CAPA Airlines in Transition report, Part 1: The natural history of airline alliances
From the first US Open Skies agreement with the Netherlands in 1992, and the subsequent granting of antitrust immunity to the KLM-Northwest joint venture in 1993, the evolution of airline alliances has been rapid and far reaching. Bilateral codeshares, immunised JVs, multilateral branded global alliances, the Etihad equity alliance: why are there so many models? In the first of a series of reports based on CAPA’s recent Airlines in Transition conference in Dublin, we examine the history and evolution of airline alliances and partnerships.
After decades of strict regulation of international traffic rights post WWII, which controlled destinations, capacity, frequencies and prices, a campaign for more liberal air services agreements (ASA) between nations began to gather pace in the US from 1977. In the words of Jeffrey Shane, General Counsel, IATA and a former senior US aviation regulator, any attempt to modify an ASA was characterised by a "highly calibrated, tit-for-tat mode of negotiation".
In 1989, the US Department of Transportation (DOT) initiated the 'Underserved Cities Program' to allow foreign airlines to provide international air service to specific US cities that did not receive that service from US carriers. Under the programme, foreign airlines had to be from a country that already had a liberal bilateral ASA with the US. In 1991, the programme was expanded to allow the non-US carrier to fly passengers from a US city to more than one city in the carrier’s home country.
Open Skies and the NWA-KLM joint venture
In 1992, the US introduced its ‘Open Skies’ policy, under which the first Open Skies bilateral was signed with the Netherlands. This removed restrictions on gateway access in both markets, so that any US carrier and any Dutch carrier was permitted to fly from anywhere in the US to anywhere in the Netherlands and vice versa. It also removed controls on capacity, frequencies and pricing. Thinking at the DOT had progressed and the view was that there was no reason to deny a foreign carrier a new service if their country was open to service from a US carrier in an approach best summarised as “you open yours, we’ll open ours”.
The US-Netherlands Open Skies agreement was followed in 1993 by the granting to KLM and Northwest Airlines of antitrust immunity (immunity from the provisions of antitrust legislation that would otherwise prevent certain forms of co-operation as illegal anti-competitive activities). Antitrust immunity (ATI) allowed KLM and NWA to implement a joint venture agreement under which they could co-ordinate prices and schedules on the North Atlantic in what was the industry’s first JV. The pioneer among such JVs by many years, this was to be the template for the agreements now at the heart of SkyTeam, Star and oneworld.
The competition authorities’ approach to approving such JVs was initially to make a simple analysis of the impact on competition and to carve out overlapping routes, where the partners competed directly with one another. However, the DOT received criticism for its approach from the Department of Justice (DOJ) and from certain members of Congress, who felt that it led to reduced competition.
The DOT consequently tightened its position and denied a request for ATI from Delta Air Lines and Air France in 2006 due to insufficient information on their planned integration. In 2008, the DOT approved a subsequent application by Delta and Air France after they demonstrated their plans to integrate using the concept of ‘metal neutrality’.
This concept ensures that the partners are indifferent as to which fleet operates the route, typically giving them the incentive to synchronise schedules to the benefit of the passenger. The regulatory approach now was to measure the public benefits (e.g. greater number of connections, lower prices resulting from greater cost efficiency) against the reduction in competition deriving from the proposed partnership.
How open are Open Skies?
The period of liberalisation of ASAs prompted an evolving series of partnership models between airlines. What started with bilateral codesharing progressed to bilateral immunised joint ventures and then to multilateral branded global alliances (BGAs) and multilateral joint ventures within BGAs. Of course, the BGAs are a surrogate for cross-border merger (generally believed to be an inferior surrogate as the cost synergies are limited), made necessary by the ongoing restrictions on foreign ownership and control still prevalent in air services agreements.
Indeed, the term “Open Skies” was, and remains, something of a misnomer. While agreements under this policy have opened up market access where international routes are concerned, they have not led to full cabotage, or the opening up of domestic air services to foreign carriers. Furthermore, they have not removed restrictions on foreign ownership and control. Now, with international routes being the principal battleground for alliances and around 63% of international ASKs already controlled by the BGAs, new alliance approaches are emerging.
New airline alliance approaches
These new approaches can be characterised by three main forms, according to Mr Shane. First, the ‘egocentric’ alliance, strategically driven by individual airlines; second, the ‘radial’ alliance, targeting specific markets through the use of partners’ metal; and third, the ‘selective’ alliance, targeting specific partners because of their presence in particular markets.
These approaches are more bilateral than multilateral and are more virtual. Moreover, LCCs are now playing more of a role: examples noted by Mr Shane include WestJet being a partner to competitors of Air Canada and the Star Alliance (e.g. codeshares with American Airlines and Delta); Virgin Australia acting as partner to competitors of Qantas and oneworld (Etihad); and JetBlue’s partnership with Aer Lingus.
JetBlue is not a member of a BGA, but has 23 separate partnerships with alliance members and non-aligned airlines and plans to add six to eight more in 2013. CEO Dave Barger says that his airline would happily link with every one of the 102 airlines at New York JFK if this brought more traffic to JetBlue.
The openness of the oneworld alliance
In many cases, these new forms of partnership are developing alongside and within the branded global alliances, in addition to cutting across them. Perhaps the most open of the BGAs is oneworld.
For example, oneworld member American Airlines codeshares with the non-aligned Gulf carrier Etihad, a shareholder in new oneworld member airberlin and also a codeshare partner of SkyTeam’s Air France-KLM. Fellow oneworld member Qantas, meanwhile, has a new joint agreement with the other non-aligned Gulf carrier Emirates.
For Allister Paterson, Finnair SVP commercial division, it is crucial to have a business that works, with the right cost structure. IAG CEO Willie Walsh agrees: “Alliances don’t guarantee success. You need to have a robust, profitable business in its own right”.
Willie Walsh (right) with Dave Barger at AIT 2013 in Dublin, 11-Apr-2013
After that, alliances can help on the revenue side, but oneworld does not fill all the gaps and so additional bilateral partnerships are also essential for members such as Finnair. This would be difficult within the Star Alliance, for example, but Mr Walsh says that oneworld is relaxed about its members looking beyond the alliance, quoting a unnamed airline CEO who said: “Just because I am married, it doesn’t mean I can’t have a mistress”.
Airline equity stakes: yes or no?
Etihad’s strategy of taking minority equity stakes in partner carriers is an alternative (and egocentric) alternative to the BGA model. Were it not for the foreign ownership limits, these investments would probably be majority stakes and it is clear that Etihad sees equity investment as a way of deepening the strategic relationship and of signalling a proprietorial position. Such an approach brings challenges and, in the case of Swissair, for example, can lead to disaster.
The popularity of equity stakes as a means of cementing a bilateral alliance has ebbed and flowed. British Airways used to have a stake in Qantas, but this was not reciprocal and it raised questions of whether BA was primarily a partner or a would-be owner of its Australian partner. Once BA had sold its stake, the relationship between the two carriers became easier and their joint business agreement continued for a number of years.
JetBlue’s Dave Barger believes that Lufthansa’s equity investment in his airline has facilitated significant learning on both sides. In some cases, an equity stake can help to secure an existing alliance/partnership relationship, preventing a competitor from usurping this (e.g. Air France-KLM taking a 25% stake in Alitalia to keep it in SkyTeam and to prevent Lufthansa from buying it). In many cases, however, airlines have taken the view that codeshares, alliance membership and immunised joint ventures on selected routes provide benefits without the additional investment and risk of an equity investment.
Government and regulatory thinking has developed
Government policies on airline partnerships are also evolving and accelerating the pace of change. There are some signs of a less protectionist approach, with more openness to considering cross-border ownership and control, facilitating greater use of equity stakes. Governments have become more open to third country codesharing, thereby leading to virtual operations. In addition, developments involving the Gulf carriers have prompted what may be a sea change in the approach of some European governments.
In the latter part of 2012, all three of the rapidly expanding airlines based in the Gulf, Emirates, Etihad and Qatar Airways, announced strategic partnerships that brought them closer to established members of the GBAs. Emirates signed a joint agreement with Qantas on Europe/Australia, Etihad signalled a new codeshare with Air France-KLM and Qatar Airways announced that it would join oneworld.
Prior to these developments, concern at growing competition from the Gulf carriers had prompted some European countries (e.g. Germany, France) to a less liberal approach to international traffic rights, denying or restricting access for these competitors. The French Government could now be expected to take a more relaxed approach, although Germany may still have concerns about the competitive threat to Lufthansa (even if airberlin may benefit from QA’s admission to oneworld).
The regulatory thinking on alliances has been broadly categorised by two main schools of thought, according to Matthew Baldwin, director air aviation and international transport policy at the European Commission. The first school of thought takes the view that alliances are essentially little more than interlining with some fancy marketing, i.e. the kind of thing that has always happened, while the second viewpoint is that they are much more significant than that, representing the first step towards cross-border mergers. Mr Baldwin tends to the second view, as have US regulators.
The global economic downturn has prompted a more rapid pace of change as airlines seek, or are forced into, consolidation. Liberalisation has tended to make greatest progress within regions, whether due to explicit deregulation, greater cultural and economic links, or a combination of these, and there is now a European market, a North American market, a Southeast Asian market and a Latin American market. A new, bigger size of player is needed to access global markets, but ongoing regulatory restrictions limit the ability of individual carriers to achieve this without partners.
Mr Shane notes that, under the administration of President George W Bush, the US DOT attempted to bring about a more liberal stance on foreign ownership and control. It proposed redefining the key elements of airline decision making that mattered to the US Government enough to ensure that they would remain in the hands of US citizens, suggesting that these elements were safety, security and defence. Commercial decisions would then have been opened up to other nationalities. Partly under pressure from the unions, this proposal did not succeed.
Ironically, perhaps, it appears to be the US that has seen the greatest benefit from full equity consolidation. Its airlines’ traffic is predominantly domestic and there are no ownership restrictions within the US market.
In its latest airline industry financial forecast, IATA predicts that North America will be the second most profitable region in the world in 2013, with an EBIT margin forecast at 4.1% compared with a global average forecast at 3.3%. This superior profitability is in no small measure due to the greater capacity restraint that has resulted from mergers among the biggest US carriers.
'Ridiculous' ownership and control restrictions; and labour is also a hurdle
Ownership and control restrictions prevent foreign ownership of majority stakes in airlines almost everywhere in the world. The view expressed by more than one participant at CAPA’s Airlines in Transition conference was that these restrictions are “ridiculous”, a view shared by the European Commission’s Matthew Baldwin. They limit the industry’s access to equity capital, a resource that is anyway limited and for which airlines must compete with other industries.
Even with greater liberalisation of ownership and control, labour can remain a significant hurdle in the path of mergers. It is an enduring challenge to blend or change different working practices, terms and conditions, seniority scales and national cultures.
However, according to Mr Walsh, “if the fixation is on dialogue with labour, the industry will go backwards. The job of the unions is to protect jobs and terms of employment, not the consumer”. He believes that it is not about unions (or politicians), but it is about management: “as an industry, are we determined?”
The chicken and egg of higher returns and reduced ownership restrictions
In addition to the archaic position often taken by governments, sometimes influenced by labour, the industry’s weak aggregate return on capital has also contributed to the lack of progress in liberalising the rules on foreign investment. If this was a high return sector, there would be more pressure from investors, whether financial or industrial, for truly global investment opportunities.
Moreover, the regions of the world are at different stages of development in terms of profitability and liberalisation of market access. This means that not everyone in the industry has an equal incentive to see ownership restrictions relaxed at the same time and to the same extent.
There is also a chicken and egg situation here: the liberalisation of ownership restrictions would help to create the conditions for higher returns, while uniformly higher returns across the industry would increase the demand among investors for the removal of barriers to investment.