Saturday, March 20, 2010

Air Canada Says "No" to Competition

Who is afraid of a little competition?  Air Canada, perhaps.  Earlier this week Calin Rovinescu, CEO of Canada's flagship carrier, issued a series of vitriolic statements against Middle Eastern airline Emirates' call for Canada to provide it with additional traffic rights.  See Nicolas Van Praet, Emirates Aims to Dump Surplus Capacity on Canada, Vancouver Sun, Mar. 15, 2010 (available here).  According to Rovinescu, "Emirates' real aim is to dump its excess capacity resulting from too many wide-body aircraft commitments, including A-380s, into the Canadian market, just as it has elsewhere in the world."  Further, Rovinescu claimed that Emirates, "as a state-owned carrier with access to virtually unlimited capital . . . would siphon passengers from other carriers who are making connections en route and connect them through its Dubai hub instead."

Even if Rovinescu's rhetoric rings with truth, should consumers traveling to, from, or beyond points in Canada care?

First, suppose that Rovinescu is correct and Emirates possesses excess capacity, it does not follow that the carrier is going to "dump" services into the Canadian market in any economically precise sense.  Similar to the concept of predatory pricing in antitrust law, dumping refers to the practice whereby a foreign firm (or firms) sells its goods or services at a price below what it charges for the same goods/services in its home and/or third country markets.  No showing has been made that Emirates plans to do this.

Second, even if Emirates engaged in dumping, any loss sustained by Air Canada would be outweighed by the surplus given to airline consumers.  Passengers flying to or from Canada would have access to more flights to or from more destinations, and with potentially cheaper prices than Air Canada is capable of providing.

Third, dumping is similar to, but not synonymous with predatory pricing, i.e., selling below marginal cost.  Again, there is no evidence that Emirates would sell air services to consumers at a loss.  It would be an irrational tactic anyway.  Were Emirates capable of driving competitors out of certain markets with predatory prices, the carrier would still have to recoup its losses at a later date by resetting its prices to a supracompetitive level.  All that would do, however, is attract other carriers back into those markets to take advantage of the new price structure.  Eventually, rates would be competed down to the competitive level, leaving Emirates to either eat the losses it sustained during the predatory period or forcing it to reengage in predation to again drive out competitors.  All during this time, though, consumers would benefit by having access to cheap airfares.

Fourth, Emirates' ownership profile should be a non-issue.  If Emirates is able to compete down prices on certain routes because of its deep (State) capital reserves, it would again be consumers which reap the benefits.  As Paul Krugman is said to have once quipped, the best policy response to foreign State subsidies is "to send a thank-you note to the embassy."  Quoted in Alan O. Sykes, International Trade: Trade Remedies, in Research Handbook of International Economic Law 62, 106 (Edward Elgar Publishing 2007). 

Given Air Canada's primacy of place in influencing Canadian air transport policy, see, e.g., Michael E. Levine, Why Weren't the Airline Reregulated?, 23 Yale J. on Reg. 269, 294-95 (2006), it seems unlikely that Canada will accede to Emirates' demands.  The "benefit" is that Air Canada will be able to keep itself afloat in markets where it lacks a bona fide competitive advantage; the "cost" will be felt by consumers.

March 20, 2010 | Permalink | Comments (0) | TrackBack (0)

Thursday, March 18, 2010

How Do Firm Financial Conditions...

Blog readers may be interested in a new working paper on financial distress and bankruptcy in the airline industry.  See Gordon M. Phillips & Giorgio Sertsios, How Do Firm Financial Conditions Affect Product Quality and Pricing? (Working Paper, Mar. 16, 2010) (available from SSRN here).  From the abstract:

We analyze the interaction between firm choice of product quality and pricing decisions with financial distress and bankruptcy in the airline industry. We consider an airline's choice of quality and price as dynamic decisions that trade-off current cash flows for future demand from consumers. We examine how airline mishandled baggage, on-time performance and pricing are related to financial distress and bankruptcy, controlling for the endogeneity of financial distress and bankruptcy. We find that an airline's quality and pricing decisions are differentially affected by financial distress and bankruptcy. Product quality decreases when airlines are in financial distress, as financial distress reduces a firm’s incentive to invest in quality. In addition, firms price more aggressively when in financial distress consistent with them trying to increase short-term market share and revenues. In contrast, in bankruptcy product quality increases relative to when the firm is in financial distress.

March 18, 2010 | Permalink | Comments (0) | TrackBack (0)

Flying With Heavy Loads

Blog readers may be interested in a new working paper from Ranadeva Jayaskera, "Flying With Heavy Loads" Capital Structure Considerations for the US Airline Industry (Working Paper, Feb. 18, 2010) (available from SSRN here).  From the abstract:

The paper discusses a hidden aspect of a firm’s capital structure through the use of a real options application. It is applied to the US airline industry, characterized by over levered balance sheets, and financial distress. The paper introduces the notion of “financial flexibility”, defined as the freedom (or flexibility) enjoyed by a conservatively geared firm to respond quickly and secure positive NPV projects, as opposed to an over levered firm. This ‘flexibility’ is then valued as a real option using a model based on arithmetic Brownian motion involving a path dependant option pricing framework. It analyses the implications of debt financing in the US airline industry and develops a capital structure model that incorporates the value of ‘financial flexibility’ enjoyed by conservatively geared carriers. In its application to South West Airlines the paper concludes that the optimal capital structure – if the value of financial flexibility is incorporated - should move closer to the origin. A methodology of integrating the value of financial flexibility into the traditional theories of capital structure is proposed and demonstrated that (at least) in the US airline industry, failure to do so can result in a significant misstatement in a firm’s value and its optimal capital structure. This paper makes two key contributions. The notion of valuing financial flexibility as a real option has been introduced previously by Beneda and Nelson (2003). However their quantification of the option value is through a standard Black Scholes equation where the underlying assumptions are not valid in quantifying a real option of this nature and this paper addresses this issue. Furthermore the paper applies the concept of financial flexibility specifically to the US airline industry and develops a conjecture on how this can be incorporated into the traditional theories of capital structure, another contribution to the academic literature.

March 18, 2010 | Permalink | Comments (1) | TrackBack (0)

Wednesday, March 17, 2010

Challenging the EU ETS

Last December, the Air Transport Association, along with U.S. air carriers American Airlines, Continental, and United, filed a legal challenge to the United Kingdom's Aviation Greenhouse Gas Emissions Trading Scheme.  See Press Release, ATA, Application of the EU ETS to US Airlines (Dec. 16, 2009) (available here).  The case has since been referred to the European Court of Justice for resolution. 

The U.K. law implements part of the European Union's controversial regulation which will bring all airlines flying to or from its territory under an emissions trading scheme (ETS) beginning January 1, 2012.  See Commission Decision 2009/339/EC, 2009 O.J. (L 103).  Under the ETS, airlines will have their emissions "capped" at 97% of their 2004-05 levels; the cap will be lowered to 95% in 2013; and the airlines will be forced to purchase 15% of their allowances (carbon credits) under the cap at auction.  Carriers which have experienced growth since 2004-05 will have to purchase additional allowances, either from another airline or industry which is also covered by the EU's ETS. 

U.S. airlines are understandably displeased with the ETS.  Since they will have to purchase at least 15% of their allowances from an EU Member State (the purchase percentage is subject to rise after 2013), carriers have complained that the ETS violates the Chicago Convention's restrictions on the types of fees and duties which may be imposed on international civil aviation.  See Convention on International Civil Aviation, art. 15, opened for signature Dec. 7, 1944, 61 Stat. 1180, 15 U.N.T.S. 295; see also "Guest Post: Frans Vreede on the Dutch Ticket Tax" (elaborating on the scope and applicability of Chicago Convention Article 15).  U.S. airlines have also criticized the ETS for compelling them to effectively subsidize EU Member States by forcing the carriers to purchase emissions allowances.  Nothing in the ETS mandates that the rents captured from the ETS will even be applied back to aviation. 

The extraterritorial application of the ETS raises additional issues under the Chicago Convention.  Article 1 of the Convention codifies the customary international law principle that States have exclusive sovereignty over the airspace above their territories.  Yet the ETS covers emissions which are released outside the geographical space of the EU.  As the ATA puts it:

For example, for a flight of a U.S. carrier from Dallas to London, the proposed legislation would regulate the emissions from that flight on the ground and as it takes off in Dallas, as it flies over Texas, Oklahoma, Missouri, Illinois, Indiana and Michigan, within U.S. offshore territory, over Canada and the Atlantic Ocean. Thus, the EU ETS provisions would regulate the entire flight, even though the flight would be in EU airspace for only a tiny fraction of the journey.

See Press Release, supra.

ETS coverage also extends to emissions released over international waters.  This, according to the ATA, interferes with the International Civil Aviation Organization's designated authority to regulate international aviation over the high seas. See Chicago Convention, supra, art. 12.

It will be interesting to see what (if any) limits the ECJ may place on the EU's authority to impose its ETS on non-EU carriers.  While climate change remains an important political issue in the EU, the agenda for a global solution to the problem has lost considerable steam after the failure of last December's Copenhagen Climate Conference to produce an international accord.  The 1997 Kyoto Protocol to the U.N. Framework Convention on Climate Change recognizes ICAO "as the global instrument for developed countries to pursue a limitation or reduction of greenhouse gas emissions from international civil aviation."  See Press Release, ICAO, Kyoto Protocol Emphasizes ICAO's Role in Addressing Greenhouse Gas Emissions from International Civil Aviation, PIO 25/97 (Dec. 12, 1997) (available here).  Despite this, in 2007 the EU entered a reservation to an ICAO resolution which reaffirmed the organization's singular role in finding an international response to the aviation emissions issue before proceeding to pass its aviation ETS rules.  See ICAO, Consolidated Statement of Continuing ICAO Policies and Practices Related to Environmental Protection, app. A, Assemb. Res. A36-22 (2007), compiled in Assembly Resolutions in Force, at I-54, ICAO Doc. 9902 (Sept. 28, 2007).  If the ECJ should strike down or significantly curtail to the scope of the ETS, will the EU be willing to continue cooperating with ICAO on an authentically global response?  A lot will likely depend on how quickly the ECJ acts.  With ICAO's 2010 Triennial Meeting set to take place this September, many eyes will be on the EU when the topic of climate change inevitably comes up.  A victory or loss before the ECJ could dictate the tone of the meeting.

March 17, 2010 | Permalink | Comments (1) | TrackBack (0)

Tuesday, March 16, 2010

More on the Suspension Clause

As discussed previously on the blog, seeNext Round of U.S./EU Talks,” one of the action items for the ongoing United States/European Union second stage negotiations is the modification or elimination of their 2007 Air Transport Agreement’s suspension clause. Under Article 21(3) of the Agreement, 2007 O.J. (L 134) 4, the U.S., along with any individual EU Member State, may suspend some (or all) of the treaty’s rights if they are dissatisfied with the progress of negotiations after November of this year. (Note: The right of an individual EU Member to suspend rights pertaining to its own territory is a post hoc interpretation by the EU Council of Ministers. Cf. European Commission, COM (2009) 229 final (May 15, 2009)). The ostensible reason for the suspension clause was to ensure the U.S. would stay committed to further liberalization in order to “balance out” concessions. Critics, primarily from Spain and the United Kingdom, charged that the 2007 Agreement provided greater benefits to U.S. airlines, specifically unrestricted access to London Heathrow, while failing to provide comparable concessions to EU airlines such as cabotage rights and foreign investment opportunities.

Whether or not the 2007 Agreement lacks parity is a complex question that can be addressed another time. The more immediate question is what, if anything, ought to be done concerning the 2007 Agreement’s suspension clause. Presumably, neither party desires an aviation trade war. If the U.K., for example, were to return Heathrow to the status quo ante the 2007 Agreement and limit access to only United Airlines and American Airlines, the U.S. could quickly retaliate by rescinding the oneworld Alliance’s recently won (tentative) antitrust immunity. Even if the U.S. refuses to budge on cabotage and foreign investment (which appears to be the case given the current political climate in the U.S.), EU airlines already have a considerable amount of time and resources invested in the current state of concessions. Every major EU carrier—Air France-KLM, British Airways (BA), Iberia, and Lufthansa—are part of a transatlantic airline alliance; all of them provide scheduled services to points in the U.S.; and none of them are looking to return to the days of tightly managed bilaterals with highly circumscribed traffic rights. All of them likely desire more concessions from the U.S. at some point in the future, but surely they, along with negotiators in the EU, know that a trade war would retard progress toward deeper liberalization.

Despite the potentially disastrous consequences which could follow an invocation of the suspension clause, eliminating it entirely is easier said than done. In the context of negotiations leading up to the 2007 Agreement, allowing for ex post suspension secured ex ante concessions. The U.K. (and perhaps Spain) would not have supported the 2007 Agreement had the suspension clause been absent. The U.K.’s reasoning is simple to understand: by assenting to the Agreement, it was sacrificing certain competitive advantages for its flag carrier (BA) in the form of increasing competition between points in the U.S. and Heathrow. The political costs were simply too high unless the U.K. could hold out the possibility that there was more to come for its flag carrier, specifically cabotage and foreign ownership rights. Why would the U.S., which may not be interested in acquiring further concessions from the EU, agree to allow the suspension clause? The political costs were comparably lower. U.S. airlines were poised to benefit under the 2007 Agreement; removing access restrictions at Heathrow and other airports in the EU created new commercial opportunities. While ex post suspension looms, the ex ante concessions for U.S. airlines—which included more than just Heathrow access—made the tradeoff palatable.

Now that both sides are back to the negotiating table, why would the U.K. and other Member States agree to allow the suspension clause to be modified or removed? Removal, though desirable from the standpoint of maintaining commercial certainty, seems unlikely. If the competitive position of BA or other major EU carriers diminishes under the 2007 Agreement, invocation (or threat of invocation) of the suspension clause will appear politically attractive. This is especially true if the EU Member States no longer believe there is any real possibility that the U.S. will make further concessions necessary to enhance EU carriers’ competitiveness. Further, the suspension clause is already in; getting it out—which appears to be more a U.S. priority than an EU one—will require new concessions from the U.S. But, as noted, the U.S. is not interested in making the sorts of concessions certain EU Member States (and their airlines) appear most interested in. The EU Member States have no immediate reason to accept removing the suspension clause.

Modification remains possible, however. The earliest the suspension clause can be invoked is November 2010. If notice of suspension is given at that time, the earliest any suspension would take effect is at the start of the International Air Transport Association’s March 2012 Traffic Season. See Agreement, supra, art. 21(3) (stating that a notice of suspension “shall take effect no sooner than the start of the [IATA] traffic season that commences no less than 12 months after the date on which the notice of suspension was given”). One possibility is that the U.S. could offer a new timetable for further negotiations in exchange for delaying the right to invoke the suspension clause, perhaps for an additional three year period. This would help maintain commercial certainty for both parties’ airlines and perhaps remove some of the latent hostility which accompanies the suspension threat. A similar possibility is that the time between a notice of suspension and the suspension’s effect could be expanded with the requirement that consultations and further negotiations, perhaps through the Agreement’s Joint Committee, would have to take place first. This would provide another avenue for keeping up negotiations, albeit under an ominous cloud.

March 16, 2010 | Permalink | Comments (0) | TrackBack (0)