Recorded at CAPA Live October from Puerto Rico

CAPA Chairman’s Update - Not a time for complacency

Speaker: CAPA - Centre for Aviation, Chairman Emeritus, Peter Harbison

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Okay. Thank you. Welcome to [Kappa 00:00:13] Live for October 2021. My presentation this time is called Not a Time for Complacency. There's a sense that the worst is behind us, but there's more to come. I think in our haste to rush for freedom, we need still to be very careful and to recognise there are a lot of issues still to come. Just a little bit of sort of perambulation before I start, a lot of this is going to be about what came out of the IATA AGM last week. And it was quite a critical meeting in a lot of ways. Well attended in Boston in the US, 600 people actually present apart from those streaming. So it was quite a landmark as far as the pandemic is concerned in some ways. So I'll pick up some of the issues from that, but they're mostly the generic ones I've been dealing with in recent presentations.

I just want to start by saying a little diversion. I'm lucky, I live by the sea and I manage to get to swim in the ocean every day. And quite often when I'm swimming, I think about aviation as we all do. And one of the things I think about is when we're swimming in the sea, there are often waves that have something funny about them. If the wave doesn't break evenly, it can create something called a rip, which is a current that runs out sort of between the waves, runs out to sea. It's a bit like a river among the waves and it can flow outwards very fast. It can be very dangerous. And as soon as you get in one of those, you feel yourself being swept along with it, and your instinct is to swim back to shore, just like you always have. That's the safety. And that's a very normal human instinct.

When you do go in the sea, often you're taught to try and foil that instinct not to repeat what we've always done, and just again, hope to achieve the same outcome as we have in the past. But in a rip, the flow is too fast. It just pushes you further back and you get exhausted. And that's when you sink, that's when you drown. So what you must do is instead of swimming against it and trying to go back to the safety of the shore, as you've always done, you've got to take a different direction to swim sideways out of the rip.

Now, maybe you can guess what I'm driving at, this stage. This isn't a time to revert to the old instincts in the aviation industry. What we're needing is some different directions. We need to be thinking outside the box because looking, seeking hard for the new normal or a new normal is really perhaps not where we need to be. We need to be thinking much more laterally and recognising that we're not going to go back to an industry that is as we knew it.

Now, I mentioned that I was going to rely a lot on the IATA AGM discussions. This slide was one that came from the IATA economics division, the forecasts for 2022. They are quite startling, particularly because the average that comes out of them is quite a low recovery forecast. But if we look particularly within Asia, the red bar represents the forecast for 2022, what that is saying is that IATA's forecast for 2022 is that revenue passenger kilometres within Asia will be 90% below where they were in 2019, 90% below. That's why I'm talking about the need for looking at things differently, that this is a totally changed environment. Because we've been through two tough years, we're looking at if these forecasts are anywhere near accurate ... and even if they're wildly wrong, it does mean another year of incredibly difficult times.

And even beyond Asia, going to the Middle East, to Europe, to North America, and to Australasia, Australia and New Zealand, even those numbers are still down, either in the teens or low twenties percent of the levels of 2019. These are stunning. These have a massive impact on where we're looking at in terms of revenue, in terms of traffic, and of course the tourism as well. It's potentially quite devastating.

And if you think of it in terms that ... in [RPK 00:04:58] terms, Asia ... and that there are lots of different definitions of it in terms of overlap and so on between different markets. But Asia we're talking about here goes from India, right through to the east, right through to China, Japan, Korea, and down into Australasia. That market accounted for about a third of global RPKs. So what we're talking about is, in 2022, again, after two dreadful years, again, being down somewhere between 10% and 25% of the numbers of 2019. It'll remain 75 ... roundabout 75% below Asia, Europe, and North America. You imagine what difference that makes to passenger revenues, not just in the region, but globally. It's a great [inaudible 00:05:55].

For the extra airlines who are operating in this region, and operating in these markets, that is also operating into Asia from other markets, that message is seriously concerning. It's not just something that we're going to turn the page and go back to normal. We've been holding our breath for 18 months to nearly two years, and now we're looking down the barrel of another whole year. Even the North Atlantic, in Europe to North America, is still anticipated to be relatively low.

So what are the issues that are behind these forecasts? Now, I'm not privy to the criteria that they're applying, but there are several obvious issues involved. And most of the quotes I'm going to rely on here in these slides come from either the economic forecast or from the IATA AGM, largely per Willie Walsh, the Director General and CEO. So demand measured in RPKs, is expected to stand for 2019 ... for 2021, is expected to stand at around 40% of the 2019 levels. That's expected to go, globally we're talking here, to about 60% of total in 2022. Again, that's still a massive, massive drop from where we were before. And the impact of that on revenues, on profitability of airlines, and in fact, on the very existence of airlines, is going to be dramatic. These are a very, very significant numbers. When we're used to talking about 5% here or there, which in itself has a large impact on aviation and its very thin margins, that is a massive change.

The one positive note in this of course has been air cargo. And demand there is looking at being something like 8% above 2019. That's 8% above. And then in 2022, growing to somewhere in the mid teens. That's positive, but in no way is it a replacement for the passenger traffic, which is the main revenue earner. But it does at the same time, help support some of the longer routes.

Now, getting down to some of the nitty gritty in Willie Walsh's presentation to the AGM, there's obviously a massive impact, not just on the airlines, but on all of the various parts of the industry that rely on the airlines for their revenues. The air navigation service providers, the airports, a whole array of others. Now, those providers have been losing money hand over fist. They probably haven't benefited as much as the airlines had from bailouts, although generic support for labour in many of the countries has helped just pay some of the salaries. But what's happening now, as we start to see some recovery, particularly in Europe and North America, is air navigation service providers looking to recoup some of those massive losses. So IATA is anticipating, as you can see in the highlighted piece there, something like a $2.3 billion charges increase during this crisis, $2.3 billion.

Now, again, to remind you that the profitability of the airline industry as a whole over 75 years as has generally wavered somewhere between plus or minus $5 billion. So just from air navigation service providers to have a $2.3 billion increase in charges is massive, particularly where ... this comes in Europe, where much of the inefficiency of the airline industry derives from in that part of the world, because of the various national administrations, which derive quite considerable revenues from there [inaudible 00:10:01].

[inaudible 00:10:04] but then another suppressive factor for air travel is just the fact that the airline industry itself is in such a drastic condition. For the period through last year. And through the next year, we're looking at something like $200 billion in losses by the existing airlines, the incumbent airlines. That's apart from the ones who've gone broke, and perhaps many others may well be staring down that barrel at the moment. It's again, putting that in context, the same context, $200 billion of losses is not something that can be absorbed and we move on. These numbers are far too dramatic for that. And that's on the back of some very, very large debt figures, something like $200 billion again of debt. We had a conversation at the [inaudible 00:10:58] AGM where one analyst suggested that the industry will not recover to its original debt levels until past the end of this decade. And that's a sort of indication of the depth of the hole we've been dug into.

But internationally speaking, perhaps the biggest suppress and suppressant of travel is going to be border crossings. As Willie Walsh himself said, "The biggest deterrent to their travel continues to be quarantine measures in various forms". And it's not just those measures. It's the variability, it's the uncertainness that makes life very difficult for the operators, but it also makes life very difficult for would be travellers. That uncertainty factor is, in anything, uncertainty is unwelcome and because there is such a residue of residual uncertainty now among the travelling public that is certainly going to be a deterrent long after the issues are resolved.

I was talking to somebody who's just been spending six weeks travelling around the world on business and saying that even though they had... and these are experienced travellers, even though they had all of their paperwork, all of the right requirements in place, when they arrived at the new airport or city, there was always something that wasn't quite right, that had to be done. This is because we haven't got to a stage where there's actually cohesion or coordination between the bodies on the ground in each of the jurisdictions. These things will gradually be eased. But in the meantime, from a demand point of view, it's a serious factor. That's born out by two slides I'll show are new, both from from Skyscanner, in a recent report they've done called, Horizons 2021.

This survey was asking, what are the main things that played a role in discovering in your choice of what to do? The first thing, the thin blue bar's there for each of the different jurisdictions that we talked about on the bottom. Thin blue bar is low fares. The market is extremely price sensitive at the moment and will stay that way. Low fares have always been a key factor, but this is consistent right across the board, and it's not going to go away. It's difficult at a time when loads are lower and frequencies are much more infrequent, as it were.

Moving onto the next one. This is the point I was making before that passengers... The question was asked, "Which of the following are important to you in booking flights for the next trip"? The two things that passengers want, and this is the other side of that coin of uncertainty. They want free cancellations and they want free changes because they know that flights have been cancelled, that things are happening, that perhaps even if the flight is upgrading, they're still not able to travel for various reasons.

This is a negative factor, obviously because it makes passengers not reluctant to fly but it's also, from the airline's perspective, these have been more than minor revenue streams in the past. When the full service carriers in the U.S. for example, first started charging for cancellations in a methodical way, and for making changes and charges, very significant charges for changing flights. These became very serious revenue streams as so-called ancillaries, to the extent that these two actually accounted for several billion dollars of profit in the U.S. domestic market when they first started to come in.

Not only is it a bad thing from a passenger's point of view that there was uncertainty, but also from the airlines point of view, that they are actually being forced in a lot of ways to lose out on those ancillary revenues that previously were very, very attractive.

Then of course, the one that's filling pretty much everybody's windscreen at the moment, if they didn't have enough to worry about already, is emissions and the environment. Willie Walsh wasn't pulling the punches, that achieving net zero emissions, which is the goal of the industry, will be a huge challenge. And while talking about some of the measures the airlines are taking, which is the new aircraft, which is trying to use sustainable aviation fuels, [inaudible 00:15:47], carbon offsets, looking for new forms of fuel, hydrogen, perhaps in future. These are things that really are marginal at the moment.

The airline industry, even though it's the airlines who are always at the pointed end, the ones who are visible, are really just the end of that supply chain which goes right back through the OEMs, goes back through everybody I was talking about before about the [inaudible 00:16:17] and the airports. Every part of that industry is involved in creating these emissions, but it's only the airlines who are the ones in the spotlight. It's very attractive from a government point of view, when there's a lot of public pressure to say, oh, we tax the airlines, were doing the right thing, we're being very environmental friendly. But in fact, what Willie Walsh is saying, and I think a lot of the industry is saying is the only way we can meet this sort of expectations of the market and do what we, as a responsible industry want to do, is with massive government support.

That means on the negative side, don't just tax the industry, which is attractive and very easy to do, but actually support the industry, looking for new sustainable aviation fuels. And if there should be any taxes, then those taxes should be applied in a hundred percent to looking for new forms and for helping develop sustainable aviation fuels, but also from a government side to reduce constraints on effective flying when you have to fly through different jurisdictions and in Europe probably spend 10 to 15 more, or create 10 to 15 more percent. So let me say it again. You have to create 10 to 15% more, in terms of emissions, just by virtue of the air traffic control system that that applies. And that's purely a govern activity, which could very, very easily be fixed [inaudible 00:17:51] the politics.

I'm going to come back to the environmental issues. But there were two big trends that I think are worth noting here, and they fit in, they don't fit in all that comfortably in the flow, but want to put them in here because they are critical to this whole theme that I'm talking about here.

Two mega trends, just to reinforce the fUture of the world changing fast and it's not just in the airline industry. The China market. Obviously China is a massive factor in those very, very low forecast numbers for Asia within Asia to and from Asia. It's become such a large market now that whatever it does makes a massive difference to the aviation industry. And as we saw, the pandemic has totally fractured China's international growth trajectory. It's essentially closed its borders for all intents and purposes and the expectation is that it'll stay that way at least well into the second half of next year, which of course has a massive impact on reducing the level of traffic flows.

That said, the domestic market has actually been very, very strong for most of the pandemic. Domestic capacity levels have been pretty much that at 2019 levels, after short sharp burst, while we're getting the pandemic under control. And to the extent this is Australia [inaudible 00:00:19:33] with one of our slides from our website, 8 out of 10 of the busiest airports in the region are still in China. That's almost entirely domestic operations. There's some freight from all freighters and some freight based operations, but essentially there's pretty much single figure percentage RPKs being operated compared with 2019. So that domestic market, as we all know, has become very strong.

Market, as we all know, has become very strong, but it's also put China in a position where it starts to become a little more introspective and look at well, if this is the situation, how can we capitalise on this?

One of the things that had occurred over the years is that the reliance of so many international markets on Chinese tourism. My country, Australia, for example, relied to the tune of about 12 billion dollars. Largely on expenditures on so-called duty free or expenditures in airports here in Australia and outside.

What China has done over the last 18 months is to enhance the role of Hainan. Which is a holiday island, as well as being quite a substantial Province as well in its own right. But, by creating and it's moving towards being completely free trade zone for China. But, it's allowed travellers to that market, because they haven't been able to travel internationally, to buy so called duty free, up to about 15,000 US dollars.

They can even use a trip to Hainan, to buy duty free products online for six months after they return home. Now this year, the expenditures on Hainan alone, this is the sort of the quasi, with the substitute international market for Chinese travellers, will be 9 billion. And it's projected by 2025, under Keqiang's government next five year plan, to grow to nearly 50 billion dollars.

That is really, I mean, by anybody's standards that's a very large number, but it is in some ways indicative of the potential that China has to substitute international operations. And, perhaps it makes it more comfortable for the government to constrain international travel for a longer period while they maintain control of the pandemic.

There's another feature though, and this is one that's just come out literally this week, following the recent census of China. If I didn't just go straight to the bottom line, the highlighted line. This is one of the, I found quite stunning outcomes, potentially of the report from this journal. The Shan University of Finance and Economics based on the census numbers.

If the fertility rate in China falls to one that is one child for every couple, in 29 years time, by 2050, the population of China will fall by one half. That is, there'll be 700 million less people in China by 2050, but on let's just go rewind that a bit though. The headline from the South China Morning Post, here is that, it could half within 45 years. So that's going a bit further out to 2065. The reason for that is that, if we go back to 2019, the UN projectors a birth rate of 1.7 Children to every couple, to every woman. And that's as recently as 2019, in fact, the census of 2021 has shown that it's only been 1.3 children per family.

It's a remarkably different outcome then was expected. And even on those numbers, the size of the Chinese market, from a consumer point of view, which is where we're interested in, is going to change dramatically. Not only are the number of Chinese going to reduce dramatically, but the profile of Chinese travellers is going to change dramatically as well.

And that speaks a lot to the way the airline industry is going to be working, not to mention the projections of the OEM's like Boeing and Airbus in that market. Which is obviously one of the fastest growing markets until now. That, of course, is the outcome of the one child policy, which matured for 30 or 40 years in China, and now means we have a very, very ageing population. For the first time ever the percentage of so-called aged of people was greater than the number of births.

So, it's tipping very, very, for quickly and with large numbers like that, it changes things very quickly. Another mega trend, as I'd call it. This leads us back into the whole issue of environment and sustainability. This article from the Economists, just last week, picked up what a lot of people are saying, that the age of fossil fuel abundance is dead. We've seen oil prices increase quite dramatically. Just recently, as to some extent was expected, because as economic recovery occurred, then obviously demand will increase. But, what hasn't increased equally is supply. To some extent that's due to the great reduction in CapEx expenditure, which seems to have a pretty direct relationship to oil production and capability for output.

And of course, it's also oil explorations being undermined by the fact that we now have green investment. That there's a greater reluctance on the government side, apart from investment side. On the government side, to be investing money in fossil fuels, that we're in this process of transition. Now, what that's done just in the last few weeks has pushed the price of Brent crude up to over $80 US per barrel.

That's well outside the comfort zone of the airlines, even in good times. And, the bad news there, of course, is being suggested by the Economist and others, is this is not just a flash in the pan. It's not just a temporary thing as the economy recovers. It's actually something which is going to be a long term problem and there are the usual forecasts around, of course, 100 dollars oil. Unfortunately there are lots of forces in the market, in the financial markets, that want that to happen. So it does tend to work a little bit like that.

As I've mentioned there too, unusually, West Texas crude is actually close behind Brent now. That's essentially what the US uses, partly because of distribution costs, also because of some one off impacts, which seem to be every year. But also because of reduction of in production in the US itself and North America.

That is definitely a mega trend, that is more than just the usual increase in low prices. This sign, which is taken from IATA and backed with Platts' reporting on jet fuel prices, shows how the red line is bread prices, on a scale. The blue line is jet fuel prices. But as you can see, when they got to the beginning of the pandemic, there was pretty much, a conjunction between jet fuel prices and Brent crude. But, just in the last couple of months, you can see that blue line tipping up much more steeply than the red line. In other words, jet fuel prices are going up faster and because jet fuel is just part of the margin of what's generally used, that does start to look somewhat ominous. Okay, a couple of interesting general trends there, which are more than interesting I think in the long run, let's go back to the environment.

Top 26 is coming up in a couple of weeks. It's very likely that there will be probably some unpleasant news for airlines coming out of that. It's unlikely that people, at the government level, are going to be saying, "Yes, let's spend lots more money to support the airline industry". The popular approach is going to be, let's tax the airline industry, let's slow it down, let's prevent that growth from the occurring. Because, for various reasons, it's the attractive target, but also corporate customers are looking to reduce their footprints, as we've talked about many times and with responsible investment, the likelihood of investing in airlines actually starts to diminish unfortunately.

We've been doing some research into, basically using publicly available data. We modelled, about 250,000 times, literally modelled the likelihoods of achieving reductions in emissions, by offsetting with the impact of, say 10% of sustainable aviation fuels by 2030. Now, in fact, what IOTA was talking about at the AGM last week was something like 6% by 2030 in the industry basis. But even at 10%, our modelling suggests that the high likelihood is there will actually be no reduction in emissions, because of the growth of the market. In those circumstances, carbon pricing becomes very, very significant. So let's go back to that, looking at those numbers and talking about this is a practical problem...

... those numbers and talking about this is a practical problem out in the marketplace, out in the popular marketplace. The industry itself is looking at most of the significant carbon reductions coming after 2030. There's not much that really is possible to be done. Okay. We've got more efficient aircraft coming in, considerably more efficient aircraft. But it takes a long time to change the balance from much older aircraft to the brand new ones.

And while Airbus and Ryan are pumping out aircraft as fast as they possibly can, it's not sufficient to change the balance of those thousands of aircraft, which are already in the market. The question really is, will activists be satisfied by that? And in turn, will governments feel the need to react in some way that shows that they're responding to the need to force airlines to reduce their emissions.

Another issue in this is, as I talked about before, investment in so called green ESG, green investment. Just this week, last week, Canadian pension funds have announced that they would cease to invest in oil, which is a big move in Canada, because a lot of Canada's exports come from the western part of the country and the oil companies there. Unsurprisingly, they're pretty unhappy with this, but it's something that the Canadian pension funds in particular, which are some of the biggest in the world, are now seeing as necessary.

I mentioned before that we were doing some analysis of the whole industry emission process. And looking, specifically in this case, at SAF costs, because SAF, even if we can get to that level of six or even 10% SAF usage by 2030, does mean in fact that there's a whole new ballgame for expenditure there too. Because even if the oil is $100, SAFs are going to be at two or $300 a barrel relatively.

And so, that then comes right back to this, in this continuum, this circle to which airlines actually can afford to pay these sorts of prices, if that's the direction we're going to go in? These are just very briefly, three lines that we've drawn using publicly available data from 46 airlines from 2019 numbers. The palest blue line at the bottom there is what happens if you have 5% SAFs, second is 10% and then the dark blue line at the top is if we have 20% SAF.

And the ability of airlines to absorb those additional costs are up to 14, 15% additional total costs to the airlines. Those are pretty dramatic impacts. What we did then was to look at which airlines can actually absorb those sorts of costs. We did a pressure test of the 2019 profit margins, which again, are going to be quite different from the ones we're looking at next year and beyond. But hopefully, as we get to 2030, they'll get back to something like those levels.

Pressure testing those profit margins against fuel as a percentage of operating cost. Now, there were a lot of the issues involved in this, which I won't go into. Obviously, some airlines are much more affected by high fuel costs than others. And LCC is to name but one. Where you want to be in this pressure test, is in that left hand quadrant where the star is. And only very few airlines are actually up there.

The rest of them, particularly the ones in the bottom right hand, are the ones that really are suffering. That along the bottom scale, there's fuels and you got running costs. And as that percentage goes out, you certainly don't want to be in that quadrant. But as we can see, there's only basically half a dozen, less than 10 airlines that actually are able to resilient with SAFs at those levels.

This one looks at the break in in carbon price, which is pretty much probably going to be the alternative. Again, we've got those same quadrants. On the bottom is, your CO2 emissions per RPK, per million, tonnes of CO2 emissions. And then, on the left-hand column, you have got the break-even carbon price. Now, again, you've only got two, four, six airlines that actually meet the criteria that you need to remain profitable in those circumstances. Now, I've rushed through these, but these actually demonstrate very, very clearly what a high level risk the airline industry is at, purely due to either SAFs or having to be investing in the carbon market. And carbon prices of course, are quite variable.

Which of the airlines too, which do have a profile of high levels of emissions? This one is the age of aircraft. Now, age 10% of the correlation, of course, with efficiency of aircraft. The newest aircraft can be something like 20 to 30% more efficient than a 10 year old aircraft. Then each one of these dots again, is an airline. And as we've calculated here, for every year of fleet age, the emissions per million RTKs increased by about 20 tonnes of CO2 per million tonne kilometres.

Looking at that in very practical terms, reducing each single year of fleet age can actually reduce about 40 million tonnes of CO2. So if the average fleet goes from 12 to 10, you can probably remove 80 million tonnes of CO2 in terms of emissions by that airline. So it really does highlight very dramatically, how important it is for newer aircraft to become very central to the profile of every airline.

In this process too in this report, we've gone through each individual airline and done a range of comparatives with its peers and with another 30 or 40 airlines. This is one I've blocked out who the airline is, but it's a taste of what we're looking at in that. And as it says there, sorry, bit of shameless promotion here, but we think it's important to have data that really do convey impartially and transparently and accurately, what is happening in the industry. Because it's very difficult to talk about net zero if we don't know what zero is, or we don't know where we are at the moment.

Let me just wrap up. In summary, going back to my original metaphor. Swimming upstream is not going to work this time. We're not going to get back to the safety of the beach by doing what we've always done in the past. Something is going to have to change. Something is going to have to be done differently. That's by governments, by airlines, by everyone who's involved in the aviation supply chain. Secondly, there can be no business as usual because of the combination of COVID impact and costs. And this new, as we are looking at it now, which has always been there, but the new urgency of the need to respond to environmental concerns and to reduce emissions of the industry as it starts to regrow.

And then finally, the ugly debt hole we've dug into. The reduction in revenues by, if you go back to the thought of the forecast that we're talking about. Which are looking at well below 2019 levels, right through next year and beyond. And the cost that come from responding to the environmental needs is going to threaten many airlines.

That's a fact. Whether they are able to remain in existence or not, there are some very, very deep threats there, which is also then going to apply to routes. The route profile is going to look very different, at least for some years. Particularly on long haul route, which are usually sustained largely by business travel, which just perhaps offer some opportunities for airlines. But for doing the same old thing of swimming back to the shore, it's probably not going to cut the mustard. Thank you very much for your attention. And we hope you found some value in that discussion. Thank you.

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