The Future of the Aviation Industry

The Future of the Aviation Industry A Report of a Public Policy Forum, May 2005 The Future of the Aviation Industry A Report of a Public Policy Forum, May 2005 Forum Chair: Lillian C. Borrone Chairman, Eno Transportation Foundation Eno Transportation Foundation TABLE OF CONTENTS Preface Background Forum Participants Summary of Proceedings Next Steps and Postscript Appendices Appendix A Forum Program iii 1 3 5 11 Appendix B Presentation — “Confronting the Crisis: Today and Tomorrow in the Aviation Industry,” by Robert E. Gallamore, Ph. D. and Aaron J. Gellman, Ph. D., The Transportation Center at Northwestern University Appendix C Presentation — “Key Issues in the Aviation Industry Today,” by JayEtta Hecker, Director, Transportation Issues, U.S. Government Accountability Office Appendix D “Commercial Aviation: Bankruptcy and Pension Problems Are Symptoms of Underlying Structural Issues,” U.S. Government Accountability Office Highlights Paper, September 2005 ii PREFACE Aviation’s support for the movement of people and goods has been an engine for America’s economic growth and a major contributor to our ability to compete globally over the last half century. Businesses, as well as governments and ordinary citizens, have come to rely upon this transportation mode in ways never imagined when the Wright Brothers first took flight at Kitty Hawk, North Carolina more than 100 years ago. The aviation industry in the United States has been successful through the years for a number of reasons. A world-class safety system has significantly reduced the number of crashes and other incidences of mechanical failure. New technologies, first from the post-World War II era and later tied to the 1960s space race, resulted in the production of efficient, durable aircraft. Deregulation in succeeding decades lowered the bar for entrants into the system, providing more choices and lower priced fares to consumers. It’s no surprise then that, given its economic importance to the country, aviation’s future has been a subject of intense interest and debate, particularly at times of perceived peril for the industry. Indeed, three national commissions have previously conducted reviews to look at where aviation was headed and how it could best meet its looming challenges. Today, the aviation industry is at its most severe crossroads yet. The Internet’s impact on how tickets are sold and the emergence of low-cost airlines and regional carriers as a powerful market force have had a major effect on the industry. Unforeseen events such as the 2001 terrorist attacks on the United States and a decline in business travel have created severe disruptions in demand. The industry is plagued by a fragmented approach to building runway and ramp capacity. Rising costs associated with the price of jet fuel, security measures, and pension and health care plans have negatively affected the airlines’ balance sheets. Air traffic management, airline financial condition, and airport development were high on the list of issues for the Eno Transportation Foundation’s Board of Directors when it set about determining how the Foundation could better assist in improving public policy choices, particularly for transportation modes in crisis. Consequently, the Foundation held a forum in May 2005 to stimulate thoughtful and, at times, forceful discussions about the many challenges facing the aviation industry. This report summarizes those discussions as well as key forum presentations. We did not expect this forum to reach absolute agreement on what should be done or who should take the lead in responding to the industry’s many challenges. Since organizations often have difficulty working together cooperatively in times of crisis, this is not altogether surprising. In aviation’s case, the industry must also first find the right way to work cooperatively across individual sectors (e.g., airports, government agencies, airlines, labor unions) on shared problems. Additionally, a number of the industry’s problems are too big to be solved all at once. They must be broken down into smaller, paired issues (e.g., implementing the Air Traffic Management System and the need for greater runway and ramp capacity) to develop comprehensive solutions. iii We did, however, find a range of thoughtful and provocative opinions on the issues raised at the forum. The participants reached consensus about a number of key next steps for the industry: • The current policy development framework, featuring individual stove-piped relationships between aviation stakeholders and the government, is broken and should be replaced with a horizontal model that encourages stakeholders to work with each other before presenting the industry’s interests to Congress and the Executive Branch. Capital investment decisions can no longer be left totally to Washington to resolve; the private sector must be allowed to pursue creative financing strategies to bring about critical modernization. The Federal Aviation Administration and the National Aeronautics and Space Administration need to work together to articulate the sources of funding for the Air Traffic Management system over the next five years. Major aviation industry sectors (e.g., carriers, airports, aviation finance community) should concentrate on relationship building by meeting in small forums that focus on points of agreement and then broaden these ties as progress is made and trust develops. • • • The forum’s most noteworthy accomplishment may have been in providing key stakeholders with divergent backgrounds and interests the opportunity to talk openly and candidly about issues affecting the industry. Many participants remarked that they could not recall a time when so many of aviation’s important players, from all corners of the industry, sat around the same table to examine its future. Eno Foundation Chairman Lillian Borrone, at the forum’s closing, reiterated the Foundation’s willingness to serve as a convener for additional discussions and challenged the participants to provide suggestions for how the Foundation might pursue small next steps to continue the dialogue about the issues that were raised. The views presented at the forum show that the range of issues and options is very broad, and that they challenge many business-as-usual notions. This far-reaching discussion provides a useful frame of reference, and we’re hopeful the new and revitalized relationships generated by the forum will enhance the nation’s ability to make policy decisions that will improve the industry’s long-term health. iv BACKGROUND In May 2005, the Eno Transportation Foundation convened a two-day, invitation-only forum to examine issues affecting the future of the U.S. aviation industry. The forum was organized in cooperation with the U.S. Department of Transportation (USDOT), Office of the Secretary. The Foundation also received organizational assistance from the Airports Council International– North America, the Cargo Airline Association, and the Air Transport Association. The forum’s genesis was a strategic discussion the Eno Board of Directors held two years earlier in which the Board expressed an interest in having the Foundation focus its resources on improving public policy choices, particularly for transportation modes in crisis. At the time of the discussion, air traffic management, airline financial condition, and airport development were high on the Board’s list of critical issues for policy conversations. Developments in early 2005, including skyrocketing prices for jet fuel, an increasing uneasiness about legacy carriers lingering in bankruptcy and its potential for disrupting the marketplace, and public liability potential for unfounded pensions of major carriers such as United Airlines, focused an even greater spotlight on the need to examine these and other issues affecting the aviation industry. The forum brought together a broad spectrum of aviation industry stakeholders, including passenger and cargo carriers, airport representatives, financiers, shippers, labor, manufacturers, executive branch officials, congressional staff, and others. Although the Foundation extended invitations to them, the Federal Aviation Administration (FAA) and low-cost carriers did not send representatives to the forum. Nonetheless, the breadth of stakeholders who did participate was impressive; many participants noted that the forum was the first time they had an opportunity to specifically engage with their peers about the future of the aviation industry. The discussion was structured around three key topics: • • • the commercial aviation industry today and tomorrow; the capital infrastructure requirements for the industry over the next five years; and system performance requirements, particularly those related to the Air Traffic Management System, for the next decade. The two-day program also reviewed important issues such as recent structural trends with the industry, emerging business models, labor cost differentials, and pension and health care costs. The forum’s role was not to decide what should be done about or who should take the lead in responding to challenges facing the industry. Rather, it was to stimulate thoughtful discussion among a diverse group of aviation leaders about these issues. To spark the discussion, the Foundation asked The Transportation Center at Northwestern University to prepare an opening paper that summarized the events of the past several years and the current situation in the aviation industry. Bob Gallamore, the Center’s director, presented this paper, which can be found in Appendix B, to forum participants. Another presentation, contained in Appendix C, from JayEtta Hecker, director of transportation issues at the U.S. Government Accountability Office, focused on financial challenges to legacy and low-cost carriers. 1 Additionally, USDOT Secretary Norman Mineta made remarks to the group on Day One of the proceedings to offer his own perspective on the most important challenges facing the industry. 2 FORUM PARTICIPANTS Janet Abrams Vice President and COO Eno Transportation Foundation Steve Alterman President Cargo Airline Association James Bennett President and CEO Metropolitan Washington Airports Authority Ed Bolen President and CEO National Business Aviation Association Lillian Borrone Chairman Eno Transportation Foundation John Carr President National Air Traffic Controllers Association James Casey Deputy General Counsel Air Transport Association Bob Crandall CEO (retired) American Airlines Dennis Dolan First Vice President Air Line Pilots Association, International Mort Downey Chairman PB Consult Tom Downs President and CEO Eno Transportation Foundation Robert Gallamore Director The Transportation Center, Northwestern University Aaron Gellman The Transportation Center, Northwestern University Karl Grundmann Director, Communications Division Next Generation Air Transportation System Jeffrey Hamiel Executive Director Minneapolis-St. Paul Metropolitan Airports Commission George Hamlin Director MergeGlobal Inc. JayEtta Hecker Director, Transportation Issues U.S. Government Accountability Office Damian Kulash Consultant John Lewis Senior Vice President Bank of America, Commercial Aircraft Group Maureen Luna-Long Senior Analyst U.S. Government Accountability Office 3 John Meenan Executive Vice President & Chief Operating Officer Air Transport Association Norman Mineta Secretary U.S. Department of Transportation Tom O'Bryant Senior Vice President LaSalle Bank NA David Plavin President ACI-North America Jeff Shane Undersecretary for Policy U.S. Department of Transportation Ted Tedesco American Airlines (retired) Stephen Van Beek ACI-North America Jordan Weltman Managing Director Boeing Capital Corp. 4 SUMMARY OF PROCEEDINGS Forum participants were mindful that there had been three national commissions to examine the American aviation industry during the previous decade. They also knew that, while a number of timely and pragmatic recommendations were made, none of these commissions had much of an impact on the issues surrounding aviation today. The forum drew attendance from a wide spectrum of industry sectors. A number of the participants remarked that the event provided their first opportunity to meet with certain of the other stakeholders. The interactions among these individuals were particularly valuable to the proceedings and created optimism that these new or revitalized relationships might help in solving some of the industry’s daunting challenges. Industry Trends Participants identified several trends with significant implications for the industry: The number of Americans traveling by air is on the rise, with passenger boardings expected to double by 2025, and aircraft operations expected to triple by the same date. Public confidence in the safety of the system is strong – so strong that forum participants expressed concern that safety may be taken for granted in the future, leading to a possible under funding of safety initiatives. Security fears persist, but travelers have shown their resilience by returning to the skies at pre-9/11 levels. For the traveling public, price is paramount in choosing a carrier. Thanks to the Internet and round-the-clock search capability, airfares are fully transparent to the public, and travelers are choosing the lowest price option. Forum participants acknowledged that brand loyalty is a thing of the past. Air travel is now a commodity business, and carriers will have to adapt further to a low-cost/low-fare environment in order to survive. Even business travelers, who have been less price-sensitive, are resisting fare increases. The only premiums that travelers are willing to pay for are time-of-day and direct flights, not brand. Capacity of the system (i.e., number of available seats) is growing without much constraint. U.S. carriers are placing orders for new aircraft for delivery in the coming decade, without clear plans to retire older planes. They are also adding significant numbers of regional jets. The air taxi fleet is also expanding rapidly. The expansion in the overall U.S. fleet, with commercial service, private aircraft, and on-demand air taxi services expected over the next decade, cannot be absorbed by the current air traffic control system or capacities. Manufacturers and financiers are contributing to the “commoditization” of passenger aircraft, the expansion of capacity, and easy entry into the industry by start-up carriers. Forum presentations on new aircraft technology highlighted the movement towards more highly standardized aircraft, with uniform maintenance and parts support. In the future, aircraft will operate more economically and will be easier to move about the marketplace, in the U.S. and abroad. The availability of standardized aircraft, with standardized contract maintenance services, makes entry into the industry relatively easy for start-up carriers, particularly new regional entrants. The 5 excess of pilots adds to the ease of entry. Airbus is thought by some to be adding to the oversupply problem by selling aircraft below cost to U.S. carriers. This makes it unlikely that there will be a reduction in capacity caused by the liquidation of one of the legacy carriers. Executives from the aircraft leasing business underscored their interest in putting assets in their portfolios to work, moving planes from one carrier to the next if need be, with relatively little concern for which logos or flags are painted on the sides. They spoke of organizing aircraft into risk groups, or “tranches,” by type of aircraft, age, length of lease, etc. Forum participants listening to the presentations were struck by the influential role these financial professionals, who are rarely seen at Washington, DC policy conferences, are playing in the industry’s transformation. The combination of these factors would seem to make it difficult to reduce capacity in the U.S. domestic aviation market, as some legacy carriers have advocated. There was some recognition that high fuel costs could lead to future changes as carriers seek greater efficiencies. Cost structures will continue to handicap legacy carriers as they compete with newer U.S. airlines, as well as with overseas carriers. A former airline CEO at the forum predicted that every legacy carrier would go through bankruptcy or a serious restructuring in the near future. Oil prices are not expected to fall. High fuel costs will weigh more heavily on legacy carriers that operate older, less fuel-efficient aircraft. Southwest profited initially from rising oil prices because it had the foresight and available cash to purchase options for cheaper fuel. However, by the end of 2005, even Southwest’s protection from fuel price hikes will begin to phase out. Some carriers are now reporting fuel operating costs are higher than their labor costs. Global competition is intensifying. Foreign carriers and manufacturers of aircraft and related equipment are competing head-to-head with U.S. firms. The European Union (EU) has adopted a detailed strategy for strengthening its transportation sector, with a specific focus on aviation as a means of improving overall EU economic competitiveness. What’s Needed and What’s Standing in the Way Participants discussed steps that should be taken to address these trends and hurdles now standing in the way of sustaining the U.S. aviation industry: The U.S. must develop and deploy the next-generation Air Traffic Management (ATM) system to handle growing congestion in the skies safely and efficiently. A representative of the Joint Program Development Office (JPDO) spoke to the group about developments now underway. Several forum participants stressed that U.S. competitiveness in air passenger service depended on the productivity gains expected to flow from the new system. One participant went so far as to say that the domestic aviation industry cannot survive without a timely and successful implementation of the new ATM system. Unfortunately, participants were pessimistic that the ATM system would meet industry needs in a timely way. They pointed to FAA’s failure over the previous two decades to bring about major 6 improvements; the U.S. focus on developing a broadband system while the Europeans are building a satellite-based, second-generation GPS system; lack of direction to the U.S. aviation instrument manufacturers on cockpit-based equipment that will be needed; and the risk that FAA’s partnership with the National Aeronautics and Space Administration (NASA) might end before the product is developed or deployed. Participants recommended that a comprehensive management plan for the JPDO be developed, to include prioritization of component systems and specific guidance to private-sector partners about their involvement. While there was recognition of the value of the Next Generation Air Transportation System (NGATS), participants voiced concern that the elements were not clearly prioritized and were not clearly linked to funding options. Of greatest concern was the FAA’s lack of a clear plan for funding the new ATM system. The user fees flowing into the Aviation Trust Fund were being tapped to cover FAA operating expenses and could not be relied upon as a direct funding source. One forum participant recommended an unconventional financing approach whereby the ATM system would be developed with private funds generated through the bonding of aviation system fees. The fees would be based on the cost savings generated by implementation of the ATM. Airport capacity must be expanded to meet increasing demand. Runway and ramp capacity must be matched with the improvements expected to come from the new ATM. Several participants noted that productivity gains of the new ATM system could not be realized if there is inadequate runway space at the destination. Airport expansion now occurs on a fragmented basis, with no connection to the needs of the national system. Expansion projects cost billions and often take decades to build. Communication between airport authorities and the airlines about expansion plans is often strained. The bond market is the main source of funding for these efforts, and each airport has to stand on its own merits when going to the market. There is currently no national ground capacity planning or prioritization done at the FAA or any other federal agency. Forum participants agreed that this fragmented approach to building capacity across the country is highly inefficient and has left the U.S. vulnerable in the new global economy. They called for the federal government to play a role in forecasting future system-wide demand for ground capacity and identifying priorities for investment, and for the airlines and airports to improve communications about needs at airports. The diversion of resources from the Aviation Trust Fund to pay for FAA operating expenses is deeply troubling and comes at the expense of other critical investments. In discussions about how to pay for the new ATM system and the multitude of needed airport improvements, forum participants expressed deep concern about the diversion of resources from the Aviation Trust Fund and indicated that the extent of this practice violates Congress’ intent in establishing the Fund. While participants recognized that Congress authorized the use of Fund resources for some of these expenses, they felt the level of the current commitment to operating expenses denies adequate capital funding to the ATM system, both now and in the coming decades. 7 The government will likely encounter significant resistance to imposing any new Trust Fund fees or increasing existing ones without providing clear justification or clear performance objectives. Forum participants spoke of their opposition to the prospect of new or increased Trust Fund user fees. They discussed the example of post-9/11 security fees, questioning the appropriateness of requiring airline passengers to pay for protections against terrorism that benefit the nation as a whole. Recruiting and training an adequate number of air traffic controllers is essential to handling expected increases in demand. A significant percentage of air traffic controllers now working are set to retire in the next several years, and participants expressed concern that the FAA is behind schedule in hiring new personnel. Forum participants also raised questions about the management structure of the Air Traffic Organization (ATO). One participant suggested that a flatter organization would be better able to integrate the new ATM system. Participants called for the FAA and the controllers’ union to establish a new framework for labor negotiations. Legacy airlines face numerous cost challenges, but both labor and management recognize there are opportunities for shedding some cost structure. Airline representatives talked about the inefficiencies built into current labor contracts with their unions and those between the FAA and air traffic controllers. A union representative stressed that airline management can hardly “plead temporary insanity” regarding the negotiation of past contracts. However, he stated, “Everybody knows defined benefit plans are dead” and acknowledged that all contract elements must be open for bargaining, including “scope clauses.” The forum yielded more agreement than anticipated about the ability of labor and management to make progress on the serious issues that have divided them for so long. Many participants felt that labor-management negotiations could yield more than had been realistically planned for in recent years. Current bankruptcy laws, according to most forum participants, allow practices that undermine industry competition and threaten the economy as a whole. Most forum participants decried the domino effect of airlines like United and US Airways off-loading their pension liabilities onto the Pension Benefit Guarantee Corporation. Other carriers, they said, are put at a serious competitive disadvantage. A representative of one carrier argued that a company should have a relatively short period of time to reorganize and then be required to compete or liquidate. There was general agreement that the law must be changed to prevent airlines from lingering in bankruptcy for years, where they can be shielded from costs that others in the marketplace must bear. Government, many participants argued, must take action to ensure a fair playing field. More effective government action is needed on the international front. Airline executives stated that for American carriers to compete effectively overseas, there must be a true U.S. commitment to “open skies.” They were critical of what they perceived as a lack of balance and equity in the individual negotiations. With respect to the EU, China, and Japan, one participant commented, “We don’t have real bilaterals.” Participants called for a uniform approach to slot pricing and suggested that U.S. policy address the lack of true “gateway access” in Europe, Japan, and China as a matter of national priority. 8 Where To Go From Here? Underlying the many concerns expressed at the forum was the question of whether the U.S. Government has a forward-looking policy for the aviation system. Apart from the federal participants, the industry leaders around the table expressed frustration at what they see as the government’s inadequate leadership on the critical issues facing their industry – the current and future air traffic control system, the increasing demand for boardings and aircraft operations, anti-competitive conditions in the marketplace caused by flawed bankruptcy protection, the use of the Trust Fund for operations, and gateway competition that is not well managed. The current federal role in aviation might be described as letting market forces lead. In response, industry leaders said that although pieces of policy exist, some policies, such as those governing fees and their use, are in conflict and that much of the industry functions on informal assumptions that are not clearly articulated or are erroneous (e.g., the coordination of the development of land and ATM capacities). They also noted that there are several areas where market forces cannot lead. Industry leaders stressed that a market-based approach alone is not adequate for the 21st century problems the industry is facing. At a minimum, the federal government must fix the things that only it can fix, such as air traffic control, bankruptcy laws, and the U.S. international negotiating strategy. Participants also said that the federal government must tie policy together with dedicated resources to accomplish these goals. Industry and labor participants acknowledged their own roles in dealing with certain inefficiencies in the system. For example, airline and union representatives indicated that there are still potential gains to be made through the labor-management negotiation process. In addition, airline and airport executives recognized the need to improve their communications as they plan for future increases in traffic. Risks The risks of not developing and pursuing an aggressive strategy for strengthening the U.S. aviation industry were made clear at the forum: The first risk is economic. America may lose out in competition against foreign airlines and manufacturers of airplanes and avionics. Perhaps more importantly, overall U.S. competitiveness is weakened relative to other nations or regions that are now investing heavily in improving their own aviation infrastructure. The second relates to safety. Secretary Mineta told the group that airline accident rates are now down to one per 6.7 million departures. While proud of their record, industry representatives voiced concern that the flying public may begin to take safety for granted, reducing the pressure to fund the safety enhancements that will be necessary to accommodate the growth in the system. Maintaining the current level of safe operations – with flight operations expected to triple over the next 20 years – will be an enormous challenge. 9 Moving Forward At the forum’s closing, representatives from the Eno Transportation Foundation, including Foundation Chairman Lillian Borrone, reiterated the Foundation’s willingness to serve as a convener for additional discussions about the aviation industry’s future and the public policy choices that will help to shape it. Borrone challenged the participants to provide suggestions for how the Foundation might pursue small next steps to continue the dialogue about the issues raised at the forum. 10 NEXT STEPS AND POSTSCRIPT For decades, national policy has been shaped through a series of vertical relationships between key aviation stakeholders and the relevant players in the Executive Branch and Congress. Airline executives have lobbied for their interests individually and as a group; airport leaders have done the same. Today, given the pressing need for action at the national level, the vertical model of policy development must be rethought. A new approach—in which stakeholders work with each other in a more horizontal manner—is essential. All players must develop better ways to pursue their individual goals while still promoting the overall health of the industry. In addition, capital investment decisions can no longer be left totally to Washington to resolve. The private sector must be allowed, through tax policy or other incentives, to pursue creative strategies to bring about critical modernization. As the experience of the three previous national commissions on aviation has shown, the traditional pattern of making recommendations to the federal government, and waiting for action, is not effective. Each commission has been accurate in forecasting outcomes and in constructing recommendations to help America strengthen its aviation industry. But few significant reforms were made as a result of the many recommendations made. It does not seem rational to attempt to repeat the process again. The previous commissions all focused their proposals on the national government, just as some of the suggestions from this recent forum focus do. There is a high likelihood that such suggestions will produce little from a system that is squeezed for resources and has such a strong aversion to anything but private sector leadership. The future of the aviation system rests squarely with the broad range of interests that are the real aviation industry. They have to develop the capacity to deal with each other directly as interdependent partners, without making continual reference to a federal government that, for a multitude of reasons, cannot perform to their expectations. This is not to say there is no essential role for the federal government. Only the federal government can set sensible aviation security standards. Only the federal government can ensure the integrity and consistency of safety standards. Only the federal government can negotiate better gateway agreements. And only the federal government can develop the new ATM system. The ATM system is the focus of a specific, but important, short-term next step that emerged from the forum. Participants agreed that the FAA and NASA need to work together through the JPDO to articulate the sources of funding for the ATM system over the next five years. The articulation should also include any possibilities for public-private partnerships. More broadly, another achievable next step is for the major aviation industry sectors (e.g., carriers, airports, aviation finance community, private aircraft owners) to begin meeting in small forums that focus on points of agreement and then broaden these relationships as progress is made and trust develops. The meetings could start with the most critical relationships, which include carriers and airports; labor and management; and carriers, airports, and the finance 11 community on funding the ATM. Some of this communication, such as the interplay between carriers and airports, has already begun but this approach needs to be a choice that the industry’s diverse elements make together. These meetings could lead to an industry-wide agreement on a blueprint for the future of American aviation. A clear plan of action, agreed to by the industry stakeholders, is a far better strategy than fighting with each other and expecting the federal government will somehow referee the struggle and solve pressing problems. There are few other options available. Postscript There were a number of significant developments concerning the U.S. aviation industry in the months following the forum. Passenger loadings continued to increase, surpassing the levels experienced before the September 11, 2001 terrorist attacks. The increased business has not helped most legacy carriers, however. They continue to struggle financially. In September, Delta and Northwest—the country’s third- and fourth-largest carriers—filed for Chapter 11 bankruptcy protection. By year end, analysts were forecasting that U.S. airlines would collectively lose an estimated $10 billion in 2005. Hurricane Katrina, which struck the Gulf Coast in late August, had a dramatic impact on the industry. The storm damage significantly disrupted regional air traffic by making airports in New Orleans and other locations throughout the Southeast unavailable for an extended period of time. Katrina’s most severe impacts were on fuel costs. Jet fuel prices, which were already elevated in the first half of 2005, climbed even higher during the storm’s approach and aftermath. At times, crude oil traded for more than $70 per barrel. Some low-cost start- up carriers such as Independence Air, which filed for bankruptcy in November and would later cease operations, had not anticipated such an extraordinary increase in fuel costs and found it difficult to operate in the post-Katrina environment. The 2005 hurricane season also further exposed the competitive disadvantage in which financially weak airlines find themselves when they are unable to hedge their fuel purchases. Financially stronger airlines (e.g., Southwest) were shielded from some of the impact of higher fuel costs because they could lock-in cheaper oil prices through long-term purchase agreements. Federal spending in the wake of Katrina has been a hot topic that may have long-term impacts on infrastructure investments for a number of industries, including aviation. Estimates indicate the price tag for post-Katrina recovery and rebuilding efforts could exceed $200 billion. These commitments, combined with a budget deficit that is estimated to exceed $330 billion in fiscal 2006 (Congressional Budget Office data), are increasing pressure on Congress and the Executive Branch to reduce discretionary spending. Investments like the funding for the ATM system may become targets for cuts under deficit reduction packages. Taken together, these developments are accelerating and deepening the industry’s challenges, and they emphasize the need to embark upon changes discussed at the forum. Looking to the future, forum participants agreed that for the U.S. aviation industry to meet expected increases in 12 demand and hold onto a global leadership position in passenger service and related industries, all of the stakeholders must come together to develop a comprehensive policy and coordinated plans for the 21st century. 13 APPENDIX A Forum Program Forum on the Future of the Aviation Industry May 10-11, 2005 Willard Hotel 1401 Pennsylvania Avenue, NW Washington, DC Tuesday, May 10 12:00 pm Welcome and Introductions Lillian Borrone, Chairman, Eno Transportation Foundation Lunch Forum Context and Purpose Ted Tedesco, Eno Transportation Foundation Board of Directors The Changing Airline Industry Bob Gallamore, Director, Transportation Center, Northwestern University The Commercial Aviation Industry and Its Next 5 Years Robert Crandall, CEO, American Airlines (retired) introduced by Ted Tedesco The Challenge Facing Aviation Norman Mineta, Secretary of Transportation, introduced by Lillian Borrone Facilitated Discussion Break Overview of Recent Examinations of Aviation Policy (The Walker, Baliles, and Mineta Commissions) Jeff Shane, Undersecretary for Policy, US Department of Transportation Key Issues in the Aviation Industry Today (Emerging business models, labor cost differentials, pension and health-care cost issues) o JayEtta Hecker, Government Accountability Office o Captain Dennis Dolan, Air Line Pilots Association 12:10 1:00 pm 1:10 pm 1:30 pm 2:00 pm 2:30 pm 3:20 pm 3:30 pm 3:45 pm 4:15 pm 5:15 pm 5:30 pm 6:30 pm Facilitated Discussion - Mort Downey Adjourn for the day Reception Dinner Speaker: George Hamlin, Director, Merge Global Wednesday, May 11 8 am 8:30 am Continental Breakfast Capital Infrastructure Requirements for the Airline Industry o John Lewis, Bank of America o Jordan Weltman, Boeing Capital Corporation Facilitated Discussion Break System Performance Requirements for the Next Decade o John Carr, President, National Air Traffic Controllers Association o Charles Keegan, Director, Next Generation Air Transportation System o Jeffrey Hamiel, Minneapolis-St. Paul Metropolitan Airports Commission Facilitated Discussion Lunch Opportunities to Drive Change, Actions Needed, and Possible Recommendations Wrap Up/Recommendations Concluding Remarks Lillian Borrone, Chairman, Eno Transportation Foundation Adjourn 9:00 am 10:30 am 10:45 am 11:30 am 12:30 pm 1:30 pm 3:00 pm 3:15 pm 3:30 pm APPENDIX B The following paper, “Confronting the Crisis: Today and Tomorrow in the Aviation Industry,” was written Robert E. Gallamore, Ph. D. and Aaron J. Gellman, Ph. D. of The Transportation Center at Northwestern University. Dr. Gallamore presented the paper’s findings to forum participants on Day 1 of the proceedings. Confronting the Crisis: Today and Tomorrow in the Aviation Industry Robert E. Gallamore, Ph. D. Aaron J. Gellman, Ph. D. The Transportation Center at Northwestern University Prepared for the Eno Foundation Conference on the Future of Aviation May 10 – 11, 2005 -1- Table of Contents Introduction ................................................................................... 3 Recent Financial Performance of the Airline Industry .................... 4 Challenges Facing the Domestic Airline Industry............................ 7 US Airline Industry Competitive Structure.................................... 15 The International and Intra-Regional Airlines .............................. 19 Aircraft Technology Development & Deployment.......................... 21 The Major Manufacturers.............................................................. 22 Airports ........................................................................................ 26 Air Traffic Management ................................................................ 27 General Aviation ........................................................................... 29 Airfreight...................................................................................... 30 Concluding Thoughts .................................................................... 31 APPENDIX: Reconsidering Applicability of the RLA to Aviation .…32 Table of Figures Figure 1: ICAO Scheduled Airline Financial Results (1988 to 2003). ............................. 6 Figure 2. Airline Demand Tracks Macroeconomic Conditions ………………………….………………… 7 Figure 3. Composition of Legacy Airline Expenses ...................................................... 9 Figure 4. Record Nominal Fuel Prices ....……………………………………………………………………………10 Figure 5. Labor Productivity Trends for Legacy and Low Cost Carriers ..……..………………...11 Figure 6. Asset Utilization Is Significantly Higher for LCCs........................................122 Figure 7. Recent Growth of the LCCs; Decline of the Legacies ................................... 13 Figure 8. Yield Has Declined Since 2000 for Both Classes.......................................... 13 Figure 9. ModelWare Adjustments for Legacy and Low Cost Carriers ……………………………..14 Figure 10. Increasing Competiveness in Large Markets............................................. 15 Figure 11. Deliveries of Jet Aircraft to US Airlines …………….…………………………………………… 17 -2- Confronting the Crisis: Today and Tomorrow in the Aviation Industry Introduction The airlines are about mobility. While this is the case for all modes and methods of transport, the airlines warrant particular attention because, first, they provide the principal means of mobility for medium-and long-haul passenger transportation throughout most of the world; second, air transport is rapidly becoming dominant in certain markets for freight transportation; and, finally, a large (and growing) portion of the airline industry is in jeopardy for various reasons. While this paper looks most closely at the U.S. airline industry, it will also briefly consider the state of air carriers in other countries and regions as well as economic and technology issues for key supplier industries and for non-carrier aviation activities which influence the future of the airlines. Robert Gallamore took drafting responsibility for Part I and Aaron Gellman drafted Part II. -3- Part I – Current Condition of the Industry Recent Financial Performance of the Airline Industry Most of us would not be here for this important meeting today if the airlines did not exist and if they were not in such dire financial straits: we couldn’t get here and we wouldn’t have much to talk about. That is the fundamental irony; why is it that important public service industries often can’t make the money they need for survival and renewal? Warren Buffet has joked (we know he never really jokes) that, over their full sweep back to the Wright Brothers, the airlines have earned negative profits. Or go see The Aviator to learn how easily Howard Hughes lost money on aircraft production and TWA operations. We love the birds, but with rare exceptions, their pro formas don’t fly. Recent press reports seem to predict even worse times in the months just ahead. In late February, credit ratings agency Standard & Poors warned that the risk of multiple, concurrent, bankruptcies in the airline industry is increasingly great. The collapse could be triggered by a new terrorist attack, a further spike in fuel prices (already at record highs in nominal dollars), or a crisis in pension funding. Despite a reasonably strong economy, almost all of the airlines have been weakened by factors such as these in recent months. Credit is deteriorating, says S&P, and balance sheets “are a mess,” according to Raymond Neidl of Calyon Securities. There could be a “domino effect of bankruptcies” as carriers try to lighten the burden of pension obligations, in the opinion of S&P’s Philip Baggaley.1 Perhaps the most authoritative report on the current economic and financial status of the American aviation industry was published by the General Accountability Office last August. It is a comprehensive review, titled “Legacy Airlines Must Further Reduce Costs to Restore Profitability.”2 The GAO pulls no punches: Chicago Tribune, February 25, 2005, Sec. 3, p. 4. United States Government Accountability Office, GAO-04-836 Airlines Financial Condition, August 11, 2004. 2 1 -4- Since 2001, the U.S. airline industry has confronted financial losses of previously unseen proportions. Over the last 3 years, 2001 through 2003, the airline industry reported losses of $23 billion, and two of the nation’s largest airlines went into bankruptcy. Following the tragic terrorist attack of September 11, 2001, the U.S. government has provided struggling airlines with $7 billion in direct assistance and many billions of dollars more in indirect assistance in the form of loan guarantees, a tax holiday, and pension relief.3 These are financial losses and governmental support funding of a scale not seen in U.S. domestic transportation industries since the railroad crisis of the early 1970s. The rail crisis was marked by collapse of the Penn Central and a half dozen other Northeast railroads – followed by bankruptcies and “near-misses” of several Granger railroads in the Midwest.4 Intercontinental air carriers have, for the most part, performed somewhat better than domestic airlines in the recent past, although they were also affected by 9/11 and the SARS epidemic. To illustrate combined financial performance for domestic and international carriers, we borrow from Dr. Peter S. Morrell of Cranfield University (UK) his nice picture of the cyclical nature of world airline results (Figure 1). Using operating margin and net margin as indicators of financial performance for the ICAO scheduled airlines from 1988 to 3 Ibid., p. 1. Three-fourths of the Federal assistance went to the so-called legacy airlines. The vast majority of the funds was aimed at compensating airlines for security expenses – including, for example, $100 million earmarked for cockpit door reinforcement. While the aviation and railroad industries are different in many respects and the causal factors not entirely parallel, the current aviation financial situation brings to mind all too many recollections of the 1970s railroad crisis: overcapacity, underlying structural shifts in demand, intense competition from carriers with more successful business models, persistence of legacy costs tracing to both labor relations and regulatory restrictions, sharply defined fixed and variable cost structures with marginal costs everywhere below average unit costs, rapid inflation in fuel prices, and that old blessing/curse – service “imbued with the public interest” and overseen by government agencies lacking the full set of policy tools to solve the crisis quickly and rationally. Arguably, there is another similarity between 1970s trains and 2000s planes – the difficulty of exiting markets. Railroads were still tightly regulated in the early 1970s, and line abandonment required ICC approval; (note parallel conditions for passenger train discontinuances prior to establishment of Amtrak in 1971). Since airline deregulation in 1978, air carriers are free to withdraw from market segments, but, like railroads, they face huge costs in exiting large portions of the industry by other means – turn-back of aircraft and airport leases, labor protection costs, pension liabilities, and, of course, bankruptcy transaction costs. Exit by merger is another avenue available to both industries, but regulatory risks in mergers and the record of benefits to shareholders is mixed for both modes; merger is no panacea. 4 -5- 2003, the chart shows deep losses in the Gulf War and early 1990 recession years, and then again since 2001.5 Figure 1 shows airline financial results were headed in the wrong direction even before 9/11, and that the damage from that awful experience has not yet been fully repaired. Morrell’s piece documents that the down cycle of the early 2000s has been worst in North and South America and Africa/Middle East, while Europe and Asia/Pacific have not fared as badly. Professor Morrell’s work also explains that leisure, regional, “low cost,” and express parcel carriers are doing better world-wide than the majors and cargo lines; Southwest, JetBlue, and FedEx have bucked the trends quite remarkably. Figure 1: ICAO Scheduled Airline Financial Results (1988 to 2003) Professor Morrell might have carried his aviation financial cyclicality chart backward to show additional deep down-swings in the early 1970s and 1980s. See Figure 2, which relates airline passenger demand to changes in GDP for the period 1979 to 2003: Peter S. Morrell, “Recent Trends in Airline Financial Results,” Cranfield University Air Transport Group, [www.airport-int.com, accessed 2/21/2005]. 5 -6- Figure 2. Airline Demand Tracks Macroeconomic Conditions Challenges Facing the Domestic Airline Industry The August, 2004 General Accountability Office report referenced earlier provides additional background worth summarizing at this point. Congress specifically requested an overview of the factors troubling American airlines today, and a report on actions the carriers were taking to improve their situation. The GAO’s summary of airline challenges is shown in the box on the next page. In response to the challenges listed by the GAO, legacy airlines and LLCs together reported to the Congress’s key oversight agency nearly $20 billion in cost saving initiatives for the period October 2001 through December 2003. During that time, actual operating costs decreased $12.7 billion, or 14.5 percent, according to the GAO report. Legacy carriers -7- GAO’s Summary of Major Challenges for the Airlines Congress asked the GAO specifically to address the major challenges to the industry since 1998, and to catalogue measures the airlines are taking in the effort to remain financially viable. GAO’s list of challenges includes: 1. Structural changes altering historical trends. a. Internet sales channels easily identifying prices * b. Advent of new-style low cost carriers (LCCs) c. Growth of regional airlines 2. External shocks depressing air travel demand. a. September 11, 2001 b. War in Iraq c. SARS outbreak in Asia d. Decline in business revenue yield (from all causes) cut their seat capacity by about 12.6 percent during this period (including by parking planes in the desert), while LCCs added over 26 percent new capacity and increased total operating expenses by nearly 10 percent. In addition to changes in capacity, airlines sought cost savings in salaries and benefits, vendor concessions, and other productivity improvements. Legacy airlines reduced labor costs by $5.5 billion during the period, about 16 percent. Figure 3 (Figure 9 in the GAO report) shows those labor cost reductions were the largest single component of savings in the study period. __________________________________ * Internet sales channels are a mixed blessing for most airlines. While enabling carriers to move away from high cost commissions to travel agencies, internet channels facilitate consumer price-shopping. Some observers go so far as to say that the visibility of fares and the ability to search alternative flights on the internet has made airline service like a “commodity” to be traded almost without “brand preference.” Some carriers are trying to buck the trend by offering upgraded seating and communications services. Also, frequent flyer rewards programs seem assured, but meals and other enticements are endangered if not gone. On balance, internet sales of airline seats appears to be both inevitable historically and a net contribution to consumer welfare. -8- Figure 3. Composition of Legacy Airline Expenses Fuel expense in Figure 3 shows a two percent decline in 2003 compared with 2001. That certainly will not be the case in 2005 compared with 2003. The spike in fuel prices this year has hit the airlines very hard. While Southwest was able to hedge fuel costs with great success in the most recent quarters, most airlines do not have the cash flow to support a robust hedging strategy as SWA was able to do. In any event, fuel hedges have by nature only short term impacts, and the current rise in energy costs shows every sign of lasting longer and doing more damage to the economy than other spikes in the last two decades. Figure 4 shows US fuel prices are at historically high levels in nominal dollars; while they have a ways to go before reaching inflation-adjusted record levels, the pain is being broadly felt. The rising cost of fuel may stimulate sales of new, more energy efficient, aircraft. During the period studied by the GAO, both legacy and low cost carriers took pricing actions to enhance revenues in the face of weak demand, but revenue enhancement actions -9- Figure 4. Record Nominal Fuel Prices in Recent Months by the airlines were small relative to the cost-cutting reported to GAO. Legacy carriers expected benefits from fare re-structuring, schedule changes, and new code-sharing agreements, but most of these were only realized in 2004 – operating revenues actually declined in the period Oct. 1, 2001 to Dec. 31, 2003. LCCs also achieved little in the way of unit revenue enhancement, but they increased total revenues over the period with volume growth. Four other charts from the GAO report – two on the supply and productivity side, and two on the demand and revenue side – tell us almost all we need to know about the differences in financial performance between the legacy airlines and the LCCs. Figure 5 shows labor productivity, measured as millions of available seat miles per employee, for the two classes of carriers over the period 1998 to 2003. While the trend strongly favors the - 10 - LCCs, the performance of the legacy carriers in the benchmark year of 1998 –and their strong improvement in 2003 – is cause for some optimism. Figure 5. Labor Productivity Trends for Legacy and Low Cost Carriers Figure 6 monitors the other large factor differentiating cost performance between the groups, asset utilization (measured here by average block hours per day per aircraft in service). This series is not a measure of total capital productivity, but it is indicative of economies the LCCs are able to achieve by concentrating on fewer aircraft types, newer aircraft with lower maintenance and fuel costs, faster turns of equipment between flights, and predominant use of point-to-point operations (in contrast to the legacy airlines’ more typical hub-and-spoke networks). - 11 - Figure 6. Asset Utilization Is Significantly Higher for LCCs On the demand side, Figure 7 (GAO Figure18) shows indexed growth in revenue passenger miles for our two groups of air carriers over the period 2000 to 2003. Low cost carrier RPMs have increased nearly 37 percent, while legacy airline passenger volume has fallen 11 percent. Yield, defined as revenue cents per revenue passenger mile (RPM), is shown in Figure 8, where it is corrected for inflation to 2003 dollar values. Legacy carrier yield has declined by about 3½ cents per RPM since 2000. LCC yield has dropped about 2 cents in the same period, and remains below legacy levels. Because “apples-to-apples” comparisons are difficult in industries that use a lot of operating leases and other less-well-understood financial strategies, Morgan Stanley has recently developed a product, called “ModelWare,” to convert operating leases to on-balance sheet entries – appropriately reducing lease expense and increasing depreciation, - 12 - Figure 7. Recent Growth of the LCCs; Decline of the Legacies Figure 8. Yield Has Declined Since 2000 for Both Classes - 13 - debt-to-capital ratio can double or triple as a result. By treating what really are financing costs as operating expenses, these companies are under-reporting operating margins, Morgan Stanley says. The adjustments for off-balance-sheet assets and liabilities typically result in slightly lower returns on net operating assets.6 Figure 8 shows how these adjustments affect the reported financial performance of some of the largest publicly traded air carriers. Figure 9. Airline 2004E Financial Performance as Estimated and as Adjusted with MorganStanley’s ModelWare (MW) Legacy Airlines Low Cost Carriers Pretax Profit Margin Before MW Pretax Profit Margin After MW Return on Net Opn Assets Before MW Return on Net Opn Assets After MW SWA 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% AMR Cont’l Delta NWA AirTran Frontier JetBlue Source: MorganStanley 9/16/04 6 MorganStanley, Global Transportation, Sept. 16, 2004. - 14 - US Airline Industry Competitive Structure Congress also specifically asked GAO to address changes in the competitiveness of the domestic airline industry since 1998. Traditional economic analyses in the field of industrial organization (IO) count the number of effective competitors in each relevant market (defined by cross-elasticities of demand for substitutable products). While numbers alone are important in IO theory (because they are thought to indicate the difficulty of organizing and policing anti-competitive cartels), modern practice also looks at relative shares of the market held by different firms to measure the degree of supposed market dominance (pricing power) of individual firms in the industry. Market share percentages are squared and added to compose the Herfindal Index, which runs from zero (perfect competition) to one (monopoly); the reciprocal of the Herfindal Index approximates the number of effective competitors in the market. The GAO’s analysis (Figure 10) shows most large markets have more than two effective competitors, and the largest markets have increased from under three to more than three since 1998. The GAO concludes, correctly no doubt, that overall industry competitiveness has increased in the last half dozen years because of the growing importance of the LCCs. Figure 10. Increasing Competiveness in Large Markets - 15 - Research is underway to measure the consumer welfare benefits of this trend empirically. In all likelihood, this research will extend traditional industrial organization theory (based on numbers and market share of competitors) to reveal more about the actual impact on consumer welfare of competition between and among both legacy and low-cost carriers. While the distinctions between these types may be blurring (legacy carriers cutting frills, and LCCs making stronger appeals to business customers), the impact of a carrier like Southwest entering an established legacy market is enormous. This can be observed in such everyday occurrences as airline customers driving two or three hours to a more remote airport in order to take advantage of a Southwest-compelled fare. An important set of implications for further observation and analysis is the impact LCCs have had and continue to have on the legacy carriers’ mainstay innovation of the last two decades, namely yield management. Unquestionably, effective yield management systems employ management features somewhat at odds with typical LCC operations., For example, yield management requires a seat reservation system capable of supporting dynamic demand forecasts for individual flights over a six to eight week period, an “overbooking” algorithm (with auctioning of oversold seats and reasonably fair compensation for “bumped” passengers), and, typically, willingness to tolerate a complex set of fares characterized by travel class and date restrictions. The benefits for airlines using effective yield management systems are higher utilization of available seat miles (ASMs) and capture of a portion of what would otherwise be consumers’ surplus in the form of contribution to airline profits. The expert consensus today continues to be that the industry has “too many seats chasing too few passengers.” In this regard, longtime industry consultant George Hamlin of MergeGlobal documents what he calls the “Battle of the Bulge” – the runaway addition of new capacity in the industry at the end of the 1990s. Figure 11 shows the pattern, and many older planes wound up parked in the desert. The build-up of all that excess capacity has put downward pressure on pricing and has hurt balance sheets and earnings statements. Sustained demand growth could bring this sunk investment back on line, of course, as has - 16 - already begun to happen in recent months, but it is not yet enough; Hamlin’s suggestion is to sell the excess capacity overseas, if possible. Figure 11. Deliveries of Jet Aircraft to US Airlines In considering the current competitive structure of the airline industry, no issue is more explosive than that of proposals to repeal the Wright Amendment. A part of the political compromise that permitted start of construction of DFW Airport in 1968, the Wright Amendment sought to move carriers out of Dallas’ Love Field to DFW, and in the event they stayed at Love, restricted their non-stop flights to within Texas and adjacent states. Southwest Airlines, of course, has done extremely well from its Love Field base, but would like to have more flexibility for its hub there. Dallas officials believe high air fares out of DFW and the restrictions on SWA non-stops hurt local business and tourism. Meanwhile, - 17 - DFW is opening a new terminal while also wondering how to find tenants for the space just vacated by Delta. American Airlines and DFW authorities will fight change in the Wright Amendment.7 The policy implications of the recent dramatic shifts in USA domestic airline industry structure are a bit messy, because, again as in the railroad industry, competition affects both pricing (direct and near term user benefits) and profitability (needed for long term industry sustainability).8 On pricing, public policy is always skeptical of price discrimination. Yield management tries instead to make it “price differentiation” (a less provocative moniker). If yield management does improve profits, public policy might gain more than it loses, because the industry needs earnings to support re-investment. The structure of industry competition enables yield management-based profits in some markets and endangers them in others. And profit per se is not the only matter of importance. Profit used for re-investment in growing low-fare operations is a good thing; profit from high margins and restricted entry is not. Profit lost in inadvisable expansion or “buying” volume yields only transitory welfare gains; excess capacity that destroys industry profitability is more a curse than a blessing. United CEO Glenn Tilton got it right in a recent address before the Chicago Council on Foreign Relations’ conference “Moving the World: Global Aviation and the Global Economy.” “Since deregulation in 1978, the U.S. Government has pursued a policy that encourages the maximum number of domestic carriers and discourages consolidation, which prevents the development of strong carriers with national coverage. . . .[T]he U.S. needs to reverse the bias against airline size and remove the barriers that prevent us from becoming competitive on a global scale. To compete with the “super-carriers” that are emerging internationally, U.S. carriers need to gain their own scope and scale.” 7 8 The Chicago Tribune, February 20, 2005, Sec. 1, p. 14 Robert Gallamore, “Regulation and Innovation: Lessons from the American Railroad Industry,” Essays in Transportation Economics and Policy, Jose A. Gomez-Ibanez, et al., Brookings Institution Press, 1999, pp. 525-526. - 18 - Part II – Perspectives & Prospects The International and Intra-Regional Airlines Air carriers operating internationally have historically faced a substantially different market than those offering domestic – or sometimes, foreign intra-regional – services. For the past quarter-century, it is the different degree of economic regulation which has most characterized the disparity. There is now a well established pathway leading to a narrowing of these differences and, perhaps, ultimately to the elimination of them. The best indication of the trend is what is transpiring in Europe. For many decades European skies were dominated by nationalized airlines. These “flag” carriers of each nation were not only protected from effective competition by national government grants of authority to serve given routes, but also were permitted secret revenueand market- sharing agreements with other flag carriers. With the rise of the European Union (EU), all this has changed. Today, European skies are open to all qualified European carriers. As a result, airline fares are down and service has increased in most intercity markets. This mirrors the experience with economic de-regulation in the U.S., which preceded that in Europe by more than a decade. Deregulation is not the only way in which the U.S. and Europe share a common aviation experience. There are growing airport and airway capacity issues on both sides of the Atlantic (about which more below), and both regions face the problem of excess capacity being pumped into the air carrier systems of domestic, regional, and intercontinental airlines. At the heart of the issue of excess capacity is the below-cost (i.e. subsidized) selling of aircraft by what can best be characterized as an aircraft producer pursuing some goal other than profit maximization. In both the U.S. and in Europe, this is a major factor – not the only one, perhaps, but a critical one – threatening the existence of legacy carriers. In fact, such behavior has already contributed to the undermining of several carriers both European and - 19 - American. The same problems will face the Far East and South America as well if the manufacturer, in seeking world domination of the large transport aircraft market, continues to pursue a policy of doing whatever it takes to make a sale regardless of the economic consequences for itself and for others. The general turmoil of commercial air transportation in most countries and regions has led to carriers exiting the industry, consolidating within it, and facing the advent of new entrants. These are signs that the worldwide airline community has become mature and, in this important respect, is behaving like a “normal” industry. More of the same can be expected far into the future. As noted earlier, intercontinental air carrier markets have, for the most part, remained profitable (except in the wake of 9/11). One reason may well be that they have generally been the last markets to retain a measure of economic regulation. Sometimes the “measure” has been substantial (e.g. service to and from China) and sometimes modest (e.g. many Europe-U.S. routes). In all such markets, carriers allege that international code-sharing has been a boon to them as unit costs have often been reduced and load-factors increased. But as traffic builds in a market, it could well be that code-sharing takes on the coloration of reregulation (now by private parties) and the benefits to the consuming public turn illusory. Regulatory scrutiny of code-sharing is unlikely to be the greatest concern of intercontinental air carriers. Far more worrisome for them – in all markets characterized as economically deregulated – is the introduction and expansion of low-cost carrier services. International routes and gateways are generally considered a refuge for the legacy airlines – a life-preserver in these stormy times. But will it last? LCCs will ultimately visit upon many of today’s most profitable intercontinental markets an experience similar to that of national and inter-regional airlines currently (e.g. USAirways and British Airways’ European services). Aer Lingus of Ireland is already operating in an LCC mode on the Atlantic and others are sure to follow. Indeed, if the Boeing 787 turns out to be as efficient to operate as projected, it will surely catalyze the spread of LCC offerings in intercontinental markets – whether operated by existing airlines or new entrants. - 20 - In the rapidly globalizing economy and society, inter-continental mobility will take on increasing importance for the benefit of all nations. Times may often be turbulent, but air transport effectively serving myriad world markets will continue to be an indispensable catalyst of economic and social globalization. Aircraft Technology Development & Deployment The development of aircraft is arguably more market-driven today than at any other period since the Wright Bothers began it all. Perhaps it is more accurate to say that aircraft producers are more driven than ever before by perceptions of what the market wants. Airbus clearly believes that large numbers of passengers – 500 to 840 – will fly between distant hubs in the same aircraft at the same time. Why else the A380? Boeing, on the other hand, holds that people would rather avoid an intermediate hub and fly directly to or from at least one non-hub point. Hence the Boeing 787, which accommodates less than half the passengers of the A380, but can also fly stage lengths of more than 7,500 miles. Of course, a shared objective of both competitors is to lower airline unit costs while offering at least “premium” customers a better “experience.” Size, however, is not all that distinguishes these two path-breaking aircraft. For example, while the A380 uses laminated composite materials (including “Glare”) in a number of components, the 787 airframe structure is virtually entirely built of integrated carbon-fiber composites – a substantially different technological approach to minimizing airframe weight and reducing maintenance costs. Following the formal announcement by Boeing of the then 7E7, Airbus countered with its A350 based upon the A330. At present, it is said to have an aluminum fuselage with a composite empennage and all-new composite wing. Plans for the A350 are to fit the same engines as the 787, but whether or not it can - 21 - match the projected efficiency of the 787 remains to be seen. The principal competitive struggle is clearly about aircraft unit size and operating efficiency. In the “regional” jet market, for some years a battle has raged between Bombardier/Canadair and Embraer of Brazil. While the latter had a broader range of aircraft – 35, 40, 45 and 50 seaters – Canadair sold more of its 50- and 70- seat models, both based on the same airframe. Then Embraer undertook development of 70- , 90- , 100- , and 120seat aircraft, all based upon a new, common airframe. It seems to have trumped Canadair, which cannot stretch its basic fuselage beyond about 90 seats; the Canadian firm is having difficulty committing to the major development program a larger aircraft will require. Meanwhile, new aircraft are expected to enter the market from non-conventional sources such as Russia and China. Some will likely be the result of cooperation with at least Embraer, but others may be entirely original, possibly embodying innovative technology. The Major Manufacturers The manufacturers to be considered in this section are those that produce large airframes, engines and avionics. The principal technological issues for each segment will also be considered Aircraft For airframes and finished aircraft, there are but two major producers of large transports and two of regional jets. These are, respectively, Boeing and Airbus and Bombardier and Embraer. Both pairs of competitors are locked in a sometimes brutal battle, as competitors should be. But the nature of the present battle is not always what serves the long-run interests of the marketplace. The Boeing-Airbus conflict illustrates the point. The former seeks to serve purely commercial goals (i.e. long-run profit-maximization) while the latter seems governed importantly by social goals such as job-creation and retention, and by objectives other than financial results. To this end, Airbus is clearly subsidized, directly and - 22 - indirectly, by several European governments. Boeing receives no direct “state aid” whatever, and precious little R&D support from government defense contracts that is relevant to its commercial products. This situation certainly does not result in a level competitive playing field; it raises the question as to how long the U.S. government will tolerate the situation and how long Boeing will remain in the business of supplying large transport aircraft to the market as it is now structured. As previously noted, Bombardier (Canada) and Embraer (Brazil) dominate the regional jet aircraft market. Embraer is likely to become the market leader, whether or not Bombardier actually chooses to develop a new, larger aircraft as Embraer has done. Importantly, these larger “regional” aircraft are putting Embraer (and prospectively Bombardier) in competition with Boeing and Airbus at the smaller end of their product offerings – the 737-600 and the A318 respectively. Both Bombardier and Embraer have been subject to counter-subsidy sanctions by the World Trade Organization (WTO), but so far with little impact on their business development programs. Engine Manufacturers As for engines, there are three major suppliers, General Electric, Pratt & Whitney (United Technologies), and Rolls Royce. With one notable exception, at least two suppliers are represented in powering each major aircraft type. (The exception: the Boeing 737, for which only the GE-Snecma CFM-56 is offered.) Again, the playing field is not entirely level, as Rolls Royce receives government funding support not available to its U.S. competitors. That said, all three firms continue to pursue the available and prospective markets through R&D and vigorous sales campaigns, and through the formation of teams to create new engines (such as the “Alliance” powerplant offered by a GE-P&W joint venture for the A380). For the past quarter-century, most aircraft engine technology was driven by environmental regulations. These had become increasingly strict with respect to both noise and emissions. Engine efficiency was ignored neither by either manufacturers nor by - 23 - regulators, but environmental performance occupied the high ground. Of late, with rising fuel prices, efficiency has moved into the spotlight once again – though certainly not at the expense of environmental protection (noise and emissions) or safety. To a significant degree, engine performance improvement has been a result of engine manufacturers’ need to meet the efficiency requirements for the Boeing 787 and, subsequently, the Airbus A350. And no doubt the poor state of airline industry finances will continue to act as an incentive to enginemakers to develop and deploy a variety of technological innovations benefiting aircraft of all sizes. Along with this quest for lower operating costs, regulators seem determined to raise the noise bar once more – and this will keep engine producers scrambling to find ways to meet expected new standards without undermining efficiency. Avionics – The Aircraft and Operator Sides Some of the most dramatic technological changes in new aircraft will be found in the avionics with which transport (and other) aircraft will be equipped. “Fly-by-wire” control systems in many larger, more modern, aircraft will be displaced by “fly-by-light” in future aircraft (in part because of its resistance to outside influences such as through terrorism). But it is in the field of communications and navigation equipment that radical changes in avionics will first be seen, not only in new aircraft but also through retrofitting existing planes. New avionics equipment will be driven largely by requirements to modernize worldwide air traffic management infrastructure as part of the solution to the unrelenting increase in demand for airspace. (Air traffic management – ATM – is discussed below.) The new avionics systems for communications and navigation will generally make use of “software radios” which promise to be less expensive to acquire and maintain than current equipment, will weigh less, and will require less space in the aircraft – all plusses. Most important, perhaps, the new equipment will facilitate worldwide interoperability and will be readily adaptable to changes in the ATM system as it evolves. Avionics dedicated to aircraft and engine command-and-control are already quite sophisticated and capable, especially in their most advanced forms. These systems already - 24 - support a high degree of flight-deck automation in all phases of flight but, no doubt, will become even better in the future. Among the most important new avionics are those which enable “weather-in-the cockpit” and a modest, but growing, capability of pilots to selfseparate in the air and to detect runway obstructions to a safe landing or takeoff. Another class of advanced avionics that will be adopted increasingly is Head–Up Displays (HUDs) which assist take off and landing in low-ceiling, low-visibility conditions. HUDs are also beginning to be equipped with forward-looking infrared (FLIR) devices, again to enhance the ability to operate into and out of fields with limited landing aids. This promises to increase the ubiquity and reliability of air service, especially in poor weather. Avionics represents a declining proportion of the price of new transport aircraft. Modern aircraft avionics provide not only communications and navigation capabilities but also flight control systems (e.g. fly-by-wire and flight management systems) and, increasingly, passenger entertainment systems. They are an integral part of the aircraft and, in a real sense, represent the “intellect” of the vehicle. Avionics costs will be more stable in future generations of aircraft but they will continue to be a major cost component both with respect to aircraft price and maintenance expense. Avionics – The Supplier Side For many decades the U.S. has dominated the supply-side of the avionics market. To the present, virtually all transport (and high-end business jets) have had avionics suites largely or entirely of U.S. manufacture. Now, however, the historic market position of the U.S. is being challenged by two developments. First, there is the transition to satellite-based navigation and communications in which Europe is making huge investments and, second, EADS, Europe’s largest aerospace firm and owner of 75 percent of Airbus, is seeking to acquire Thales, the largest and most capable European producer of avionics. It is reasonable to expect that, if this acquisition is completed, U.S. avionics manufacturers will be shut out of Airbus aircraft, if only gradually. In large measure, this will be due to the necessary integration of avionics with airframes and engines, leaving aircraft buyers with no option but - 25 - to accept the avionics choices of aircraft producers. To a considerable extent, it suggests that U.S. commercial avionics producers will, in the long run, be tied to sales of Boeing products and possibly regional aircraft of foreign manufacture. Airports It is trite to say that without airports, aviation is the sound of one hand clapping – but it is nonetheless true. Availability of runway capacity is the principal issue – and it comes in two parts. First there are the actual runways themselves and, second, the intensity with which given runways can be used. At present, the focus is almost entirely upon the former. Although everyone in aviation acknowledges it is a long and tortuous process to build a new runway (much less a new airport), little attention is being paid to the latter. This will have to change if civil aviation development and growth are able to respond to the nation’s (and the world’s) need for more air service. The limits of airport and airway capacity (the two are closely linked, of course) at certain times and places has led inexorably to a consideration of peak-hour (congestion) surcharges. What is not clear is the level of prices necessary to cause airlines to shift their operations off such peaks. Nor are either the effect on the mobility of a region and the nation – or the safety implications – of such surcharges well understood. Before being imposed, these issues should be resolved. It is also appropriate to point out that airports wrestle not only with a peak capacity problem but also with a capability one. Anticipation of the Airbus A380 highlights the issue; at virtually all airports it is intended to serve, advent of the A380 requires substantial incremental investment if the airport investment to be capable of accommodating it. There are two aspects to be considered: making the “aeronautical surfaces” capable of accommodating the aircraft and having terminal facilities capable of handling nearly twice the passenger and baggage loads of a typical 747. There is also the problem of making - 26 - alternate (backup) airports around the world A380-capable. All this raises the question of who should bear the unprecedented “capability costs”; perhaps it should be only the carriers that operate such aircraft or the manufacturer (for which there is precedent), but it is to be hoped that in no event would a burden be placed upon those airlines with no plans to acquire the A380. Air Traffic Management Few knowledgeable observers would deny that there must be a shift in approach from the concept of “air traffic control” (ATC) to “air traffic management” (ATM). It is distressing, therefore, that some current controllers and their union leaders declare that the automation which comes with the step-up to “management” means that controller jobs will be lost. The truth is that jobs will not be lost, only changed. If the demands for airspace by all aviation users are to be met, it is necessary that there be fundamental changes in the way air traffic is handled. At base, the problem is that most navigation currently relies upon terrestrial reference points, which channelizes traffic and significantly reduces the capacity of the air traffic system. Development of sufficiently accurate positioning through the Global Positioning System (GPS) opens the door to more efficient use of airspace and to a substantial increase in system capacity. Also, ATM creates an ability to fly more directly and more safely from take-off to landing. The challenge – and the opportunity – of advanced ATM systems is recognized not only in the U.S. but throughout the developed and much of the developing world. Yet there is great disparity in the national and regional responses to this urgent problem – more in the timing of changes than in the likely technological solutions. Most important, Europe is moving smartly to implement primary aircraft navigation by satellite within this decade. Ironically, the U.S., which pioneered satellite-based determination of latitude, longitude, and altitude with its Global Positioning System (GPS), is looking to make the transition no earlier than the middle of the next decade. - 27 - For many reasons, this is intolerable. First, asynchronous implementation of nextgeneration ATM will mean additional training and avionics for all pilots and aircraft flying in both terrestrial and satellite-based environments. Second, it gives European avionics firms a competitive advantage in equipping aircraft meant not just for Europe but for many regions of the world that will find satellite-based systems more appealing than the ground-based alternatives. In turn, this will threaten -- perhaps undermine -- the balance-of-trade benefits the U.S. has enjoyed from avionics exports for many years. Third, it provides Boeing’s principal competitor with an excellent opportunity to tie the acquisition of its aircraft to the provision of a modern ATM system. This will be made easier if EADS folds Thales into its enterprise. Returning to the opening theme of this paper, it is clear that the current U.S. air traffic control system is not capable of meeting the mobility needs of the nation. The limitations of the current system are a major threat to airline viability and must be recognized as such. It is frustrating that the U.S. is tip-toeing in an area where it should be leading boldly. Unless the FAA moves forcefully towards a more capable ATM system with technology already largely available, the U.S. will extract a high price from both its aviation sector and the public at large. To meet the growing crisis, Congress must support both the FAA and NASA (which is responsible for ATM-related research and some level of development). These two agencies must be connected by an “intellectual bridge” which serves as the means for transferring NASA achievements to FAA for implementation. The development-deployment bridge must be effective and efficient; it must ensure that the FAA’s Air Traffic Organization (ATO) will deploy NASA developments in a timely manner. For its part, FAA must recognize that the required ATM changes represent a substantial discontinuity in air traffic control technology and technique; ATO leadership cannot be handicapped by a bias towards “control” and a consequent antipathy to “automation.” The need for change, therefore, is not only technological, it is also institutional and cultural. - 28 - General Aviation The term “general aviation” refers to all civil aviation except air carriers. Its development has several important implications for the airlines. Most important, perhaps, is that general aviation’s needs for airspace and runway access often conflict with those of the carriers at major airports. The FAA program to encourage “reliever” airports has met with only limited success. Also, the failure to preserve former military airfields for civil use has been especially pernicious. These are but two reasons why the competitive demand for airport capacity exceeds the supply at critical times; matters are not likely to improve in the near future. For example, as “fractional” (shared) jet ownership continues to grow, the problem will become worse.9 And then there is the advent of the “microjet.” The first such aircraft out of the box will be the Eclipse, a small, highly capable jet which promises to encourage advanced individual pilots (e.g., those now flying single or twin tuboprops) to move up to a jet. Such aircraft will be the basis for emerging ubiquitous air taxi services even while broadening the market for corporate-owned and fractional jets. The microjets, along with other sources of growth for general aviation, will also create ATM challenges which must be met if all categories of civil aviation are able to make their full contribution to national welfare and mobility. There is still more. The high-end of general aviation – business jets and microjets – will certainly compete with the airlines for the latter’s “premium” passengers, those that fill the front of the cabin at high fares and make many flights worth the effort. Any threat to front-cabin passenger demand is a threat to airline service on many routes. The threats will become increasingly real as general aviation aircraft become more capable – as evidenced by development of the Gulfstream 500/550, Dasault 900, Canadair Global Express, Boeing BBJ, and Airbus ACJ. How the “full-service” airlines react to this new competition will tell much about their service strategy for the future. 9 Fractionally-owned jets operate about three times the number of hours per year as other business jet aircraft. - 29 - Airfreight The most dramatic growth in civil aviation is air cargo. Both “categories” of airfreight – package express and heavyweight – are expanding rapidly and are expected to do so for many years to come. To the present, the operations of airfreight aircraft have not interfered significantly with those flights primarily devoted to passengers. The cargo air carriers have simply tended to fly during different times of the day. But, as demand for airfreight services expands and as new services are developed, it is likely that competition for airspace and airport “slots” will intensify. This will be the result of the growing number of freighters as well as freight carriers’ use of more of the clock to raise the daily utilization of aircraft. (Already FedEx’s U.S. Postal Service operation has some sixty wide-bodies doing a “day turn” at Memphis.) Package express services are both domestic and international, with the latter now growing most rapidly. The conventional wisdom is that heavyweight airfreight service is largely an international market, and so it was for many years. But domestic heavyweight airfreight is growing in the U.S. and its analogs in Europe and China are as well. The implications are substantial both in number and importance. Certainly these airfreight operations will tax the airways and airports they share with passenger carriers. They also represent a growing worldwide market for airlift and, therefore, aircraft. While there are examples of new freight aircraft being acquired (e.g., FedEx’s original acquisition of the MD-11, A300-600F and A380 aircraft – and UPS’s newly acquired or ordered 757, 767, A300-600F and A380), most often freighters are converted passenger aircraft. This is likely to continue to be the case in the future. The conversion trend is of substantial benefit for all commercial aviation; it provides a market for aircraft which would otherwise be sold overseas, scrapped, or consigned to the desert – most often ultimately for parts. Looking further into the future – at least a decade or two – many observers anticipate that airfreight carriers will pioneer the use of large unmanned civil aircraft (UAVs). Today the government, through several of its elements, is flying UAVs every day. The missions are varied, ranging from defense and intelligence-gathering to border protection to scientific - 30 - research. None of the UAVs are large by transport standards – yet. But experience is being extended rapidly in the areas of design, deployment, command and control of the “birds,” and in the management of airspace populated by a mixture of piloted and unmanned aircraft. Concluding Thoughts With all the turmoil the airlines have faced, with all the economic and market challenges, it is well to recognize explicitly that the civil aviation sector in the U.S. and most of the world represents the very safest form of passenger transport. The trend to even greater levels of safety is clearly established, as is the realization that it is largely due to the dedication and skill of most aircraft operators, their employees and suppliers, and regulatory authorities that oversee safety. Airlines clearly recognize the critical importance of safety to their individual survival – “good safety is good business.” For the U.S., it is important to appreciate the challenge to U.S. primacy regarding the development and deployment of civil aviation technology, techniques, and services being mounted in Europe. “Vision 2020” of the European Commission is “must” reading for those involved with or simply interested in the future of the U.S. in civil aviation, including Congress. Vision 2020 and subsequent documents lay it on the line: Europe is embarked on a course to become dominant in all aspects of aviation even it if requires massive “state aid” to achieve Europe’s goals. The U.S. needs to dedicate itself no less to thwarting Europe than Europe seems bent on trumping the U.S. – even if the techniques employed to safeguard U.S. positions differ from those of Europe. - 31 - APPENDIX: Reconsidering Applicability of the Railway Labor Act to Airlines10 Labor-management relationships in the airline industry are governed by the Railway Labor Act (RLA) of 1926, which, in turn, is administered by the National Mediation Board (NMB). A main objective of the RLA is avoidance of interruptions in interstate commerce through reaching labor-management settlements; indeed, this objective may rise above all other interests. The consequence is greater governmental intervention in the collective bargaining process of airlines and railroads than would be the case under otherwise applicable labor law. The key steps followed by the NMB, as highlighted in sections 5 and 6 of the RLA, are as follows: 1) One party sends notice to the other about its desire to alter certain identified contract provisions. 2) A period of direct negotiations. 3) An unlimited period of mediation. 4) An offer of arbitration. 5) A 30-day cooling off period after strike or lock-out notification. 6) Repeat as needed – or imposition by Congress of a settlement. In rare cases, actual work interruption. This process is intentionally cumbersome both in time and resources and requires the parties to make every effort to reach agreement. In essence, the process sacrifices flexibility and responsiveness for stability and compromise. Labor relations stability is important, but with increased competitiveness in the airline industry on both domestic and international routes, more managerial flexibility in tailoring operations to market realities may be essential to airline survival outside bankruptcy proceedings. Can collective bargaining between unions and management be more 10 This Appendix was drafted by Patrick Lortie, a Northwestern Kellogg MBA student. - 32 - responsive to passenger demands and competitive pressures without sacrificing stability? Is it possible to open up the labor-management process to include more discussions around strategic business decisions, greater exchange of information, and more teamwork in day-today service of customers? Indeed, new cultures of “cooperation” (management term) or “participation” (union term) may be explored as a source of long-term stable labor relations – as opposed to slow observance of all the stages of the formal RLA legal process. Southwest Airlines is an example of a heavily unionized carrier at which a positive culture and effective labor-management relationships have gone hand-in-hand with competitive and mutually beneficial employment contracts. Southwest has discovered that involving its unions in an advisory role can ease resistance to management initiatives. Indeed, unions can serve as a powerful and constructive medium to communicate the carrier’s competitive strategy to its members as well as to facilitate employees’ acceptance of management initiatives. Southwest Airline’s experience with labor relations, including its artful use of stock options, suggests that good labor-management practices at all levels can help bring about positive financial results. Management has to consider sharing more information and involving its unions in the decision-making process on a regular basis in order to explain its position and obtain real input from unions. Additionally, management has to make genuine efforts to enhance job security and to seek alternatives to contracting out work when possible. Unions need to show greater flexibility in work rules, compensation and benefits, and may have to adjust future proposals to the carriers’ competitive circumstances – including by re-thinking their strategy of making airline wages equal across the industry. Unions may also be called upon to agree expeditiously to new carrier business opportunities. These kinds of trade-offs require involvement and communication at all levels of the organization and throughout the contract term rather than solely during the triennial full-blown collective bargaining seasons. - 33 - “Getting to Yes”11 Without the RLA? Unions often see cooperative programs as unilateral initiatives by management to avoid dealing with the employees’ chosen representatives. Cooperation, taken in this sense, differs from the essence of collective bargaining, seen as bilateral, shared decision-making. Ron Carey, President of the International Brotherhood of Teamsters, when asked to comment on “management cooperative initiatives,” is reported to have said: “We already have a way to establish healthy relationships between workers and management. It is called ‘collective bargaining’.” Joint labor-management initiatives may be more permanent and effective if they are a product of collective bargaining. Under today’s law and practice, the collective bargaining process is perceived as being too drawn out, and entailing too much risk of calamitous and undesirable confrontation. Long-term contracts and contract amendable dates currently limit the opportunity for discussion and dispute resolution over corporate changes that affect both labor and management. In light of those obstacles, new approaches might help the industry adapt to the fastchanging and competitive international economy. One approach would feature frequent but limited re-opening of collective bargaining agreements. Factors underlying a decision to reopen an agreement could include recessions, international agreements, mergers, expansions or major equipment purchases. Partial re-opening of agreements could facilitate the carrier’s response to shifts in the political, economic and market environments. The initial contract would have to be explicit about these triggers and which party would initiate reopening under the given circumstance. SWA and jetBlue have apparently been very successful with 10 year employment contracts embodying options for renewal and update. The phrase is from Getting to Yes: Negotiating Agreement Without Giving In, by Roger Fisher, William L. Ury, and Bruce Patton (New York: Penguin Books, 1983). 11 - 34 - A second approach would invoke creative procedural options outside the RLA to avoid undesired actions, such as strikes, lock-outs, or unilateral implementation of changes by carriers. One option would be the use of formal arbitration with a professional mediator. Procedures governing the arbitration process would include development of a pre-arranged schedule and criteria for decision-making. These would need to be defined and agreed upon upfront by both parties. Contractually agreed-to arbitration has already been used by the Air Line Pilot Association (ALPA) and Alaska Airline several times, to mutual advantage. In particular, the process facilitated ALPA and Alaska Airlines reaching a voluntary agreement to avoid arbitration in 1993. A third possibility is to grant labor organizations equity interest in carriers. In 1994, United gave a 54 percent equity stake to its unions, but the record of success with such plans as UAL’s Employee Stock Ownership Plan (ESOP) is not promising. A more successful example is that of Northwest Airlines, which in 1993 exchanged wages, benefits and work rule concessions for a 37 percent equity interest in the carrier. Several ESOP agreements have included innovative non-confrontational dispute resolution procedures, including interest arbitration. Finally, the NMB has a mediation service that could be called upon to help parties reach a voluntary settlement at mid-contract. The NMB should evaluate, in light of its mission and capabilities, whether and to what extent it should play this role. - 35 - APPENDIX C The following presentation, “Key Issues in the Aviation Industry Today,” was made by JayEtta Hecker, Director, Transportation Issues, U.S. Government Accountability Office. Ms. Hecker spoke to forum participants on Day 1 of the proceedings. Key Issues in the Aviation Industry Today ENO Transportation Forum ENO Transportation Forum JayEtta Hecker, Director, Transportation Issues U.S. Government Accountability Office May 10, 2005 Overview • Financial challenges frustrating the financial viability and competitiveness of legacy and LCC carriers • Against a backdrop of falling yields,… • Legacy and low-cost carriers’ actions to control unit costs, especially labor-related costs… • Effectively offset by rising fuel costs… • Adding liquidity pressures from long-term obligations • What are some major external challenges likely to affect structural reform? The Airline Industry’s Restructuring Brought on by Unprecedented Cost Pressures • Dramatic changes in demand and supply since 2000 led to severe demand-supply imbalance • Accordingly, airlines have had little pricing power since 2000 • Therefore, airlines were forced to bring down their costs, which has been very difficult for legacy airlines Yields Have Declined and Legacy Airline “Yield Premium” is Shrinking Yields, 1998 through 2004 Quarterly In cents per revenue passenger mile 14 13 12 11 10 9 8 20 02 20 03 20 04 19 99 20 00 19 98 20 01 Legacy LCC Source: GAO analysis of DOT data. Meanwhile, LCCs Have Maintained Their Unit Cost Advantage Unit Costs, 1998 through 2004 quarterly Cost per Available Seat Mile, excl. Transport Related Expenses 12 11 10 9 8 7 6 1998 1999 2000 2001 Legacy 2002 LCC 2003 2004 Source: GAO analysis of DOT data. Cents Legacy Airline Cost Growth Has Slowed As Compared to LCCs … Changes In Legacy and LCC Operating Expenses, 3Q 2001 - 4Q 2004 In billions of dollars Billions 2.5 2.0 1.5 1.0 0.5 0.0 (0.5) (1.0) (1.5) (2.0) Labor Fuel Legacy Other Costs LCC Total Change Source: GAO analysis of DOT data. …But LCCs Continue To Maintain A Unit Cost Advantage Over Legacy Airlines Legacy and LCC CASM, 4th Quarter of 2004 12 10 Cents 10.6 ¢ 8 6 4 2 0 Other Labor 7.8 ¢ Fuel Labor Fuel Other LCC Legacy Source: GAO analysis of DOT data (Not stage-length adjusted). Legacy Airlines Have Obtained Substantial Cost Savings From Labor, For Example… Pilots American (2003) $660 Flight Attendants $340 Machinists & Other $700 Mgmt $100 Total $1,800 United (2003) Dollars in millions $1,100 $300 $804 $300 $2,504 Fuel Costs Are Rising Despite Increased Efficiency Industry Fuel Cost and Consumption, 1998-2004 7 6 5 4 3 2 1 0 Billions Source: GAO analysis of DOT data. 98 Q 98 1 Q 98 2 Q 98 3 Q 99 4 Q 99 1 Q 99 2 Q 99 3 Q 00 4 Q 00 1 Q 00 2 Q 00 3 Q 01 4 Q 01 1 Q 01 2 Q 01 3 Q 02 4 Q 02 1 Q 02 2 Q 02 3 Q 03 4 Q 03 1 Q 03 2 Q 03 3 Q 04 4 Q 04 1 Q 04 2 Q 04 3 Q4 Industry Inflation Adjusted Fuel Costs, Quarterly Industry Gallons of Fuel Issued Fuel Costs Now Represent 20% of Operating Costs and Rob Airlines of Progress in Reducing Costs Fuel as percentage of total operating expenses 25% 20% 15% 10% 5% 0% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 1998 1999 2000 2001 Quarter Industry Legacy 2002 2003 2004 LCCs Source: GAO analysis of DOT data. Airlines Would Be Profitable If Not For Fuel Costs Billions $8 $6 $4 $2 $0 -$2 -$4 -$6 1998 1999 2000 2001 Quarter 2002 2003 2004 Operating Profit Operating Profit Excluding Fuel Source: GAO analysis of DOT data. Legacy Airlines Also Face Substantial Liquidity Demands Over the Next 4 Years $18 $16 ollars B illions $14 $12 $10 $8 $6 $4 $2 $0 Cash at End of 2004 Long Term Debt 2005 2006 2007 2008 Capital Leases Operating Leases Pension Obligations Source: GAO analysis of SEC 10K and PBGC data, as of 12/31/04. LCCs Will Also Face Challenges, Especially If Their Growth Stagnates • Maintenance costs of an aging aircraft fleet will increase • Wage and health care benefits begin to grow with older workforce • Growth is a requirement to maintain a unit cost advantage Major Aviation System Challenges Will Also Affect Industry Restructuring • Aviation System Financing • How to assess taxes and fees for ATC services, airport infrastructure, and TSA security that promotes efficiency and equity? • Can FAA implement significant cost control? • ATC Issues • How to ease congestion in the near term? • How to develop the Next Generation Air Transportation System (NGATS) in a constrained budget environment? • Government “Ownership” of Airlines • What does PBGC and ATSB investments in struggling airlines mean for the industry? Thank You! APPENDIX D “Commercial Aviation: Bankruptcy and Pension Problems Are Symptoms of Underlying Structural Issues,” U.S. Government Accountability Office Highlights Paper, September 2005 September 2005 COMMERCIAL AVIATION Highlights Highlights of GAO-05-945, a report to congressional committees Accountability Integrity Reliability Bankruptcy and Pension Problems Are Symptoms of Underlying Structural Issues Why GAO Did This Study Since 2001 the U.S. airline industry has lost over $30 billion. Delta, Northwest, United, and US Airways have filed for bankruptcy, the latter two terminating and transferring their pension plans to the Pension Benefit Guaranty Corporation (PBGC). The net claim on PBGC from these terminations was $9.7 billion; plan participants lost $5.3 billion in benefits (in constant 2005 dollars). Considerable debate has ensued over airlines’ use of bankruptcy protection as a means to continue operations. Many in the industry have maintained that airlines’ use of this approach is harmful to the industry. This debate has received even sharper focus with pension defaults. Critics argue that by not having to meet their pension obligations, airlines in bankruptcy have an advantage that may encourage other companies to take the same approach. At the request of the Congress, we have continued to assess the financial condition of the airline industry and focused on the problems of bankruptcy and pension terminations. This report details: (1) the role of bankruptcy in the airline industry, (2) whether bankruptcies are harming the industry, and (3) the effect of airline pension underfunding on employees, airlines, and the PBGC. DOT and PBGC agreed with this report’s conclusions. GAO is making no recommendations. www.gao.gov/cgi-bin/getrpt?GAO-05-945. To view the full product, including the scope and methodology, click on the link above. For more information, contact JayEtta Z. Hecker at (202) 512-2834 or heckerj@gao.gov. What GAO Found Bankruptcy is endemic to the airline industry, owing to long-standing structural challenges and weak financial performance in the industry. Structurally, the industry is characterized by high fixed costs, cyclical demand for its services, and intense competition. Consequently, since deregulation in 1978, there have been 162 airline bankruptcy filings, 22 of them in the last five years. Airlines have used bankruptcy in response to liquidity pressures and as a means to restructure their costs. Our analysis of major airline bankruptcies shows mixed results in being able to significantly reduce costs—most but not all airlines were able to do so. However, bankruptcy is not a panacea for airlines. Few have emerged from bankruptcy and are still operating. There is no clear evidence that airlines in bankruptcy keep capacity in the system that otherwise would have been eliminated, or harm the industry by lowering fares below what other airlines charge. While the liquidation of an airline may reduce capacity in the near-term, capacity returns relatively quickly. In individual markets where a dominant carrier significantly reduces operations, other carriers expand capacity to compensate. Several studies have found that airlines in bankruptcy have not reduced fares and rival airlines were not harmed financially. The defined benefit pension plans of the remaining airlines with active plans are underfunded by $13.7 billion, raising the potential of more sizeable losses to PBGC and plan participants. These airlines face an estimated $10.4 billion in minimum pension contribution requirements over the next 4 years, significantly more than some of them may be able to afford given their continued operating losses and other fixed obligations (see figure). While spreading these contributions over more years would relieve some of these airlines’ liquidity pressures, it does not ensure that they will avoid bankruptcy because it does not fully address other fundamental structural problems, such as other high fixed costs. Comparison of Legacy Airline Cash Balance with Future Fixed Obligations 20 In billions of dollars Cash at end of 2004 15 Other obligations Operating leases 10 Capital leases Long term debt 5 Pension obligations 0 2004 2005 2006 2007 2008 Source: PBGC data and SEC 10K filings. United States Government Accountability Office