Business

LET AIR CANADA GO

A top airline expert calls for foreign competition on all-Canadian routes

PHILLIP PHAN November 26 2001
Business

LET AIR CANADA GO

A top airline expert calls for foreign competition on all-Canadian routes

PHILLIP PHAN November 26 2001

LET AIR CANADA GO

A top airline expert calls for foreign competition on all-Canadian routes

PHILLIP PHAN

Is there a Canadian airline industry? In the maelstrom that has accompanied 9/11, few have realized that there are hardly any domestic solutions to what is really a global problem. When Onex Corp. and Air Canada batded for control over Canadian Airlines barely two years ago, both sides wrapped themselves in the Canadian flag, as if somehow the airline industry was unique to Canada or the problems it faced were uniquely Canadian. The post-merger guarantees that Air Canada gave to the public, labour unions and government were designed to protect Canadian travellers and taxpayers, or so everyone involved claimed. And by attempting to manage the industry without appearing to do so, the government acquiesced to the overly bold acquisitions made by Canada 3000 as it attempted, unsuccessfully, to position itself as a reincarnated Canadian Airlines.

Now, there are new calls by the companies and public for government to take

further steps in remming the industry to health. I fear this will precipitate more misguided attempts to manage the unmanageable, and thus induce more inefficiency into an already broken system. In my view, the Canadian government has two choices: regulate, which will lead to higher domestic prices, less choice and a viable Air Canada —or unleash market forces, which will lead to lower prices, more choice, and the eventual control of Air Canada by a large foreign carrier.

Today, Canada has one national airline, but there is still no guarantee the monopoly will be healthier than when it was part of a competitive market. One reason is that the domestic industry is significantly smaller than the North American or global one. With 80 per cent of the population living on the border with the United States and more economic integration south of the border than in the east-west direction, there is more air traffic flowing across the border (and into Europe and Asia) than within Canada. Furthermore, the Open Skies agreement that Canada and the U.S.

signed in 1995 vastly increased the number of cross-border flights and could one day be expanded to allow American carriers to compete freely in the Canadian domestic market. Globally, Europe and Asia are also moving towards regional open skies. These agreements favour the giant global airlines, such as American, United, British Airways and Singapore Airlines, leaving other carriers unable to fill seats.

Excess capacity is a worldwide problem, not just a Canadian one. The problem is that capacity—the number of seat miles available—is relatively easy to add (lease planes, add routes and negotiate airport slots) but extremely difficult to get rid of. Aircraft and ground handling equipment are specialized, with very low used-market values; licences for gates and slots at airports are sometimes negotiated for 25 years; and labour contracts are multiyear and very restrictive. Even the across-the-board flight reductions most airlines have made since 9/11 are problematic, since many costs, such as airport gate fees, are fixed.

Moreover, the decrease in domestic ca-

pacity through the takeover of Canadian and the demise of Canada 3000 does not mean that Air Canada is protected from the forces of global competition. On the contrary, the concessions the carrier had to give because of its monopoly role probably made it more difficult for it to compete against the worlds large airlines.

Smaller airlines such as Calgary-based Westjet are less burdened with onerous labour contracts and have more appropriate equipment to serve the short-haul, low-volume, north-south bicoastal routes. Global airlines such as United or American, with significant economies of scale, are better positioned to serve the longhaul, high-volume, east-west transcontinental markets.

That leaves Air Canada exposed on its flanks, with two apparent choices. It could drastically downsize: its new discount carrier, Tango, is an attempt to do this, but to work it would have to be completely spun off from the parent and freed of overhead baggage like its union contracts. Or Air Canada could massively upsize by acquiring other smaller airlines, reducing excess capacity and forging a stronger transcontinental presence to challenge the big three (United, American, Northwest). The problem with the latter strategy is that Air Canada has no money and will probably never find a financier to bankroll the effort—annual returns in this industry are dismal (averaging 3.5 per cent in its most profitable times, compared with the S&P 500s 12.7 per cent over the past decade). Thus, the carrier is doomed to exist in limbo on quasi-government subsidies and bailouts unless the government allows it to be acquired by another airline.

Under any scenario, significant job cuts will result. The inability of Air Canada to maintain its no-layoff promises after the Canadian merger had very little to do with 9/11. It has everything to do with pure economics. The point of capacity consolidation is to improve the fundamentals of the business by reducing the pressures to discount. In North America, 97 per cent of economy passengers fly on discounted fares, most of which are below the real cost of the trip; 80 per cent of profits come from business and first class, which represent only 10 per cent of capacity. Roughly a third of an airlines expenses come from fuel, over which the airline has little control; a third comes from

depreciation of fixed assets, which are long-term investments; and a third from labour, which is the most direcdy controllable cost component.

In this era of globalization, to talk of a Canadian airline industry is misleading. The world is increasingly being divided into regions controlled by ever-expanding multilateral alliances. What the partners of these alliances do is very much constrained by their agreements and by their leadership (United and Lufthansa in the case of Air Canadas Star Alliance). In the international markets, where most of the money is made, airlines are increasingly constrained by agreements in their service standards, route scheduling, routing structures and even fares. Even their domestic schedules are increasingly co-ordinated with their international routes.

My sense is that the economic imperative will prevail and that Canada can no longer afford to pay for a flag carrier. Here is what I propose:

■ Remove the airline foreign-ownership limit, as it is meaningless in a global industry driven only by the market dictate of efficiency, and even encourage Air Canada to shop itself to potential acquirers. Nationalism is costly and misplaced in the airline industry—there are better places to fly the Maple Leaf than from the tail of a 747.

■ Resist the temptation to micromanage industry restructuring by imposing price controls or requiring services on unprof-

itable routes. Instead, recognize that air service to remote regions is a necessary form of transportation and offer subsidies and incentives to regional or charter carriers to service these routes. They have cost structures that make them ideal for running such taxi services. In other words, treat these routes like public transportation.

■ Allow foreign competition in the form of cabotage (the right to pick up and drop off passengers from one Canadian city to another by a foreign airline) to impose a market-based, rather than regulation-based, cap on monopoly power.

■ Work with the unions and management to offer job retraining, outplacement, and other incentives to absorb the inevitable job losses but not to block the layoffs.

The choices are stark for Canada— either pay the price to keep bragging rights to a flag carrier through higher ticket fares and taxpayer bailouts, or allow the development of a healthy air travel network through open competition for markets and ownership. EÛJ

Phillip Phan, a former management professor at York University in Toronto, is one of Canada’s leading experts on the airline industry. He currently holds the Bruggeman Distinguished Chair in Management at Rensselaer Polytechnic Institute in Troy, N. Y.

Should foreign airlines be allowed to compete domestically with Air Canada? j