The Power of Flight

Ladies and Gentlemen, distinguished guests, good evening. It is a pleasure to be here tonight and an honor to have been invited to deliver the Beaumont Lecture, in memory of Major Kenneth Beaumont, one of the founding fathers of aviation law. Through his work with the predecessor of the International Air Transport Association (IATA), and later with the International Civil Aviation Organization (ICAO), Major Beaumont helped to shape the legal framework for modern aviation.

He was a true Renaissance man. I was particularly impressed that he took up flying at the age of 41—and equally impressed that he also found time to become a highly accomplished figure skater and to judge international skating competitions. You'd think that as a member of the aviation fraternity, he spent quite enough of his professional life on thin ice, but clearly he was someone who went out of his way to find more of it!

The theme of tonight’s speech, “The Power of Flight”, is something in which I believe deeply. In a relatively short period, aviation has transformed our world for the better. It has permanently changed arrangements of global trade and commerce as well as how we work--and play. We owe much of this to people like Major Beaumont, who was a young man approaching his 30th birthday when Tony Jannus piloted the first commercial airline flight between St. Petersburg and Tampa on 1 January 1914. I’m sure at that time he had little notion of the important role he would play in helping guide aviation from its infancy in the 1920s to maturity.

In many respects, the aviation world in which Major Beaumont lived and practiced bears little resemblance to the one we inhabit. When he died in 1965 propeller planes were still a common sight and the Boeing 747 was just a concept on a drawing board. Airport security was virtually non-existent. Fares, service and capacity in nearly all markets were regulated by governments; and outside the United States – and Hong Kong! – nearly all international scheduled airlines were state-owned. Airlines carried 177 million passengers in 1965, equivalent to around 5% of the world’s population. Air travel was not only for the elite—that’s a myth—but it was far from being a common experience. It certainly had the power to thrill.

Contrast that to today, when, with a few exceptions, airlines may price according to demand. Jets have replaced propeller aircraft in all but the smallest markets – although having said that I flew on a prop-plane only last week. Airport security is ubiquitous—and for good reason. Airlines are expected to carry more than 3 billion passengers this year, equivalent to around 44% of the Earth’s population. Aviation is mass transportation for the global economy.

It has also become a vital driver of economic growth. The aviation industry supports 57 million jobs worldwide and has a global economic impact of $2.2 trillion. A third of world trade by value moves by air, worth $6.4 trillion.

And its safety performance has continued to improve to levels Major Beaumont might not have imagined possible. Last year was the safest in history, with a Western-built jet hull loss rate of 0.20 per million flights, or an average of one major accident for every 5 million flights. The members of IATA did not experience a single hull loss accident last year, nor did any of the more than 380 airlines on the IATA Operational Safety Audit (IOSA) registry. Of course there is always room for improvement, as we were tragically reminded just a few weeks ago in San Francisco. Our thoughts and prayers go out to the accident victims and their loved ones and we are thankful the toll was not worse, in large part owing to advances in cabin structures and materials.

Plus ça change…

Yet were Major Beaumont to return in 2013, he would see that some things have not changed very much. For one thing, to my mind aviation still has the power to thrill! But, significantly, it remains an enormously capital and labor intensive business that is extremely challenging across the business cycle. It is an industry that is highly vulnerable to external events and shocks over which we have little to no control.

And, partly owing to these factors, throughout aviation’s history, airlines in all parts of the globe have struggled to generate a satisfactory return over the long term. In fact on an aggregate basis, the industry was profitable in just 33 of the 66 years from 1947 through 2012, according to ICAO data, and the best net profit margin over that period was 6.1% in 1966. Poor Major Beaumont narrowly failed to live to see that happy day.

Since 2001, the industry has enjoyed just five profitable years. This year we expect airlines to earn a $12.7 billion net profit. I know that sounds like a lot—and it is certainly an improvement on the $7.6 billion we earned in 2012. But on $711 billion in revenues, that’s a 1.8% net profit margin. So I guess you could say the industry has spent the last 46 years trying to get back to 1966 profit levels! And to put that into further perspective, it means that this year we will earn a $4.00 profit per passenger carried, less than the price of a sandwich in many parts of the world.

I do not mean to downplay the industry’s recent achievements. If we look at our history, it’s surprising that airlines are in the black at all in current conditions. And it bears witness to the enormous business transformation that airlines are successfully continuing. Global GDP growth this year is expected to be 2.2%--barely above the 2% stall speed, below which the industry has traditionally been in the red. And we are expecting the oil price to average $108/barrel (Brent) —leading to a jet fuel price of just over $127/barrel. That means that the price of our largest cost item has increased 55% since 2006—or more than tripled if you look back ten years.

In a business as highly competitive as ours it hasn’t been easy to fully recoup these cost increases: Average fares are one-third lower than 20 years ago in real terms. As an industry, the only way we could have survived such a dramatic change in our operating environment is by thoroughly transforming ourselves, examining all aspects of our business for ways to become more efficient and to create more value for the customer.

And that sums up what the industry is still trying to achieve: Business transformation that leads to enhanced efficiency that leads in turn to more value for our customers.

The point I want to leave you with today, however, is that our ability to continue this transformation and bring the power of flight fully to support global GDP growth, is at risk from an array of government policies that will have to be adjusted if we are to be successful.

Simply put, governments have refused to let go of the reins even as they have shed their ownership stakes and proclaimed aviation to be a deregulated activity subject to the forces of the marketplace. Instead, governments appear to have created a wholly unique legal and regulatory regime for airlines – one that seems almost intentionally designed to prevent airlines from partaking fully of the global economic revolution they themselves have done so much to facilitate. To move aviation forward into the next century, we must change this mindset.

Here are just a few examples of what we face:

  • International traffic rights are still subject to tedious state-by-state negotiations; while citizenship and ownership rules limiting foreign investment in airlines are the norm. Concurrently, airlines are routinely prohibited from serving the domestic markets of countries other than their own, despite the enhanced competition that might result from a relaxation of the prohibition on “cabotage”.
  • Fares may be deregulated, but airlines must conform to a web of overlapping rules intruding on their commercial practices and customer relations.
  • Too many governments continue to behave as if air travel was a luxury item for a select few, and stifle it with punishing taxes and charges that often go well beyond the contribution that airlines might reasonably be expected to make toward infrastructure.

Chicago Convention

Let’s look at each of these in turn.

The Chicago Convention of 1944 was a monumental achievement for aviation. It created an international regulatory structure that we rely on to this day to help keep our industry safe. But the failure at Chicago to achieve a progressive and consistent approach to market access has imposed a huge penalty on aviation’s ability to drive economic growth around the globe.

What do I mean by that? Simply this: In virtually every other commercial activity, markets are normally assumed to be open for commerce. Notwithstanding the progress that many countries have made with liberalization, the effect of the Chicago Convention is to stand this assumption on its head. For airlines, international markets are assumed to be closed and can only be opened by carefully calibrated bilateral agreements that limit entry, capacity, and routes to what governments decide to allow.

Imagine if other industries were subject to the same restrictions, so that, for example, the governments of the United States and South Korea had to negotiate with each other over Apple’s right to open a new store in Seoul. In return, South Korea might demand that Samsung be permitted to open a retail outlet in New York, with a second city to be named in two years. Perhaps after months-or years-of tedious back and forth negotiations, the two sides would settle that Apple could sell iPhones and iPads in Seoul, but not MacBooks or iTunes, while Samsung could sell the Galaxy S III but not the S4 in New York.

What would be the impact on jobs, and economic growth and entrepreneurship of this regime, were it to be applied globally to other commercial activities?

Now imagine if the situation was reversed and airlines were treated like virtually every other business. They could quickly respond to emerging markets with new services, helping to drive economic growth and development. The money wasted employing hundreds of lawyers to draft enormous documents justifying their suitability to enter a new market—I know I am on sensitive ground here—could be better spent in investing in new aircraft, hiring staff and developing services to respond to market needs.

Airlines are also treated differently when it comes to corporate governance and capital structure. Fiat’s purchase of Chrysler—which saved many thousands of jobs as well as one of the best-known car brands in the world--would not have been possible in the airline industry. That’s because of the well-known ownership and control laws in most countries that restrict foreign investment to less than a controlling stake—and in the case of the US to not more than 25%.

The result is drastically reduced sources of funding for a capital intensive business, while also preventing consolidation across borders, resulting in a highly fragmented industry. For example, the top 10 global airline companies have a combined passenger market share of less than 40%. By comparison, the top 10 car makers have around a 90% market share and just two players dominate the soft drink market with a 60% global share.

Adding to the complexity of cross-border mergers are the so-called nationality clauses embedded in most bilateral air service agreements, so that a merger between airlines from different countries could result in either or both losing their rights to serve other countries.

The difficulty in achieving true consolidation has led to a business arrangement that I don’t believe has a parallel in any other industry: the global airline alliance. Global alliances bring value to airlines and passengers through the creation of larger and more integrated networks. At the deepest level of cooperation--in which airlines receive antitrust immunity to behave commercially as one --the benefits can be significant. But I think that even enthusiastic proponents of global alliances will acknowledge that they are a weak substitute for a full merger. And of course, even alliances must be approved by governments, a process that usually involves months of expensive filings to regulators.

It is a testament to the industry’s determination to pursue the best course for the traveling public, employees, and shareholders, that in spite of these obstacles, we have seen a number of cross-border mergers accomplished. However, such transactions are far more complex to structure than they are in other industries. And notwithstanding the progressive attitudes taken by some governments, we have yet to see a cross-border merger involving large airlines in which the outcome was one fully integrated carrier with a single AOC, employee seniority list and brand. I am not saying that this is necessarily or always the best way to proceed, but for international airline mergers, it is not usually even an option.

Commercial Regulation

The unique legal and regulatory structure imposed on international aviation limits its ability to create and respond to market opportunities that are largely due to the connectivity provided by aviation. Unfortunately, the “aviation is different” mindset does not stop there. It is applied to economic and commercial regulation as well. The airline industry may be deregulated to the extent that in most jurisdictions carriers are free to set their fares according to demand and in many also to serve destinations at will. But regulators around the globe aim to design the details of competition in a manner that is wholly at odds with how other industries are treated and with the workings of the free market.

In particular, regulators appear determined to hold commercial aviation to a different business standard than they impose on any other form of transportation—or consumer facing activities. It is a strange paradox: We are a service industry that operates in a hyper-competitive environment. Yet governments actually prevent airlines from competing with each other in terms of the way they deal with their customers. It is totally appropriate that governments set some simple minimum standards. But that’s not what’s happening. Regulators are micro-managing our businesses. And the rules can be so prescriptive that they stifle innovation. We have regulations that define:

  • How we advertise our services (1)
  • How long we must hold a reservation that has not been paid for and (2)
  • How we compensate and care for passengers when there are operational disruptions—regardless of the root cause (3)

Most passenger rights regulations are centered on levying penalties on airlines or preventing activities, rather than providing solutions. For example, we have different rules on how to compensate passengers for delays. But where are the regulations to fix the air traffic management issues that cause so many delays? Already some 50 countries have passenger rights legislation. They are not aligned. And the bad news is that more states are considering joining in this daunting and diverse mess. It’s as though governments have decided that they need to protect our own customers from ourselves.

Some governments also seek to intervene in the normal commercial relationships between airlines and their suppliers. The US Department of Transportation (DOT), for example, is seriously considering whether to dictate where airlines must display certain products and services, regardless of the impact this has on airlines’ ability to negotiate with suppliers of distribution services. Does the government tell Apple how and where to display its products? Or does it let Apple decide and rely on the discipline of the marketplace to protect consumers from abuse?

In the end, the decision to treat aviation differently imposes huge costs on the economy. The tarmac delay rule in the US that creates an artificial three- or four-hour deadline by which time a flight must either depart or return to the gate sounds like a good idea, but it has resulted in thousands of flights being canceled for no particularly good reason – simply because airlines might have faced enormous fines if they had not canceled. These are, in effect, arbitrary, government-imposed cancellations and they play havoc with airline schedules and passengers’ travel plans. Without a doubt the rule has virtually eliminated extended delays, but the cost to passengers and carriers alike has been enormous. And of course it did not begin to solve the underlying factors that resulted in these delays.

In a study conducted not long after the rule took effect, the US Government Accountability Office estimated that the number of flight cancellations increased by more than 5,000 over similar time periods before the passenger rights rule went into effect. And in an analysis released last month, the Massachusetts Institute of Technology concluded that the rule “is an ineffective mechanism for reducing passenger delay, and overall, can lead to significant increases in delays for passengers.” The analysis also estimated that the total cost of passenger delays is around $9 billion per year. So the tarmac delay regulation addressed a very small but highly visible problem by imposing a very large but unseen cost on the overall economy.

In Europe, the European Commission may be about to make a similar mistake. It has proposed a rule that would have the effect of placing the entire financial obligation to compensate a delayed passenger on a connecting itinerary on the first carrier. So a small regional airline that delivers a passenger 45 minutes late to a hub, resulting in a missed connection for an intercontinental flight, would have the responsibility of forking out compensation for the entire journey.

Understandably, regional carriers, often the first carrier on an interline journey, may be reluctant to offer interline flights to hubs and onward connections, because compensation to a couple of long haul missed connecting passengers would wipe out all the revenue from the entire flight! The result will be that these integrated connections go away, leaving passengers to manage their own arrangements for connecting themselves and their bags, adding time and complexity to the travel process. Or carriers may decide to stop serving a market altogether, resulting in lost connectivity.

The fact is that airlines are committed to ensuring the safety and comfort of passengers and recognize the need for passengers to have access to basic protections during their journey. To that end, IATA members recently affirmed a set of core principles on consumer protection that aim to strike a balance between protecting passengers while maintaining industry competitiveness and recognizing the power of the marketplace.

Taxation and Fees

Governments’ refusal to allow aviation to operate as do other businesses extends into the realm of fees and taxes, where airline revenues and passengers’ wallets continue to be picked to bolster the treasury. Meanwhile infrastructure is starved of much needed investment that would go a long way to address the underlying factors contributing to the operational issues governments seek to regulate out of existence.

The tax bête noire of the industry is the UK’s Air Passenger Duty (APD). At the moment, it collects around GBP2.9 billion annually, and this will increase to GBP3.3 billion by 2015/16. Without a doubt, it is the biggest tax on aviation in the world but it is not the only one. In the US, taxes and fees represent an estimated 20% of the cost of a domestic ticket and the Obama Administration’s budget proposal for the 2014 fiscal year includes a slew of tax increases and new fees adding further billions to the cost of air travel. In Brazil, the government policy on aviation fuel pricing results in Brazil having among the highest aviation fuel costs in the industry, despite the fact that around 75% of the jet fuel is produced domestically.

Interestingly—and reflective of the fact that airlines are treated differently, we often find that governments have no issue with rubber-stamping fee increases that are charged to airlines (and ultimately, their customers). This willingness does not seem to be affected by whether the infrastructure providers are state-owned or investor-owned, the classic example being London Heathrow, where some airlines will absorb up to a 19% increase in charges in the 2013-2014 year. Although we are pleased to see a bit more firmness on the part of regulators in demanding future efficiency improvements, the targets they are setting are nowhere near the level that is necessary in order to align Heathrow with the efficiency improvements airlines have been making for many years.

Heathrow is just one of many examples around the world of governments viewing airlines and passengers as an inexhaustible financial resource. Let’s recall the $4 per passenger profit we expect airlines to earn this year. With that paltry figure in mind, it is not hard to understand why even a small increase in the passenger tax can have big consequences for the bottom line.

Conclusion

We can speculate as to why international aviation has been treated so much differently than, for example, the shipping industry. It could be that the transport of goods and persons on water dates back at least to Noah’s Ark, long before the emergence of the nation state and the creation of regulatory and legal structures around such activities. By contrast, air commerce will not mark its first century until 1 January 2014. Simply put: aviation followed the flag, and flags have been ruling aviation ever since.

But understanding the reasons for this discrimination is less important than persuading governments that it is in their own best interests—and those of their citizens—to remove the fetters from aviation and allow it to participate as a full and equal member of the global economy. This is a message that I am pleased to hear my colleagues at regional associations delivering to governments, in particular my (dare I say, learned) friend Nick Calio, head of Airlines for America. We need to make this argument at the global level, at organizations such as ICAO. In doing so, we can be confident that we are carrying on the legacy of our industry’s guiding pioneers, like Major Beaumont.

Aviation is an irresistible business. It captured Major Beaumont at a relatively early age, and never let go. We must not lose our enthusiasm. And we must work together to restore to every flyer the thrill of that first flight, regardless of how many times they walk up the air bridge and take their seat. Aviation is a powerful force for good in this world, connecting people to markets, bringing commercial opportunities to the developing world and enabling greater understanding among cultures. We must tell governments: We can do even more, if you will only let us.

Thank you

Foot notes

1 - The US Dept. of Transportation mandates that airlines must include all government fees and taxes in the advertised price. In the Philippines disclosures such as conditions attached to the fare type, baggage allowances, refund and re-booking policies shall occupy not less than 1/3 of the advertising material.
2 - USA Consumer Rule II – Carriers are required to hold the reservation for 24 hours (if the consumer makes the reservation one week or more prior to a flight’s departure).
3 - The EU’s Passenger Rights Rule EC 261. For example, carriers had an obligation to provide care and assistance to passengers during the Volcanic Ash incident in 2010, when airspace was closed.