Inquiry Into the Operation, Regulation and Funding of Air Route Service Delivery to Rural, Regional and Remote Communities

Professor Rico Merkert Professor and Chair in Transport and Supply Chain Management Deputy Director, Institute of Transport and Logistics Studies The University of Sydney Business School

Sydney, 05 February 2018

Dr Jane Thomson Senate Rural and Regional Affairs and Transport References Committee

Inquiry into the operation, regulation and funding of air route service delivery to rural, regional and remote communities

Dear Dr Thomson,

Thank you for inviting me to make a submission to the above Inquiry.

The aim of this submission is to address the operation, regulation and funding of air route service delivery to rural, regional and remote communities, with particular reference to a number of key areas that were pointed out in your letter which will form the structure of this submission. Paramount to finding equitable and efficient solutions to issues raised by the Inquiry is to recognise regional air services as being essential for the future development of Australia. The federal government has many options to improve requisite commercial viability of scheduled regional air services (i.e. through better integration at various levels and more relaxed security regulation) which should in return improve connectivity, accessibility of transport/mobility and frequency of flights and overall social, health, cultural and economic activity.

1. social and economic impacts of air route supply and airfare pricing;

Aviation has a significantly positive impact on economies, businesses and communities. This has been evidenced by a large amount of empirical studies (e.g. Oxford Economics and ATAG, 2014)1. It is widely accepted that aviation plays an even more vital role in the regional, rural and remote (RRR) context. Local businesses, airline operators and remote airports frequently highlight the substantial economic impacts of air transport to geographically remote or isolated regions.

1 Oxford Economics, Air Transport Action Group (2014). Aviation benefits beyond borders. April 2014, Geneva.

Institute of Transport and Logistics Studies T +61 2 9114 1883 ABN 15 211 513 464 CRICOS 00026A The University of Sydney F +61 2 9114 1863 The University of Sydney Business School E [email protected] 378 Abercrombie St (H73) W sydney.edu.au/business/itls NSW 2006 Australia

Economic impacts usually refer to employment and income generated. The four main types of impacts are: direct impacts (generated by the direct construction and operation of remote aviation); indirect impacts (generated by the chain of suppliers of goods and services related to remote aviation); induced impacts (generated by expenditure of incomes from employees created by the direct and indirect impacts); and catalytic impacts (generated by the role of air transport in remote regions as a driver of productivity growth and an attractor of new firms). Research on these impacts has been limited to Europe (for example in Norway it has been shown that remote airports are important catalysts for local investment; see for example, Halpern and Bråthen, 2011)2), Canada, the US and Australia where I have with colleagues discovered a strong bidirectional relationship between regional aviation and economic growth (Baker et al., 2015)3. Our study results show a very significant impact of regional aviation activity (i.e. passenger numbers) around all regional, rural and remote airports in Australia on the aggregate taxable income of the local government agency in which the relevant airport is located. From further studies and from talking to stakeholders in the regions we know that air transport services are not only essential to the economic sustainability but also to the social sustainability of Australia’s regional communities. Hence in many jurisdictions these services are also called lifeline services. Approximately 171 regional airports across Australia account for 35% of all aircraft movements and over 4 million Australians rely on regional air services across the country (AAA, 2014).4

Although Rex has recently reported a slight improvement in outlook, other regional airlines including Virgin Australia Regional Airlines and QantasLink are still seeing tough trading conditions in the regional and domestic Australian aviation markets. With continued volatility in the resources sector and tourism being inherently seasonal, soft demand from regional and business communities has unsurprisingly resulted in lower profit margins for regional airlines. Profitability is an even greater issue for regional airports, with their number having dropped by

2 Halpern, N. and Bråthen, S. (2011): Impact of airports on regional accessibility and social development, Journal of Transport Geography, 19(6), 1145-1154. 3 Baker, D., Merkert, R. and Kamruzzaman, M. (2015): Regional aviation and economic growth: cointegration and causality analysis in Australia. Journal of Transport Geography, 43, 140-150. 4 Australian Airports Association (2014), Submission to New South Wales Legislative Council Inquiry into Regional Aviation Services.

46% over the last 20 years. Additionally the Australian Airports Association (AAA) reported in 2016 that 60% of Australian regional airports are still operating at a loss with many of them struggling to fund infrastructure maintenance and ongoing operation. Being largely council run, they suffer from restricted access to capital markets, and lack management and incentive structures to grow profitably. Consolidation appears to be the name of the game, which is on one hand necessary and useful for improving profitability for both regional airports and regional airlines but can also lead to losses of essential air services to some communities.

I am of the strong view that regular passenger transport is a critical service to rural Australia as it connects regional and remote centres to each other and to capital cities. Passenger transport service is closely linked to quality of life by maintaining strong social networks in rural communities. The service enables rural and remote residents to access everyday amenities that urban residents take for granted. In addition to facilitating movement for passenger and freight, regional airlines and airports provide special services across Australia including essential medical and flying doctor flights, search and rescue, education, social and law enforcement services to the bush, as well as business, and tourism travel. It is therefore no surprise that regional Australia has a vital interest in securing and maintaining regional air services. Interesting, our research (Merkert and Beck, 2017)5 further suggests that residents and businesses in metropolitan areas also have a relatively high willingness to pay for regional air services, which justifies public support. Our findings suggest that, compared to other modes of travel to regional areas, Sydney residents are willing to pay a premium for regional air services of on average $126 ($99 leisure; $153 business) for one hour of travel time savings. Regional airlines, for example QantasLink, could charge a premium of $189 as part of the ticket price from say Sydney to Port Macquarie, where the saved travel time is 1.5 hours compared to driving a car. The high premiums for time savings resulting from regional aviation services suggest that some form of industry support may be warranted, at the least through ensuring a business friendly institutional environment. Industry subsidies may not be required if the regional air services’ essential role is otherwise recognised as part of the future development of the regions. In the context of regulating Sydney Airport (KSA) our findings provide

5 Merkert, R. and Beck M.J. (2017): Value of travel time savings and willingness to pay for regional aviation, Transportation Research Part A: Policy and Practice, 96, 29-42.

justification for the mandated level of peak hour slots for regional carriers. Our findings also suggest that there is value in considering a further scheme to provide ‘medium’ and ‘large’ regional airports with guaranteed access to slots at KSA. This would include a minimum of two slots in both the morning and evening peak-hours (ideally six) which in turn would generate the potential for some true competition between regional carriers. Allowing multiple operators to compete for the lucrative business travel market, which demands morning departures and an evening return, would make regional air services more competitive and therefore attractive to the travelling public. This may prove more difficult in the regional context than at metropolitan airports and certainly won’t be the panacea to solve low passenger numbers. Attracting non-aeronautical revenues through car parking, adjacent business parks or freight is another option that some airports are currently exploring, for example in Wellcamp, Dubbo and Tamworth. Opportunities around jointly developing routes with all stakeholders (including tourism agencies) which could include federal or local government route development funds is also an option that should be explored. It should be noted that some of the options are difficult to implement in some rural, remote and regional areas that suffer from low, seasonal and/ or volatile passenger numbers.

2. different legal, regulatory, policy and pricing frameworks and practices across the Commonwealth, states and territories;

Recognising regional air services’ essential role in the future development of regional Australia should be a key outcome of this inquiry. What to do in order to improve the efficiency, commercial viability and accessibility of such air services is a complex matter. Although the air service contracts of Australian carriers are simpler than their European counterparts (for more details on this see for example Merkert and Hensher, 2013)6, the governance structure for regional air transport in Australia is still diffused and complex. What seems to be of vital importance is the recognition that regional air services are only one element of a wider system of stakeholders (i.e. regional airports) in the (ideally fully integrated) regional aviation chain which should be seen and treated as providing mobility as a service to communities and businesses. While the various elements of this supply chain often

6 Merkert, R. and Hensher, D.A. (2013): The importance of completeness and clarity in air transport contracts in remote regions in Europe and Australia, Transportation Journal, 52(3), 365-390.

have their own priorities and strategies, it is the governance structure around all of this which makes the system overly complex.

Although airports remain primarily a federal matter (i.e. safety and security aspects but also slot regulation), as a result of deregulation many local governments are now responsible for the maintenance and development of airports, a role that they are in many respects poorly resourced to fulfil and in some cases has decoupled infrastructure investment decisions from a guaranteed associated income stream. At the federal level regional air services receive public support and subsidies under the federal government Regional Aviation Access Program (RAPP) which is administered by the Department of Infrastructure and Transport to provide support for regional and remote aviation services that are commercially not viable. As of 2017, the RAAP consists of: the Remote Airstrip Upgrade (RAU) Programme, the the Remote Aerodrome Inspection (RAI) Programme, the Airservices Australia Enroute Charges Payment Scheme and perhaps most important to this inquiry the Remote Air Services Subsidy (RASS) Scheme. In comparison to the international experience we note that the federal government supports both airports through infrastructure funding and regional airlines through support with enroute cost as well as financial support through the RASS similar to the European Public Service Obligation (PSO) scheme. It should be noted that the RAAS scheme appears to be designed for the very remote and isolated areas of Australia as shown in the current 10 regions/routes supported by the scheme. This is somewhat different to Europe where non-remote regions are also supported for the sake of regional development.

In addition to the above, the Australian Constitution gives state and territory governments power over regional aviation (which historically has been defined as any regular public air transport service to regional Australia using aircraft with 38 or less seats but today regional airlines often use larger aircraft) as it is largely seen as an issue of intra-state trade. Licensing of intra-state aviation services is administered by state authorities in the following four states:  New South Wales—Transport for New South Wales  Queensland—Department of Transport and Main Roads  South Australia—Department of Planning, Transport and Infrastructure  Western Australia—Department of Transport

Intra-state air services in Victoria, Tasmania, Northern Territory and the Australian Capital Territory are deregulated and it is worth noting that the trend of deregulation is also apparent in some of the other states, most notable in Western Australia. While their 2015 “Review of Regulated Regular Public Transport Air Routes in Western Australia” clearly supports their aviation strategy and “vision to maintain and develop quality air services that are essential to regional and remote communities in WA”, the key recommendation of this report is to follow in principle a preferred “light-handed regulatory approach as it allows for a more flexible system that can be more responsive to volatile markets”. As a result WA intrastate air service regulation is now based on route-by-route recommendations (which essentially resulted to date in the reduction of regulation on one route) and subsidies beyond 2016 will only be considered by the State Government when absolutely essential.

Similarly, in Queensland there has been some deregulation and competitive tendering of regional air services in 2014 with the result from 1 January 2015 three routes being deregulated (Cairns-Weipa, Cairns-Horn Island and Townsville- Cloncurry-Mount Isa) and others now being operated by new operators (much to the benefit of Regional Express REX who has been successful in NSW in winning a relatively large number of these routes). While the federal government subsidises a number of remote air services, in addition to the limited state support in the above four states, there have also been a few cases where local councils were prepared to support routes, such as Mudgee council trying to financially incentivise airlines to fly to their airport (into Sydney). While there is limited evidence on its effectiveness in Australia, based on our analysis of the international experience I would like to argue that subsidies directed to residents do not represent good value in terms of supporting regional flights. Evidence from Spain has shown that such subsidies often inflate regional air fares. Some regions have also suggested to relax carbotage restrictions for international airlines. In my view this would have very limited positive impact on regional, rural and remote areas. Such practices have benefited tourism areas such as Cairns but it is highly questionable whether small remote and rural airports would even be able to accommodate a large wide body aircraft and would those aircraft really be interested in a stopover for the sake of say 30 passengers? More importantly if international airlines would indeed make use of this option then the result would be a further deterioration of the commercial

viability of Australia’s regional airlines. That commercial viability could be improved by treating regional aviation as an integrated system with the common denominator of all stakeholders being the provision of mobility as a service for communities and businesses. For example, changes to airport regulation or existence of public ground transport at airports will impact on the attractiveness and commercial viability of regional air services. If passenger numbers increase, services will improve in quality and quantity and air fares will become more affordable.

3. how airlines determine fare pricing;

While the economic and social impact of regional aviation is widely accepted, there are thin (or demand volatile) routes in Australia, where commercially viable regular air services are virtually impossible to undertake. Regional airlines will either seek subsidies or regulation (licenced or competitively tendered routes that provide monopoly security in the way of protection the route from competition for the duration of the contract/license) if not granted either will not provide any services on these routes unless they are of strategic importance or can be bundled and cross- subsidised with other routes. Despite the significant impact of regional aviation, particularly for some communities whose existence depends on such services, from an equity perspective it is important to realise and acknowledge that regional airlines are no charities. They must be allowed to generate profits or at least break even. The implications of if they are not provided with that opportunity can be seen in the numerous financial defaults of regional airlines in Australia (see for example, Brindabella Airlines or Aeropelican Air Services). Air carriers note that in addition to government-imposed fees and taxes, the continued and rapid escalation in airport infrastructure costs significantly affects their ability to offer customers competitive fares, to grow their services and to compete internationally.

The above mentioned low, seasonal or volatile demand in regional aviation is only one part of the problem for regional airlines. The other one is cost structures. From our previous research we know that air carriers note that in addition to government- imposed fees and taxes, the continued and rapid escalation in airport infrastructure costs significantly affects their ability to offer customers competitive fares, to grow their services and to compete internationally. In the regional, rural and remote

context it must also be considered that operating aircraft in these regions is relatively expensive when assessed on a per seat basis. Small aircraft and relatively short sectors, shorter operational windows because thin routes can only bear low frequencies, and limited bargaining power with suppliers, means remote airlines are not able to spread their operating cost over the 500 seats in an A380 but the 12-30 seats typical of a small regional aircraft. This results in relatively high costs per seat and per available seat kilometre which translates into significantly higher fares. This affects consumer demand for the services and forces regional residents who rely on the services to pay more for their tickets. The unfavourable cost structures which result from diseconomies of scale and scope do not have to be a profitability challenge as long as the airlines can secure sufficiently high yields. Although high yields can be obtained from the corporate, charter tourism and mining sectors, airlines operating in remote regions remain heavily dependent on regional economic development and the prosperity of a specific industry or economic sector. As one would expect, in order to achieve profitability from these yields airlines need to factor in volatile fuel cost (they are often too small to hedge fuel which leaves them exposed to this significant financial risk), manpower cost (which can be high in the regions as it can be difficult to retain skilled staff in the regions and even for pilots there is now a shortage which drives salaries and hence staff costs), security charges, landing fees and many other operating cost when determining regional air fares. In addition to the willingness and ability of passengers to pay for regional air fares on many routes airlines will use also try to offer relatively low fares just to a) been seen doing their part in assisting regional Australia to grow (such as QantasLink offering resident fares/discounts on some of their routes) and b) to grow passenger numbers on certain routes.

It is also important to note that most of the equity issues around regional air fare pricing are usually limited to routes to/from small airports (less than 50.000 passengers per year). Routes serving middle sized (more than 50k passengers p.a.) are less problematic and routes serving large sized regional airports (more than 300.000 pax p.a.) such as Coffs Harbour or Ballina Byron usually don’t experience the high air fare discussions. This is mainly because of competition from low cost carriers but also because of much higher demand that enables the operators to deploy larger aircraft (e.g. A320) and thereby allows for very competitive pricing. In the NSW context there is therefore a view that consolidation in the sense of

focusing on a number of larger regional centres rather than lots of small airports all trying to get into Sydney. This could be sensible from a regional airline perspective as it would allow for better economies of scale (larger and better utilised aircraft) but would of course also mean that some communities would lose their air service in return to a drive by car to the next regional centre.

4. the determination of airport charges for landing and security fees, aircraft type and customer demand; pricing determination, subsidisation and equity of airfares; determination of regulated routes and distribution of residents’ fares across regulated routes;

I have referred to most of these aspects under point 3 but would like to highlight again that in my view the lowest hanging fruit for improving the cost efficiency of the regional aviation chain and hence its accessibility and attractiveness to regional communities is to improve the cost competitiveness of regional airports which could be achieved through better governance structures and a relaxation of safety and security compliance regulations/regimes for the regional airport context. The Aviation Transport Security Act 2004 (Cth) does not only create inconsistencies (and to some extent unfairness) in terms of how the security charges for all aircraft weighing over 20 tonnes are passed on to regional airlines (and ultimately to passengers as evidenced through for example different fares of Qantas and Rex on routes they share in NSW with the former deploying aircraft that are heavier than 20 tonnes while all Rex aircraft are below 20 tonnes) but also puts a huge cost burden on regional airport more generally. Why regional airports face the same amount of red tape and security regulations as metropolitan airports (who can recoup at least some of these expenses through non-aeronautical revenues) is difficult to comprehend and certainly part of the issue in terms of regional air fares being relatively expensive in Australia.

In addition I would also highlight again, that evidence from research suggests that if subsidies are to be considered then they should go directly to the airlines rather than to residents in the form of discounts as the latter incentivises airlines to inflate their fares.

5. airline competition within rural and regional routes;

It is widely accepted that competitive forces have the potential to reduce fares and to improve air service offerings. Fostering competition by deregulating regular public transport aviation routes where feasible is hence a preferred strategy and has been a trend across all states in Australia in the last few years. Competition between airports does exist in some states (e.g. NSW where many regional airports are in close proximity to each other and often just a short flight away from Sydney) but less in other states such as Queensland, Northern Territory or Western Australia where distances between regional airports are much bigger. It is hence also no surprise that these three states are the frontrunners in Australia in terms of developing and implementing a regional aviation strategy and interestingly deregulation of air services as well as public support for selected routes and regional airports more generally feature highly in all three strategies.

Airline competition at the route level is virtually non-existent for the medium (less than 300k but more than 50k passengers p.a.) and smaller sized airports (less than 50k passengers p.a.) and even at the larger airports it is often limited to ‘Visiting Friends and Relatives traffic’ (which in the case of NSW has partially to do with the scarcity of slots at Sydney airport during peak hours which only enables one airline to have business friendly daily return flights into Sydney from regional NSW). It would be desirable to change that competitive landscape. For the thicker regional routes it appears that the solution is the entrance of low cost carriers that also cater for the business traveller market. For the thin regional/remote routes the context is different (in terms of size of airlines, equipment, demand profile, willingness to pay, traffic volumes etc.) and on these routes competition for the market (through competitive tendering of routes that are then protected from competition for the duration of the awarded contract/license) may be favourable as regional carriers struggle even in those circumstances and would walk away if there would be any threat of competition let alone real competition in the market. Again, it is important to design a framework in which private operators are enabled to generate at least some profits, otherwise no one else will deliver these essential services. Research from one of our previous studies (e.g. Merkert and O’Fee, 2016)7

7 Merkert, R. and O’Fee (2016): Managerial perceptions of incentives for and barriers to competing for regional PSO air service contracts, Transport Policy, 47, 22–33.

has shown that regional carriers want to innovate and grow routes but they need to be able to do that in an environment where they can at least somewhat control the financial risks and where there is at least some chance of sustainable commercial viability. This shows that introducing competition in such environments whilst desirable is often not straightforward. Even when the contracts are competitively tendered, they have to include appropriate incentives and benefits from competition enhancing government frameworks to ensure they attract a sufficient number of bidders. Having only one bidder or one provider for all small routes will not provide the competitive benefits desired in terms of service offering and value for money (government support). In order to achieve such competition for the market but also in order to keep the regional aviation strategy current we recommend that all stakeholders (airports, airlines, councils, tourism agencies) be proactive in terms of communicating with each other on a regular basis, to jointly develop routes and to share information wherever possible.

In terms of route competition another idea would be to encourage carriers to operate more intrastate services; an example for such services is JETGO trying to connect regional centres in NSW with Brisbane and Melbourne. Connecting the regions with metropolitan is important but in terms of public support and potential competition connecting regional centres (intra and interstate) should also be considered.

6. consistency of aircraft supply and retrieval of passengers by airlines during aircraft maintenance and breakdown;

While it is known that some regional carriers use relatively old aircraft that would need to be replaced at some point (e.g. Rex’s fleet has an average age of 24 year as of February 2018), those ageing fleets still appear to be relatively reliable (and cheap to operate). An increasing shortage of pilots and an underfunding of regional airports are in my view more pressing issues to be considered. In addition, it appears that a sensible strategy to deal with the above issues would be one that is well informed and I would therefore recommend benchmarking of regional airlines and airports to obtain and maintain a fuller picture of their performance and monitoring of their impact on regional Australia. Useful information on regional airline performance is for example patronage, load factors, yields as well as punctuality

and reliability. In the regional airport context one would also track revenue (including non-aeronautical, subsidies and grants) and cost efficiency data relating to the set of indicators which should be more readily available given the public ownership of most regional airports. This would also reveal how effective any targeted federal and state government interventions were and would better inform reviews which should occur on a regular basis (ideally every two years).

7. all related costs and charges imposed by the Civil Aviation Safety Authority; and any related matters.

As stated above, I am of the view that the regional aviation value chain would benefit from a relaxation of safety and security compliance regulations/regimes as any cost occurring at either the regional airport or airline level will result in either less profitable services (and as a result a lack of investment, innovation and potentially route closures) or less attractiveness of regional air services where such costs are passed on to passengers and businesses. It should be a priority to support integrated regional public air transport and to improve its competitiveness compared to individual car traffic in order to keep people and goods mobile/moving and hence regional Australia connected and growing.

Please feel free to contact me if you have any further questions concerning this important subject area.

Best regards,

Professor Rico Merkert Professor and Chair in Transport and Supply Chain Management Deputy Director, Institute of Transport and Logistics Studies (ITLS), The University of Sydney Business School