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Fading Vision

The United States started the deregulation ball rolling in 1978 but may not be the driving force in the future

Fading Vision

The aviation industry has faced an uphill struggle in recent years given the external factors at work, such as record high fuel prices and global economic uncertainty. Staying in the black has been a major achievement. US airlines in particular have managed to put in a solid performance, thanks largely to major restructuring.

Profitability in 2012 was $2.3 billion and tight capacity management promises even greater rewards in 2013. The number of seats has shrunk nearly 10% since 2007.

Positive growth

Consolidation has been the key driver in this upswing. US Airways and America West set the ball rolling with their merger in 2005, along with other big name mergers including Delta/Northwest, United/Continental and Southwest/AirTran.

Consolidation has proved a boon not only for the airlines but also for the airline customer. Buoyed by the stronger capital structure resulting from the mergers, airlines have embarked on product upgrades and ordered new aircraft with superior comfort and environmental performance. Furthermore, US Department of Transportation data show that the industry’s operational performance has improved over the past few years, with fewer flight delays, cancellations, and lost bags.

“While the airline industry is making the transition from razor-thin to paper-thin margins, keeping just 2.1 pennies per dollar of revenue generated in the first half of 2013, it is reinvesting in the product and travel experience for customers at a rate not seen in 12 years—to the tune of $1 billion per month,” says John Heimlich, Vice President and Chief Economist for Airlines for America (A4A). “Airline customers, employees, investors and the US economy are all vastly better off with a financially strong industry that can cover its costs over an entire business cycle and compete effectively on the global stage, while expanding air service and creating even more American jobs.

“The fact that airlines are still able to post a modest profit at jet fuel prices north of $3 per gallon is nothing short of remarkable,” Heimlich continues. “It speaks to the work the airlines have done to transform their businesses over the past 13 years. The good news for customers is that air travel remains a great bargain with 2012 domestic round-trip airfares actually 15% below 2000 levels when adjusted for inflation.”

Wall Street analysts agree that the industry’s ability to maintain profitability and investment in product in the face of negative economic trends and soaring fuel prices in large part is owing to the consolidation that has occurred since 2005.

A shocking decision

That makes the US Justice Department (DOJ) decision to file an antitrust suit against the proposed deal between American Airlines and US Airways something of a shock. The $11 billion merger would have created the world’s largest airline although its market share in the United States would have been far from dominant. Low cost carrier, Southwest Airlines and Delta Air Lines both carry more than 100 million passengers every year.

Significantly, neither United Airlines nor Delta Air Lines opposed the merger. And although DOJ expressed concern about the level of concentration that would occur at Reagan Washington National Airport just outside Washington, D.C., it rejected the merger on the grounds that competition would be diminished in dozens of connecting markets and that fewer airlines could result in higher fees for such things as checked bags.

Some have speculated that rather than the deal itself, the DOJ was influenced by the relative stability of the industry. Simply, the pattern of ruinous competition has been halted and there is no appetite for further consolidation at the DOJ. Certainly, concerns about higher fares would be hard to understand. When adjusted for inflation, US airfares have dropped around 30% since 1990 while taxes on aviation have gone up closer to 40%.

Aside from the fact that fares have fallen federal taxes constitute about 20% of the typical $300 round trip. These taxes contributed $19 billion to the US government coffer in 2012, according to A4A. Proposals for yet more taxes would add another $5 billion to this figure. So if the concern is that passengers are paying more, the logical answer would seem to be to reduce the tax burden. American and US Airways intend to contest DOJ’s lawsuit and are seeking an early trial but whatever the final outcome the industry has been left stunned not only by the decision to sue but also by DOJ’s attack on industry business practices, such as ancillary fees, which have nothing to do with issues of market power or concentration.

Jeffrey Shane, IATA’s General Counsel, agrees that DOJ’s tone was troubling. “It is a broadside attack on the global airline industry that is as unsupported by facts as it is inappropriate,” he says.

An opaque strategy

“Airlines make money by giving their customers maximum value so they can retain them and grow their businesses in a sustainable manner,” says Doug Lavin, IATA’s Vice President, Member and External Relations, North America. “What the government needs to do is decide how to let airlines deliver that value. An industry that cannot make money cannot serve the customer nor can it provide the US economy with the connectivity it needs to thrive. At the moment, the notion of a deregulated industry seems to be fading very fast.”

The unwillingness by regulators to accept industry consolidation where it makes business sense and where it delivers value to consumers may be the ultimate litmus test for the premise of airline deregulation: that aviation should be treated like any other private sector activity. But it is not the only one. Plenty of other actions by regulators suggest that Washington is unwilling to accept that, in commercial matters, the market should be the ultimate arbiter, according to Lavin. Instead, the view seems to be that consumers need to be protected from airlines that do not have their interests at heart.

The so-called Tarmac Delay Rules, for example, places the entire burden for a delay on an airline, despite the fact that most delays are owing to weather and other factors outside the control of airlines. Furthermore, the fines are so draconian that airlines will pre-cancel flights rather than risk exceeding the three hour limit. In the United States, airlines were 24% more likely to cancel flights after the tarmac delay rules went into effect. So the net result is that passenger disruptions and inconvenience have actually increased.

“Remember, this comes from a government that led the way with airline deregulation in 1978,” says Lavin. “But clearly there has been some backtracking on that ideal. Today’s approach is inconsistent and punitive. The only thing they seem sure about is that the US government no longer trusts the airlines to do the job.”

Distribution control

Passenger rights is not the only issue that shows that Washington distrusts the marketplace. The US Department of Transportation has also dictated how airlines advertise their products by requiring that they include all government fees and taxes in the advertised price.

And it is on the verge of proposing that airlines must necessarily display the prices of certain add-on products in Global Distribution Systems (GDSs) even though such information is available on airline websites. Airlines have argued that this is a clear interference in a contractual arrangement between commercial companies and that, in any case, it could cause technology innovation to stagnate.

Moreover, two GDSs control more than 90% of the agency market in the United States. The proposal would put even more market power their way by mandating airlines to do business with them. And it would discourage any new players looking to enter the market.
The bigger picture

Outdated foreign ownership rules also raise doubt as to whether the United States is serious about deregulation. As it stands, foreign ownership of US domestic airlines is restricted to 25%. It’s a rule that has stood since 1926 and has severely limited US airline access to foreign capital. There have been repeated attempts to introduce a 49% limit but it has never been implemented. Some have argued that this failure to relax the foreign ownership rule played a crucial role in the Chapter 11 contagion that rolled through the US airline industry in the first decade of the 21st century. In an antitrust hearing about the American/US Airways merger in February 2013, it was even argued that the foreign ownership rule and fears about consolidation are in direct opposition.

“If policymakers are concerned that the proposed American-US Airways merger may have anti-competitive effects…then an effective way to address those concerns, obtain the efficiency gains, and significantly benefit travelers would be to take steps to stimulate additional competition by creating a deregulated global airline industry,” testified Dr. Clifford Winston of the Brookings Institution. “The final step to create a highly competitive global airline industry would be for the United States to allow foreign airlines to serve US domestic markets.” 

Forfeiting leadership

The cautious approach has arguably cost the United States a leadership role in the aviation industry. It is not just the growth of Asia-Pacific and other markets that have demoted the United States. The lack of progress on initiatives such as NextGen also speaks of a domestic malaise at the regulatory level.  

NextGen has been on the agenda for some time, but—like the slow progress of the Single European Sky, its counterpart in Europe—it seems to have become a millstone around the neck of the Federal Aviation Administration (FAA).

Recent cuts in the FAA budget certainly won’t help the project. Aviation has in effect been a sacrificial lamb in efforts to balance the national budget. This has forced FAA to analyze what it can and cannot do with the available money. The politicization of the industry—with both sides of the house using aviation as a proxy for deeper, ideological struggles—is a reminder of the lowly role afforded to air transport in recent times.

A Benefits of Air Transport study complied by Oxford Economics shows that this lowly role is completely inappropriate. The aviation sector contributes $669.5 billion in Gross Value Added to the United States, equivalent to 4.9% of the US economy. It supports 9.3 million jobs.

“We will soon be celebrating 100 years of commercial aviation and that first commercial flight was in the United States,” says Lavin. “US airlines are performing well but they could do even better with a coherent aviation policy. There is a danger that the US government has forgotten the role aviation plays in the country and the economic and social benefits air transportation brings.”

IATA’s Shane agrees that the regulatory framework has created a “worrisome environment.”  He believes there appears to be real confusion among regulators about the appropriate extent of regulatory micromanagement in a market-driven environment.

“The net result has been a stifling of innovation, and thus competition, among airlines,” he notes. “Moreover, government leaders apparently believe that regulating the airline-passenger relationship enhances popularity, even where the regulation goes far beyond what governments do with other consumer products and services.” Deregulation will always be associated with US leadership. But less certain is whether the United States will continue to be its home.

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