It has been a rough year for the airline industry, to say the least. High overhead costs, fluctuating fuel prices, and costly labor contracts have left airlines scrambling for every last penny in fliers’ pockets. The rash of cancelled flights, increased fees, bankrupt airlines, and fewer routes has frustrated both passengers and communities. But, the fact remains that the airline industry as a whole is hemorrhaging money and continues to limp toward the protection and salvation of bankruptcy court.
How did we end up here in the land of unhappy customers, unsatisfied creditors, and unconvinced investors? Thirty years ago Congress passed the Airline Deregulation Act, essentially deregulating the airline industry and releasing companies into capitalism and the free marketplace. It took three presidential administrations to get the law passed and one of the most sweeping acts of industry deregulation in the country’s history was signed by a Democrat – President Jimmy Carter. Have the promises of lower prices, greater profits, and better service been met? The answer to that likely depends on which side of the cockpit you are on.
Deregulating the Airline Industry
Prior to 1978, the Civilian Aeronautics Board (CAB) set airline prices, routes, and schedules across the country. If an airline wanted to add a route or change a price, it had to go through a tedious and lengthy regulatory process. For pricing, the CAB followed a straightforward approach where shorter flights cost less than longer flights and there was not the “hub and spoke” system there is today. In general, the CAB assumed most flights would be about 55 percent full and set prices so airlines could make a 12 percent profit on a standard ticket. The CAB became notoriously slow and conservative in reviewing and approving changes in routes or service and, in fact, allowed no new national carriers to enter the market from 1938 to 1978, despite almost 80 applications for new service being filed with the CAB. The CAB forced airlines to maintain non-lucrative routes and famously took eight years to approve Continental’s request to begin service from Denver to San Diego (and did so only after a U.S. Court of Appeals intervened). The legal standard for granting an airline permission to fly a new route was called “public convenience and necessity.” In order to win approval, the airline had to show that its services were required by the public convenience and necessity, which may not sound hard, but if another airline could show the addition would hurt its business, it automatically was deemed not required by the public convenience and necessity.
The CAB also determined which planes could fly on a specific route. In the early 1970s, Federal Express requested permission to fly a jumbo jet on its busiest routes, but it was denied. Instead the company flew two smaller planes wing-to-wing to keep up with its growing business.
Advocates fighting for deregulation found a warm reception in the U.S. Senate Judiciary Committee Subcommittee on Administrative Practice, then chaired by Senator Ted Kennedy (D-MA). Kennedy, aided by then-committee counsel Stephen Breyer, held hearings and pushed forward the debates. The opponents were the airlines themselves – who were mostly happy with the cost plus pricing structure – labor unions, smaller cities, airports, and safety experts. The major proponent was the general public and its major gripe was cost. After years of debate and hearings, President Jimmy Carter signed the most sweeping act of deregulation the United States had ever seen in the fall of 1978.
The Industry Since Deregulation
As would be expected with such a massive overhaul of an industry, deregulation has created both winners and losers in the new marketplace. And, the winners and losers tend to line up just as predicted, with a few exceptions.
“Adjusting for inflation, even though people complain about them a lot, airline tickets today are lower than they were in 1985,” said Jack Creighton ’57, a former member of the board of directors and interim CEO and chairman of United Airlines.
According to a 2006 General Accountability Office (GAO) report, the median fare has declined almost 40 percent since 1980 as measured in 2005 dollars. While prices may not seem to still be dropping, in July 2008 the GAO reported that airline fare prices had dropped 20 percent in real dollars since 1998 because of increased competition in the market. However, fares in shorter-distance and less traveled markets have not fallen as much as fares in long-distance and heavily trafficked markets. Since 1980, markets have generally become more competitive; the average number of competitors has increased to 3.5 per market in 2005 from 2.2 per market in 1980. In total, industry capacity and passenger traffic have tripled as passengers hit the friendly skies with greater frequency.
Today the industry has seven legacy airlines that pre-date deregulation – Alaska Airlines, American Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, United Airlines, and US Airways. There are also seven major “low-cost” airlines that entered the market after deregulation – AirTrain Airways, America West Airlines, ATA, Frontier Airlines, JetBlue Airways, Southwest Airlines, and Spirit Airlines. Northwest and Delta merged in 2008 and America West and US Airways merged in 2005.
Deregulation has not been all wine and roses, however. Demand for airline travel is highly cyclical and influenced by the state of the economy, political events, international events, and even health-related epidemics and events. However, costs, in particular aircraft and labor contracts, are constant and not easily adjusted to match fluctuations in demand. Jet fuel prices, however, do change in a blink of an eye, making it very difficult to price tickets purchased in advance accurately.
While the first decade following deregulation saw increased profitability for the airlines and lower fares for consumers, since the late 1980s the industry has seen a lot of turbulence. Since deregulation, more than 170 airlines have gone into bankruptcy, with some restructuring and reemerging, but most being liquidated. In recent years, the bankruptcies of Delta, Northwest, United, and US Airways are considered among the largest corporate bankruptcies ever, excluding financial services firms. How much deregulation is the root cause of more than half the industry going belly-up is a much-debated topic. Other factors – recession, high fuel costs, bad management, greedy labor, and low demand – are often blamed and have little to do with regulation. Other culprits like excessive capacity were closely monitored during regulation. Advocates of regulation point out, however, that recent economic factors have not risen to the level of crisis seen in the early 1970s when recession and the Arab Oil Embargo of 1973 hit the U.S. hard, but during which the airlines all skated through with minimal disruption and profits.
“Often, when it comes down to it, bankruptcy can be a good thing for the industry” said Peter Swire, the C. William O’Neill Professor in Law and Judicial Administration at Moritz and an expert in antitrust law. “The planes get sold and the gates get transferred to other airlines with less cost and the next round of competition begins.”
Southwest and Low-Cost Airlines
Since deregulation, perhaps the biggest change in the marketplace has been the creation, entrance, and failure of hundreds of new airlines, many so-called “low-cost” carriers. The prodigal child among them is Southwest Airlines, the only airline to make a profit every year for the past 30 years.
Southwest built a successful business on an unusual model: flying multiple short, quick trips into the secondary (more efficient and less costly) airports of major cities, using primarily only one aircraft type, the Boeing 737. Southwest also does not use the hub and spoke method of arranging flights that other airlines use. Instead, it uses a linear route, or point-to-point, system like those mandated prior to deregulation. As a result, according to the airline, an average of 80 percent of Southwest passengers are local passengers, meaning only 20 percent of all passengers are connecting passengers.
Although Southwest is considered a “low fare” airline, it is heavily unionized when compared to other airlines. The Southwest Airline Pilots’ Association, a union not affiliated with the Air Line Pilots Association International, represents the airline’s pilots. The aircraft maintenance technicians’ are represented by the Aircraft Mechanics Fraternal Association. Customer service agents and reservation agents are represented by the International Association of Machinists and Aerospace Workers Union. Flight attendants, ramp agents, and operations agents are represented by the Transport Workers Union. Flight dispatchers are represented by the Southwest Airlines Employee Association.
While Southwest has developed a successful business plan and has become a leader in the industry, most low-cost start-ups skid to an abrupt halt within months of their first take-off. In Columbus, Skybus Airlines took to the skies on April 22, 2007 and ceased all operations and headed to Chapter 11 bankruptcy on April 5, 2008, stranding thousands of passengers in the midst of a round-trip. The airline offered ultra-low prices – sometimes as low as $10 one-way – and hoped to turn a profit by charging customers for services and items, selling advertising on its planes, and keeping costs low.
“Start-up airlines like Skybus have really disrupted the entire industry,” Creighton said. “Charging $68 to fly to Washington state wasn’t economical. I didn’t understand the business plan, and a lot of these startups have folded up. This is one area where the government should regulate.”
According to the GAO, in 2006, low-cost airlines were competing directly with legacy airlines in 42 of the top 5,000 markets and were an option for about 80 percent of passengers. Low-cost airlines carried 78 million passengers in 1998 and 125 million in 2006, an increase of 59 percent.
“It is not a predatory pricing problem when a low-cost carrier helps consumers with bargain prices,” Swire said. “That is how Southwest became successful. They went to underused airports and the consumers flocked. Competition between airports gives customers excellent new choices.”
Airlines have traditionally relied on union labor, and labor relations have been covered by the Railway Labor Act since 1936. The union bargaining structure that developed within the airline industry has been highly decentralized and separated by craft (e.g., pilots, mechanics, etc.). Before deregulation, unions and airline management engaged in carrier-by-carrier bargaining whereby the last contract signed by one carrier generally served as the starting point for the next airline (known as “pattern bargaining”). During regulation, labor relations were generally good because CAB’s fare-setting allowed airlines to pass increased labor costs on to passengers. Airlines’ bargaining power was enhanced by the Mutual Aid Pact, a strike insurance plan created in 1958, through which a struck airline was compensated by nonstruck airlines based on increases in traffic the latter received during a strike. The Mutual Aid Pact was eliminated with deregulation, thereby enhancing airline labor’s power in contract negotiations.
“In many industries, management has a stronger hand than labor,” Creighton said. “Labor has a much stronger hand in airlines than management does. And as a result in certain categories wages have been driven too high. The pilots say they are going to go out on strike, they threaten, and then they go on strike. It doesn’t just shut down the airline in Columbus or Chicago. It shuts it down in New York, Singapore, everywhere. No airline can survive a strike more than a few days.”
Over the last few years, facing intense cost pressures from growing low-cost airlines like Southwest, both United and US Airways entered bankruptcy, voided labor contracts, and terminated their pension plans. For example, according to the GAO, Northwest Airlines’ pilots agreed to two pay cuts during recent bankruptcies – a 15 percent cut in 2004 and a 23.9 percent cut in 2006. On average, the number of employees for a legacy airline has decreased by 26 percent since 1998, with the payroll shrinking from about 42,558 employees to an average of 31,346. Pension plans have also been cut, costing the Pension Benefit Guaranty Corporation, the federal government insurer of defined benefit plans, $10 billion and beneficiaries more than $5 billion. Only two airlines still have active defined benefit pension plans.
Alliances, Mergers, and Antitrust
Immediately following deregulation, there was a flurry of mergers and acquisitions in the 1980s as airlines adjusted to the new market. The industry has also creatively come up with new alliance and code-sharing programs to increase capacity with minimal investment.
The Department of Justice (DOJ) reviews every potential airline merger and acquisition for possible antitrust violations. To determine whether a potential merger or acquisition is anticompetitive, the DOJ uses the analytical framework set forth in the Horizontal Merger Guidelines. The five-part process assesses: 1) the city-pairs served by both airlines involved; 2) the potential anticompetitive effects resulting from a merger or acquisition; 3) the likelihood and impact of other airlines possibly entering the market and anticompetitive effects; 4) measurable efficiencies, or benefits, that a merger would bring; and 5) whether one of the airlines involved in the transaction would fail if the merger or acquisition does not go through.
“Antitrust authorities get nervous when the last two competitors in a market merge,” Swire said. “Often the remedy is to sell that route, or city-pair, to another competitor.”
The Department of Transportation (DOT) conducts its own analyses of mergers and acquisitions and provides its findings to the DOJ. Once the transaction is approved and moving forward, the DOT sets forth multiple economic and safety hurdles that must be passed before new operations can take off.
Not every proposed merger gains approval. For example, in 2000, the DOJ opposed a merger between United and United Airways and the parties abandoned their proposal. In other instances, other factors including labor issues and information technology problems have killed the deals. In 2006 a proposed merger between US Airways and Delta fell apart because of opposition from Delta’s pilots and some of its creditors.
To enhance revenues without merging or expending capital, legacy airlines have entered into domestic and international alliances that give them access to some portion of each others’ networks. In recent years, alliances have grown tremendously, to the benefit of those holding frequent flier cards. Regional airlines also often provide service from smaller communities under code-sharing arrangements with legacy airlines, which allow passengers to book their flight as if all the segments were through the same airline.
In March 2008, the Open Skies agreement between the United States and European Union became effective and, as a result, airlines are already asking the DOT for antitrust immunity to not only code-share internationally, but jointly plan and operate flights and share profits.
The airlines began the new century in a slump and the terrorist attacks of Sept. 11, 2001, the mandated ground stop, and the drop in passengers threatened to shatter the already fragile industry. On Sept. 22, 2001, President Bush signed the Air Transportation Safety and System Stabilization Act, which provided $5 billion in emergency assistance to compensate the nation’s air carriers for these losses. In total, the industry estimated that it lost between $7 to $10 billion.
“There wasn’t any question in my mind that United would survive,” Creighton said. “We took some draconian steps: we furloughed 40,000 employees; we sent all our 727s to the desert; we really cut back on many, many things. Some of the things we should have done we couldn’t because of the union contracts.”
Many of the costs related to 9/11 are not concrete, predictable, or easily tracked on a balance sheet. For example, some experts estimate that increased security has cost the industry over $2.5 billion and increased insurance costs millions more.
While the government has provided substantial help to the airline industry since 9/11, in other areas it has fallen flat. In August 2007, Congress passed a law stating that all the recommendations of the 9/11 Commission should be implemented, including screening all cargo that flies on passenger planes. The law did not, however, provide any funding for the purchase of the screening equipment or staff and instead required airlines and airports to fund the mandatory screenings. In Congressional hearings this summer, the industry said it is not likely it will be able to comply with the new law, which requires that 50 percent of cargo be screened by August 2009 and 100 percent by August 2010.
The airline industry is commemorating 30 years of deregulation with a year that is disastrous by any measure. The International Air Transport Association (IATA) estimates that airlines will lose more than $5.2 billion in 2008 and an additional $4.1 billion in 2009, depending on fuel costs. The industry as a whole had been unprofitable between 2000 and 2005, but made a turnaround in 2006 and 2007 by reducing capacity, concentrating flights in profitable markets, reducing long-term debt, and reducing costs relating to employee contracts, pay, and pensions. In 2007, the airline industry carried more than 700 million passengers and had operating revenues of nearly $172 billion, which is more than one percent of the gross domestic product.
“I don’t think you can single out one thing that has put the industry in the pickle that it is in,” Creighton said. “Some of the things that have happened to the industry are not reversible – some are – but plenty are not. For instance, the Internet and the ability of the customer to find out exactly what the price structure is and to go direct to buy that ticket. In the past, I think people felt like ‘I have flown United; I liked United.’ They would call their travel agent and say, ‘I want a ticket on United.’ That is not the case today.”
In the first half of 2008, airline ticket prices rose approximately 7.1 percent compared to 2007. Taxes and fees account for about 14 percent of the average ticket prices and more than 22 percent on tickets with connections.
Airlines have canceled twice as many flights in the first half of 2008 as they did in 2007 – almost 65,000 – and are expected to trim their flight schedules even further. Like most industries, the airlines’ goal is to get as lean as possible by running every flight full to capacity with passengers that will pay as much as the market will allow.
To stay out (or get out) of bankruptcy, airlines have switched to what experts call “a la carte pricing,” under which a passenger checking two bags can pay upwards of $150 extra for a ticket. Airlines have also sold and made it harder to redeem their second favorite type of currency: frequent flier miles. Over the past year, United, Delta, Continental, and others have turned to major banks for “advances” on the credit cards miles marketed as incentives on those banks’ credit cards. For example, United in July turned to Chase to plug its cash flow woes and the bank ponied up a $600 million prepayment for the miles that will be distributed to customers as rewards for using a Mileage Plus Visa. The move increased the United’s amount of unredeemed miles by more than 12 percent. At the same time, many airlines have raised the number of miles required for rewards, reducing the number of reward seats on flights, and increasing fees associated with redeeming miles.
Customers are also giving airlines low marks when it comes to customer services. According to JD Powers & Associates, customer satisfaction with the airlines industry is at an all-time low. In September, Congress failed to pass a Passenger’s Bill of Rights when it extended funding for the FAA. The Department of Transportation then took a stab at passing its own regulations in October, but again failed to include any language that would help passengers stranded on the tarmac for countless hours. Interestingly, prior to October, regulatory officials had no way of measuring or reviewing tarmac delays because once a plane pulls away from a gate it is not considered delayed, and once it is cancelled, it is not delayed. Last year, the DOT drafted a proposed rule with comment period that would require airlines to have contingency plans for lengthy tarmac delays and incorporate them into their contracts of carriage. Currently, only Hawaiian, JetBlue, and Southwest have language in their contracts of carriage regarding deplaning in the event of a lengthy delay. While others may claim to have extra planes in place, the language is only found in their customer service agreements, which do not entitle customers to compensation if they do not.
The recent summer of misery for the airlines has also included a new round of safety violations and record fines. In April, FAA inspectors testified before Congress that they felt threatened and afraid for their jobs when they reported maintenance and inspection problems at some major airlines. In response, the agency ordered an audit of maintenance records for all major domestic airlines and discovered 17 cases in which 11 airline carriers did not comply with government safety orders. While that means that 98 percent of the 5,600 safety orders were followed, the audit led to a $10.2 million fine of Southwest Airlines for flying planes that had not had their fuselages inspected for cracks and a $7.1 million fine of American Airlines for flying planes after safety problems were reported and for drug-testing violations. The DOT is currently reviewing all FAA practices and policies.
The 2008 rise in oil prices came just as most major airlines were starting to get back on their feet. In the past year, jet fuel prices have increased 80 percent. According to the IATA, the airlines are predicted to spend $186 billion on jet fuel in 2008, which is $50 billion more than they did in 2007. Fuel will make up about 36 percent of airlines’ costs in 2008 while it made up 13 percent of operating costs in 2007.
Many of the on board items typically maintained on the plane – magazines, in-flight entertainment systems, water, etc. – have been removed to save weight and, therefore, save fuel. Airlines are leaving “non-essential” items behind and engaging in “just enough” fueling techniques in order to reduce a plane’s weight and increase gas mileage. As a result, on some planes, in the event of a rare water landing, passengers will have to make a swim for it because life jackets are no longer available. Late-night comedians and an April’s Fools joke have suggested that airlines start charging passengers by weight to account for differences in fuel usage by heavier customers. It’s unlikely that large scales will make their way to check-in counters in the near future; currently only Southwest has a strict policy requiring “passengers of size” to buy two tickets but this may change as other airlines continue to look for ways to generate revenue and offset costs.
What the Future Holds
The airline industry, like the rest of the economy, is struggling through these unpredictable times and is continuing to try to adapt to the changing needs of its customers while searching for red on the balance sheet.
“I think the biggest change will be that there will be fewer airlines,” Creighton said. “There is a good chance United, American, Continental, and Delta will survive, but they will likely merge with one another. Delta and Northwest have already merged. There will be more global combinations, whether that is code sharing or actual mergers. With the Open Skies now, European airlines can fly into the United States and the U.S. airlines can fly into anywhere and this will have a huge impact.”
One thing that does seem certain, however, is that the government will not be reregulating the industry any time soon. While Congress asked the GAO to investigate the possibility in 2006 in an effort to save employee pensions, GAO found the option not viable and likely to lead to huge increases in ticket fares and still not enough revenue to cover legacy airlines’ high labor costs. In addition, the main purpose of deregulation was to lower airfares and increase competition, both of which have been realized with outstanding success. That success, however, has come at the cost of airlines’ bottom lines and employee jobs and paychecks.
Tags: Jack Creighton, Peter Swire