMAN SCHOOL OF LAW AVIATION LAWINTERNATIONAL REGULATORY ISSUES IN AVIATION J. Otto Grunow Associate General Counsel American Airlines November 8, 2007
OVERVIEW• What are the business models used by airlines today?• What is the international regulatory framework governing airlines?• What is the relevance of the regulatory framework to emerging business models?
COMPETING BUSINESS MODELS• “Hub and spoke” airlines• “Point to point” airlines
Scenario A“Point to Point” BermudaNew Orleans Caracas Bogota
Scenario BHub With 2 Flights Bermuda Miami New Orleans Caracas Bogota
Scenario B Hub With 2 Flights % Scenario A Scenario B CHANGEMarkets Served 2 8 300%Passengers in MarketsServed 3 662 25914%Aircraft Miles 3533 4580 30%Ground Crews 4 6 50%Air Crews & Aircraft 2 2 0%
Hub Scenario B• Combining passengers from different origin cities to a common destination increases revenue• Requiring an aircraft to stop at a hub (instead of going nonstop as the crow flies) only increases costs relatively modestly (more fuel, more ground crews) > in reality, instead of one aircraft flying through the hub, use optimal mix of small and large aircraft transferring passengers at the hub
Hub Dynamics2600 Markets Served24002200200018001600140012001000 800 600 Ground Crews, 400 Air Crews & Aircraft 200 0 0 5 10 15 20 25 30 35 40 45 50 Number of Flights in Complex
Point to Point Scenario• Focus only on markets that have sufficient demand relative to aircraft capacity• Simplified fleet: one type of aircraft; less training; eases maintenance, etc.• No frills service• Extreme focus on cost control• Result: even with lower ticket prices, unit revenue should exceed unit costs
INTERNATIONAL NETWORKS• Traffic aggregation power of a hub and spoke system is well suited to international service• Low cost “point-to-point” airlines have not yet fully demonstrated the ability to serve international markets – Aircraft type, range and seat density – Product complexity• But hub and spoke networks have greater challenges to overcome in the rigid international regulatory environment
INTERNATIONAL REGULATORY FRAMEWORK• Unlike international freedom of the seas, there is no general “freedom of the air”• Chicago Convention of 1944 established the framework for economic regulation of international aviation – Also created the International Civil Aviation Organization (ICAO) to address technical issues, safety, navigation, etc.• A multilateral approach to air transportation favored by the U.S. was rejected in favor of a bilateral approach favored by the Europeans• The Bermuda conference of 1946 produced a bilateral agreement between the U.S. and U.K., and served as a model for many agreements to come
CONTENTS OF BILATERAL AGREEMENTS• A patch quilt of bilateral aviation agreements restricts the number of carriers that can serve a particular market – Capacity restrictions – Limited routes – Pricing – Limits on foreign ownership and control and cabotage – Nationality clauses• U.S. bilateral agreements are executive agreements, not treaties
CONTENTS OF BILATERAL AGREEMENTS• Bilateral framework created the need for quasi-judicial proceedings between air carriers competing for limited traffic rights and opportunities – Administered initially by the Civil Aeronautics Board, and now by the U.S. Department of Transportation – Resulted in issuance of certificates of “public convenience and necessity” authorizing service on specific routes – Emergence of national “flag” carriers to exercise bilaterally-obtained rights
U.S. REGULATORY INITIATIVES• Buoyed by deregulation of the domestic airline industry which started in 1978, the U.S. started pressing for less restrictive and more flexible international bilateral agreements• The United States has since signed approximately 60 “open skies” agreements worldwide• U.S.-E.U. break through agreement signed in 2007
TRAFFIC AND NATIONALITY RESTRICTIONS• But even “open skies” agreements are not truly open• Two levels of economic regulation embedded in all bilateral agreements – “Freedoms of the air”, dating back to the Chicago Convention of 1944, define what specific markets can be served – Nationality clauses only permit airlines “substantially owned and effectively controlled” by the country in question, or its nationals, to exercise traffic rights
First FreedomNation Nation A B The right to fly over another country without landing.
Second FreedomNation Nation A B The right to make a technical landing without picking up or letting off revenue traffic.
Third FreedomNation Nation A B The right to carry revenue traffic from Nation A to Nation B.
Fourth FreedomNation Nation A B The right to carry revenue traffic from Nation B to Nation A.
Fifth FreedomNation Nation Nation Nation A B C D Third Freedom Fifth Freedom Fifth Freedom The right to pick up or let off revenue traffic between two foreign nations.
Sixth FreedomNation Nation Nation B A C The right to carry traffic between Nations B and C via the homeland of the airline, Nation A, is not recognized by the Chicago Convention.
Seventh FreedomNation Nation Nation A B CThe right to carry traffic moving wholly between Nations B andC, not to, from, or via the homeland of the airline, Nation A,is not recognized by the Chicago Convention.
Eighth FreedomNation Nation Nation Nation B B B BThe eighth freedom or cabotage, is the right to pick upor let off revenue traffic between points within a nation that isnot the homeland of the airline. Not recognized in theChicago Convention.
RELEVANCE OF BILATERALAGREEMENTS TO HUB STRUCTURE • Recall the need to combine passengers from many different origin points traveling to a common destination > some traveling from a spoke city to the hub > others originating at the hub going to a spoke city > others going from one spoke city to another spoke city through the hub
BILATERAL AGREEMENTS / HUB STRUCTURE• When the spoke cities and hubs are located in different countries, complexity quickly arises• A given plane load of passengers is often governed by a myriad of bilateral agreements with passengers authorized by different freedoms of the air• For example, on an AA flight from Miami to Buenos Aires and then on to Montevideo there are passengers in the following categories• Originating in the U.S. bound for Argentina (3rd freedom under the US/Argentina Agreement) Miami Buenos Montevideo Aires
BILATERAL AGREEMENTS / HUB STRUCTURE (cont.)– Originating in the U.S. and bound for Uruguay (3rd freedom under the U.S.-Uruguay Agreement) Miami Buenos Montevideo Aires– Originating in Spain and bound for Argentina (6th freedom under the U.S.-Argentina Agreement) BuenosSpain Miami Montevideo Aires
BILATERAL AGREEMENTS / HUB STRUCTURE (cont.) – Originating in Buenos Aires and bound for Uruguay (5th freedom under the U.S.-Argentina Agreement and under the U.S.-Uruguay Agreement) Miami Buenos Montevideo Aires
BILATERAL AGREEMENTS / HUB STRUCTURE (cont.)• If traffic rights not available or available in sub-optimal mix, hub-type economics unravel – not enough seats / frequency – not enough markets to feed sufficient passengers, particularly from the foreign end – inefficient use of aircraft (long lay-overs)
STRATEGIES FOR COPING WITH REGULATORY RESTRICTIONS • Imagine the power of a “double hub” structure to serve an exponentially greater number of “city-pair” markets U.S. Spoke Spoke Cities Cities EuropeCanada Spoke Chicago London Spoke Cities Cities Middle East Other Spoke Spoke Cities Cities Africa • Could create 40,000 or more city pair combinations
FOREIGN OWNERSHIP AND CONTROL• If a U.S. airline does not have sufficient traffic rights beyond London, why not buy a U.K. airline or vice versa?• 25% voting equity limit on foreign ownership of U.S. airlines (49 U.S.C. 40102(a)(2) and 2(15))• 49% non-voting equity interest permitted if no de facto foreign control• Similar (49%) ownership restrictions in Europe
FOREIGN OWNERSHIP AND CONTROL (cont.)• If a U.S. airline cannot fly beyond London to spokes in foreign countries, why not at least gather passengers by flying aircraft to points within the U.K. – Cabotage restrictions almost universal – In the U.S. 49 U.S.C. 41703: foreign airlines may not carry revenue passengers between points within the U.S.
STRATEGIES FOR COPING WITH REGULATORY RESTRICTIONS• International airlines seek network breadth and depth through – Codesharing to garner “feed” traffic – Joint ventures – True mergers – Alliance branding – Locally “controlled” subsidiaries
CODESHARING• Holding out of air transportation for sale using a flight designator code (“AA” for American Airlines, “BA” for British Airways, etc.) to simulate on-line connections• Codesharing as a form of sub-contracting by the “marketing” carrier to the “operating” carrier• Regulators require the marketing carrier to hold traffic rights under the bilateral agreements
MULTILATERAL ALLIANCES• oneworld, Star, Sky Team Alliances• Multilateral combination of codesharing, frequent flyer reward program reciprocity, and harmonization of other customer service features• Antitrust immunity
MULTILATERAL ALLIANCES (cont.) oneworld Star Sky TeamAmerican Airlines Air Canada AeroflotBritish Airways Air New Zealand AeroMexicoCathay Pacific ANA Air FranceFinnair Asiana Airlines KLMIberia Austrian AlitaliaJapan Airlines (JAL) bmi Continental AirlinesLAN LOT Polish Airlines Czech AirlinesMalév Lufthansa Delta Air LinesQantas Scandinavian Airlines Korean AirRoyal Jordanian Singapore Airlines Northwest Airlines South African Airways Spanair SWISS TAP Portugal THAI United US Airways
ANTITRUST IMMUNITY• To increase economies of scope and scale, and maximize traffic rights, airlines have created joint ventures as a substitute for true mergers – U.S. Department of Transportation has power under to grant antirust immunity – Bestows ability to act as a single enterprise collaborating on marketing activities and sharing revenue and profits• STAR carriers have been granted broad multilateral immunity• The SkyTeam carriers have re-applied for similar multilateral immunity• oneworld Alliance historically limited by “closed” skies
U.S-E.U. DEVELOPMENTS• Moving away from “freedoms of the air” and statutory limitations on foreign ownership and control• This follows a European Court of Justice decision declaring nationality clauses in the U.S. Bilateral Agreements with various European countries unlawful – Violates a European “right of establishment”: e.g. a Greek carrier must have the right to set up shop and exercise traffic rights from France
U.S.-EU OPEN SKIES• After nearly five years of negotiations, the U.S. and EU agreed to a first stage “Open Skies” agreement in March 2007 – The agreement will take effect March 2008• Under the terms of the agreement, EU carriers will be able to operate from any city in the EU to any city in the U.S. and vice versa – In traditional bilateral terms, these are seventh freedoms
U.S.-EU OPEN SKIES (cont.)• Most important is the opening of Heathrow airport – Today only American, United, British Airways and Virgin Atlantic are permitted to operate in the U.S.- Heathrow market• U.S. carriers will launch new services to Heathrow – Delta, Continental, Northwest and U.S. Airways have already announced new services – Incumbents will shift Gatwick services to Heathrow to respond to increased competition
U.S.-EU OPEN SKIES (cont.)– The agreement does not provide for new landing and takeoff slots at Heathrow; carriers must find their own slots and facilities in order to operate Heathrow routes • Lucrative “gray” market has developed, with carriers relying on the UK High Court’s decision in the Guernsey case to legitimate multi-million dollar slot “swaps”
COMPETITION TO CONTINENTAL EUROPE WILL ALSO INCREASE• Virgin Atlantic has announced plans to launch new service from Paris, Frankfurt, Milan and Zurich initially to New York, and later to other U.S. destinations• British Airways has plans to launch a series of new services from continental Europe to the U.S. in the summer of 2008• Relaxation of bilateral constraints in U.K., Spain, Ireland and other EU countries will facilitate antitrust immunized Alliances
POINT-TO-POINT INTERNATIONAL SERVICE• Emergence of Maxjet, EOS and Silverjet in the U.S.- London market – Operating from secondary airports (e.g., Stansted, Luton) – Less dependent on connecting passengers and hub flows – Premium product focused on locally-originating business travelers• Low cost carrier Ryanair is considering service from Stansted, Dublin and Frankfurt to U.S. points
POINT-TO-POINTINTERNATIONAL SERVICE (cont.) • Eos Cabin Configuration• MAXjet Cabin Configuration
FUTURE U.S.-E.U. DEVELOPMENTS• Second stage negotiations to be completed by 2010 to address more controversial issues including: – Further liberalization of traffic rights (cabotage) – Additional foreign investment opportunities and control of U.S. carriers
CONCLUSION• International strategy will continue to be driven by two important principles: – Hubs will continue to be valuable traffic aggregators – Network ubiquity is important to customers • Codesharing and brand alliances enhance the network and provide a transition strategy • Ultimately, cross-border M & A will help international airlines find optimal scope and scale• Point-to point niche carriers may get stronger