Deregulation in the European Airline Industry

The European Airline Market

Transport is one of the key sectors in Europe, with commercial, economic, and cultural implications for European Union citizens. It accounts for over 10% of Europe's GDP and provides jobs to nearly 10 million people. In the last two decades, air transport in Europe has shown the greatest rise in passenger volumes, with an average annual growth rate of 7.4% in terms of passengers per kilometer. Passenger numbers rose by 19% during the period 1998–2001, driving demand in the European air markets. Since 1970, cargo traffic moved by air transport has increased five-fold. More than 25,000 planes fly over European skies on any given day. The European Union was also expected to see an additional population of some 75 million in the medium term, as ten countries were preparing to join the Union, becoming party to the EU's Open Sky Treaty, which provides for point-to-point services from any member country.

National flag carriers, or state-owned airlines, dominate the European airline market, commanding a share of approximately 70% of passenger traffic. Such airlines include British Airways, Air France, and Lufthansa. However, this dominance was beginning to be challenged as free-market forces increasingly shaped market dynamics. In 1998, flag carriers accounted for 75% of all passenger traffic, while only 2% went to the low-cost segment and the remaining 23% to charter airlines. Just three years later, the market share of low-cost airlines had grown to 7%, while flag carriers saw their share fall to 72% in 2001.

A major demand driver has been the increasing affordability of flying for Europeans, with the average fare of low-cost airlines representing only 3% of average European Union industrial wages. Of the 280 airports in Europe, over 100 are served by low-cost airlines. The major hub airports, however, remain dominated by a handful of flag carriers — British Airways at Heathrow, Lufthansa at Frankfurt, and Air France at Paris Charles de Gaulle. These three airlines held market shares of 11%, 12%, and 7% respectively in 2001, followed by Alitalia and Iberia with 7% each, SAS with 6%, and KLM with 4%. The remaining share was distributed among several smaller players (Riley, 2003).

Deregulation of the European Airline Industry

For many years, the European airline industry operated under tight regulation. Low passenger traffic and high prices created unfavorable economic conditions, forcing governments to subsidize airlines, often for political reasons. The United States took the lead in economic liberalization of the airline sector by enacting the Airline Deregulation Act in 1978. By the mid-1980s, the U.S. airline industry had been largely deregulated and the benefits were clearly visible. The European Union began its own liberalization measures in 1987, with the main aim of granting airlines greater operational freedom, provided they had no significant business links with non-EU airlines and did not engage in price discrimination or cartelization.

The market transition was significant: from a highly controlled, duopolistic market based on bilateral agreements between countries, the European airline industry transitioned to a competitive single market. The final package of liberalization was implemented in 1988. One of the most far-reaching reforms was the reduction of state authority over airlines, granting them considerable freedom to decide on fares, routes, and capacities. This meant that market forces — rather than government decree — would drive decisions, and it was expected that the resulting competition would benefit customers in terms of service, safety, and price.

As part of the progressive policy on "freedoms of the air," any airline holding a valid certificate of operation in the European Union cannot be prevented from flying any route within the Union. This is referred to as the seventh freedom, which includes the right to pick up passengers in one country and fly them to another without a stopover in the airline's home country. The seventh freedom is regarded as a major step toward the free movement of people and goods across the EU.

Although deregulation spurred the creation of numerous regional low-cost airlines, the European airline market remains somewhat distorted because state-controlled carriers continue to enjoy substantial subsidies, giving them a competitive cost advantage over privately owned players — especially smaller ones. In an attempt to reduce costs, large airlines have been withdrawing from unprofitable routes and using subsidiaries and franchisees to serve them instead. Furthermore, airlines are still restricted to operating from their national bases, which limits their ability to pursue the mergers and acquisitions freely available to companies in other industries under the EU single market. The consequence is stark: while only six airlines operate on the American side of transatlantic routes, as many as twenty operate on the European side (Doganis, 2001).

European airlines are therefore confined to a single market and often dependent on a single hub for intercontinental services. This constrains their ability to offer a range of routes and can cause them to miss profitable opportunities. By contrast, a U.S. airline can operate from multiple hubs and offer intercontinental services to numerous destinations through alliances with other carriers. Following deregulation, airlines gained the freedom to set and revise fares at will. Close to 85% of passengers within the EU now travel on reduced fares. On certain routes, however, fares remain high, depriving passengers of low-cost options. Another drawback is the duplication of flight services on busy routes combined with the use of smaller aircraft to increase frequency. These practices have raised fuel consumption per passenger, generating energy conservation and environmental concerns. Critics argue that the short-term, profit-oriented approach of private airlines is the root cause of this situation and that government intervention is needed to prevent further deterioration.

Low-Cost Airlines

Liberalization of the airline industry gave rise to low-cost scheduled airlines, primarily aimed at providing an affordable mode of transport for ordinary citizens, thereby stimulating passenger growth. Lower fares are only possible when operational costs are substantially reduced relative to traditional airlines. Cost reductions are achieved through a variety of techniques: internet-based ticket sales, maximizing aircraft utilization to reduce unit costs, direct sales without travel agents, ticketless travel, and the elimination of complimentary in-flight meals. The extensive use of the internet for ticketing and the removal of commission agents result in significantly lower operating costs. Additional measures include using secondary airports and operating a single aircraft type across the fleet, which lowers maintenance and training costs.

The U.S. carrier Southwest Airlines was among the first to pioneer the low-cost model in the early 1970s. Europe was slower to adopt the concept, and it was only in the late 1990s that low-cost airline services were widely introduced. Ryanair, EasyJet, Virgin Express, Go, and Buzz are among the carriers that have offered low-cost travel in Europe.

A key benefit of low-cost air transport is that it has encouraged middle-income groups to fly for leisure, expanding the passenger base well beyond traditional business travelers (Graham and Guyer, 1991). In 2001, one-way fares from London to Frankfurt were as low as £5, and from London to Brussels, Stockholm, and Dublin just £8 — far below fares prevailing four years earlier, before low-cost services existed. In the United Kingdom, low-cost airline traffic was projected to grow at 6.6% per annum between 1998 and 2015 (Humphreys, 2003). Much of this demand growth stems from passengers formerly traveling by road or rail switching to air travel for its obvious advantages. For example, travel time from London to Scotland is four times faster by air, often at comparable cost.

From the demand perspective, the low-cost sector appeared poised for strong growth. According to the International Air Transport Association, overall air transport market growth in Europe was just over 5% per year during 1999–2003. The low-cost sector, which carried only 4% of passengers in 1999, was projected to increase its share to 12–15% by 2010. However, survival in the low-cost market is not straightforward. Because earnings per passenger are slim, these airlines depend heavily on high passenger volumes and frequent services on profitable routes. There is also constant pressure to minimize costs to protect profitability. Larger airlines are better positioned on both fronts, enabling them to edge out smaller competitors and new entrants. According to a study reported in 2003, only two or three low-cost airlines may survive in the long run (Riley, 2003).