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A Black Box Approach To The Airline Mess

BY ALEX PHILLIPS •

Canada's failing airline deregulation policy finally hit the fan when the Federal Conservative Government realized it had to give a $50 million loan guarantee and Terence Corcoran of the Globe and Mail proclaimed in his column of November 25th, 1992 entitled Ottawa's Flight To Nowhere that "The federal government is caught in a business-political- policy-economic mess of almost indescribable complexity."

Mr. Corcoran used similar language in his column of February 2nd, 1993, This Is No Way To Set Airline Policy, to suggest that the future of the Canadian airline industry would depend on the outcome of a "murky proceeding before the Competition Tribunal over the Gemini computer reservation system" involving a "knee deep load of legal, economic, business and political claims from all sides" where "most of the evidence will be beyond average human comprehension".

In my view, the current financial and competition policy mess in the Canadian airline industry may indeed be complex but it is not beyond average human comprehension.

The current airline mess is a predictable result of adopting a flawed airline deregulation policy from the United States coupled with a reluctance to strictly enforce Canadian competition laws when the deregulation policy was not only failing to achieve a truly competitive marketplace but was effectively resulting in anticompetitive conduct among rival airlines.

* Alex Phillips is a transport economist and lawyer based in Victoria and a member of the B.C., Manitoba and N.W.T. Law Societies. He is a former transport law professor at the University of Manitoba and wrote his Master of Laws degree paper on U.S. airline deregulation and its effects on international aviation competition at the London School of Economics in 1985.

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to apply existing As a regulatory tribunal with independent discretion called upon by laws, the Competition Tribunal, was recently competition Consumer and the Bureau of Competition Policy within the Department of lawful competition Corporate Affairs to help determine what the limits of particularly given should be within a deregulated Canadian airline industry the shared use of computer reservations systems. step in fixing the Calling on the Competition Tribunal was a positive first Minister of airline mess but this should not be confused with the airline policy. Transport's continuing responsibility to establish a workable that the former Indeed, the very existence of the airline mess itself suggests deregulation has Conservative Government's "flight of fancy" with airline airline industry led to a near "crash and burn" scenario for the Canadian and air travellers alike. I suggest we Consequently, in order to assist our new Liberal Government, to use a "black replay Canada's "deregulation" flight recorder now and try airline mess. box approach" to identify the likely causes of the current

Intended Destination and Alternative Flight Plans that even To begin with, Canada's deregulation flight recorder indicates finally adopted before a legislated U.S. style deregulation flight plan was Canadians in July, 1985, the intended destination seemed clear enough. possible air wanted adequate air service for their communities, the lowest which would fares based on fair competition and efficient air carriers on invested operate at a profit and generate a reasonable rate of return capital so that they would remain financially viable. early 1980's Indeed, many different flight plans had been discussed in the continued in order to reach this destination. Transport Canada wanted U.S. style regulation. The Economic Council of Canada wanted to adopt Committee on airline deregulation. The House of Commons Standing framework. Transport advocated liberalization of the existing regulatory Transport The former Air Transport Committee of the Canadian restrict its Commission wanted limited reforms that would not substantially regulatory powers.

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Regulatory Framework Overhaul

In May, 1984, Liberal Transport Minister Lloyd Axworthy adopted a liberalization flight plan known as The New Canadian Air Policy based on the recommendations of the Standing Committee and the first stage of U.S. airline deregulation. He also proposed we take a liberalization test flight before we imported the entire U.S. deregulation model.

In adopting a liberalization policy, Lloyd Axworthy recognized the consensus which emerged from the lengthy review process in the early 1980's that Canadians did not want to import a legislated U.S. deregulation model in its entirety. At the same time, he also recognized that the old regulatory air framework needed some initial overhaul work.

The original regulatory air framework was inefficient and unreliable in helping us to reach our intended destination. Under this framework, the Air Transport Committee had their hands on independent regulatory controls to licence new commercial airlines, to authorize service on new routes and to control the level of air fares. The exercise of this regulatory discretion took into account Ministerial policy statements which included protecting the routes of Crown-owned and promoting a regional air carrier policy.

Under this regulated air framework, new competition for existing demand was restricted. There was virtually no price competition only service competition and regional carriers could not expand beyond defined geographical boundaries. Carriers tended to develop high cost linear non- stop route patterns and service levels. Carriers also had no incentive to reduce inflated costs associated with their service schedule because their regulated fares were based on covering their costs plus receiving an adequate rate of return.

This regulatory air framework first began to crack in 1979. In that year, the Federal Government allowed Canadian Pacific Airlines to compete to a greater extent on a transcontinental basis with Air Canada. In addition, the regional boundaries defined under the regional air carrier policy were beginning to be overlooked by the Air Transport Committee when it granted new routes to the existing regional jet carriers. These initial moves to promote greater competition within the existing regulatory framework

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legislation in 1978 also coincided with the enactment of airline deregulation in the United States.

New U.S. Deregulation Model discretion Under U.S. deregulation legislation, the independent regulatory and set of the Civil Aeronautics Board to licence carriers, grant new routes Specifically, air fares was initially restricted during a liberalization period. consider from 1978 to 1982, the CAB was required by the legislation to factor in the greater competition and the encouragement of entry as a major Similarly from licencing of new carriers or the granting of new routes. approved 1978 to 1983, all fares filed with the CAB were deemed to be The fare provided the fares fell within a defined zone of reasonableness. that the fare zone established a ceiling above which the CAB could rule established a was too high and amounted to unjust discrimination. It also too low or fare floor below which the CAB could determine a fare to be predatory in nature before the fares filed could become effective. and any In 1982, the CAB's control over licences and routes was abolished domestic fit, willing and able U.S. carrier has since been free to enter any and the U.S. airline market. In 1983, the CAB's control over fares carriers were reasonable fare zone concept was also abolished. Thereafter, laws free to set air fares at will and were only subject to antitrust abolished. prohibiting predatory pricing. In 1985, the CAB itself was of Justice. Antitrust oversight was transferred to the U.S. Department and fares Regulatory control over international air transport licences, routes was transferred to the U.S. Department of Transportation.

Liberalization Flight Plan

Lloyd Axworthy's liberalization flight plan of May, 1984 incorporated U.S. similar provisions to the initial liberalization provisions of the discretion deregulation legislation. He maintained independent regulatory for the ATC but at the same time, his liberalization policy statement asked in the ATC to take into account competition as the primary factor exercising its licencing discretion. He also proposed flexible fare zones within which fares should be deemed by the ATC to be just and reasonable. In doing so, he maintained the independent regulatory as discretion given to the ATC to deal with both high discriminatory fares well as low predatory fares before these fares would become effective.

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The ATC copilots felt that this liberalization flight plan took away too much of their independence to regulate. While there appeared to be a struggle for control of the cockpit behind the scenes, the election- of the Conservatives in September 1984 effectively grounded Mr. Axworthy and put any debate over the extent of regulatory independence to rest.

Switch To Autopilot

Within one year, the Conservative navigators filed a fully legislated U.S. style deregulation flight plan. With it came the abolition of the Air Transport Committee copilots and their exercise of independent regulatory discretion. There would be one supreme commander - the Minister of Transport - who now had the power to issue binding policy directives to be followed by a new agency called the National Transportation Agency. The flight plan would also rely on free market forces to achieve greater competition as the U.S. legislation had done since 1982.

The initial Conservative commander in charge of importing a U.S. style deregulation flight plan and modifying it for use in Canada was then Transport Minister Don Mazankowski. His White Paper entitled "Freedom To Move" in July, 1985 served as the framework for the transport deregulation legislative reform package enacted in January, 1988.

Ironically, this was the very same commander who returned to the cockpit in late November, 1992 to join the latest in a series of pilots, Jean Corbeil, to switch off the deregulation policy autopilot and take corrective action before crash landing at an unintended destination known simply as monopoly.

And whether deregulation theorists and policymakers like it or not, these emergency commanders showed great courage in the face of economic reality by agreeing to give $50 million in government assistance to Canadian Airlines and by recognizing the need to address the structural problems and anticompetitive conduct which resulted from enacting the entire U.S. style airline deregulation model in Canada. In this respect, Jean Corbeil and Don Mazankowski deserve some credit for taking evasive action to avert imminent economic disaster for Canadian Airlines and for ignoring "stay the course advice" from would be pilots at the Royal Commission on National Passenger Transportation.

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The Royal Commission on National Passenger Transportation publicly concluded just before the Government decided to provide financial assistance to Canadian Airlines that continued reliance on "free market forces" and deregulation without government intervention would have been the preferred course of action and that consumers would continue to benefit from lower,fares and improved service levels from free market forces under a continued deregulation policy.

Unfortunately, Commission navigators must have been continuing to rely on faulty economic instruments to conclude that we were still on the right course because our commanders should have been approaching our intended destination by now rather than rapidly approaching monopoly.

Instrument Inspection

A closer inspection of the economic instruments reveals that airline airline deregulation in theory relied on the economic assumption that the and industry is characterized by few if any economic barriers to entry therefore airline markets should be contestable by potential new entrants.

With few barriers and contestable markets, a deregulation policy relying on free market entry and pricing promised a self-regulating competitive market of efficient firms, lower air fares, greater service and no tendency among existing airline firms to consolidate or engage in anticompetitive on conduct to acquire market share. To this extent, the need to rely fair competition laws which generally apply to all industries to ensure that market competition resulted in the airline industry seemed unlikely.

The fundamental problem with airline deregulation in practice, however, is that the economic assumption of there being few if any entry barriers in the aviation industry is simply wrong.

There are numerous barriers to entry in the aviation industry for new competition. These barriers include the high costs associated with (i) the cost of equipment and having the proper aircraft type for both long-haul and short-haul markets of differing passenger traffic levels; (ii) establishing market identification and brand loyalty particularly given the establishment of frequent flyer programs; (iii) establishing a ticket distribution network through travel agents including the ability to market flights through computer reservation systems;(iv) gaining access to limited airport landing

Phillips 6 A.C. 322 and takeoff time slots and airport gates particularly since hub airports have developed and (v) providing convenient through ticketing and baggage handling services through carrier alliance agreements.

Given the existence of entry barriers, existing firms could more easily engage in anticompetitive mergers, market sharing and predatory tactics to gain market share rather than be forced by new entrants or the threat of new entrants to compete solely on the basis of innovation, efficiency gains and lower costs.

As a result, deregulation with its reliance on free market entry and pricing when coupled with entry bariers and the opportunity for existing firms to grow through anticompetitive behaviour placed the burden of achieving fair market competition on the enforcement of general competition laws and not self-regulating free market forces.

Stormy Weather Forecast

In January, 1988, when the legislated deregulation policy was enacted, I filed a "stormy weather forecast" with the University of Manitoba Transport Institute entitled "Airline Deregulation: Its Process, Effects and Implications For Canadian Competition Law" which read in part:

As a policy choice, the success of deregulation in achieving the goals of an economic, efficient and adequate air transport system depend on the effects of deregulation as well as the suitability and potential effectiveness of new Canadian competition laws in dealing with the anticompetitive effects of deregulation. To the extent that competition law is inadequate in performing its complementary role with a deregulation policy, the effects of deregulation, particularly those associated with increasing concentration, market power and anticompetitive conduct may be far worse than the costs associated with liberalized regulation.

In effect, unbridled deregulation may prevent the very competition originally viewed as the engine of economic efficiency and innovativeness and may lead us upon reflection, to the view that liberalization of the former regulatory framework would have been a more prudent policy choice rather than the adoption of a U.S. style deregulation competition policy. .

Turbulence Throws Us Off Course

Indeed, the effects of deregulation were not what was promised in the flight plan.

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deregulation was Statistics Canada data indicates that, since legislated economy class implemented in 1988, there has been a dramatic increase in as promised fares compared to the consumer inflation rate not a decrease fares are by deregulation theory. The airlines suggest higher economy flying on lower necessary to make up for the fact that more people are now using fares. It is true a higher percentage of travellers are discount fares some form of discount ticket and while the average price of discount this was did indeed go down during the first year of deregulation in 1988, In 1989 largely attributable to the limited fare war initiated by . to merge and 1990, however, after Wardair was driven by mounting losses discount with Canadian Airlines in January, 1989, the average price of fares increased faster than the annual consumer inflation rate. fare levels The net result of the increases in both economy and discount all fares (ie. particularly in 1989 and 1990 is that the average price of overall than business, economy and discount classes) has increased faster the rate of consumer inflation since deregulation was introduced. increased flight In addition, improved service levels are a reflection of commuter frequencies and the use of smaller turboprop aircraft by aligned and the carriers which replaced regional jet service to small communities linear adoption of hub and spoke route networks which replaced nonstop route patterns. have been Despite a trend which suggests higher average fares overall to make charged under deregulation coupled with cost-cutting measures from them more efficient, the major airlines in Canada are still sufferring huge losses. has To the average Canadian, this makes no sense at all. If deregulation more led to higher not lower average fares and airlines are operating efficiently, why are the major airlines losing so much money?

The answer lies in the fact that though passenger levels have declined time during the recession, capacity (ie. flights and seats) has increased at a when the airlines are burdened with extremely high levels of debt fares compared to shareholders equity. When the major airlines say that are "too low" then, this means that existing fare levels do not generate enough revenues to cover their costs which have been progressively inflated by debt service charges and by providing excessive capacity.

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Debt has been progressively incurred to finance the merger activity with the former regional jet carriers and the staged process of greater equity participation in local commuter carriers now known as alliance or connector carriers. Continual merger activity coupled with joint feed and scheduling agreements with local commuter carriers has resulted in rapid consolidation and increased concentration in the airline industry.

The market power economies of scale and scope of the major carriers also increased as the respective "carrier family" networks expanded. So did the major carriers ability to engage in anticompetitive behaviour such as predatory pricing (ie. pricing below cost) and predatory scheduling (ie. flooding particularly competitive city-pairs with excessive capacity by increasing flight frequencies and the number of seats regardless of demand) in an effort to gain market share from competitors and deter new entrants.

To the extent that predatory scheduling has been engaged in, service levels as measured by increased flight frequency and seat capacity will temporarily be high. However, if independent competition is driven from the market (ie. like Wardair or Nationair) by continued losses and forced merger or bankruptcy and potential entrants who could choose to compete on a scheduled basis (ie. ) are effectively deterred by the likelihood of incurring the same fate, such predatory tactics ultimately lead to service level cuts and an even higher average level of air fares.

As a result, in my view, Canadians have been paying higher average fares overall under deregulation to help service the debt incurred by existing carriers to finance the pursuit and achievement of less competition in the Canadian airline market. Clearly, paying more to achieve less competition and a potential airline monopoly was not our intended destination.

Corrective Action

If an airline monopoly ultimately results, commissioners at the National Transportation Act Review Commission have recommended that the Federal Government allow foreign air carriers to serve domestic routes within Canada to achieve a competitive marketplace.

In my view, placing even greater reliance on deregulation theory in this way would not be effective. It would only perpetuate and enlarge the current structural problem, create a greater potential for renewed

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anticompetitive conduct and likely lead to consolidation and control by larger U.S. carriers and their alliance carrier networks. It would not promote greater competition by independent carriers and it would likely result in inadequate service in the long term.

Consequently, in my view, the Federal Government should consider adopting a revised policy approach of ensuring "effective competition".

Specifically, Canadian airlines should continue to compete freely by setting their own fares and entering domestic markets at will without Government preapproval. However, the National Transportation Agency, with its existing airline monitoring expertise, should be given a limited "preemptive" jurisdiction to review upon complaint and disallow air fares which are set so high as to be discriminatory, air fares which are set so low as to be clearly predatory and capacity levels (ie. flights and seats) which are clearly excessive relative to demand (ie. passenger traffic) in particular city-pair markets.

In addition, the Competition Tribunal should play an active and conduct complementary role by clearly defining unlawful anticompetitive from lawful competitive practices in a deregulated airline marketplace particularly with respect to anticompetitive versus failing business mergers, predatory versus competitive response pricing and market sharing conspiracies versus efficient carrier alliance agreements.

Final Approach

In short, unbridled deregulation and anticompetitive conduct needs to be managed, in my view, to achieve an economic, efficient and adequate air transport system in Canada. Canada can no longer afford to solely rely on simple but flawed economic theory from the United States to solve complex economic and regulatory problems.

Canada needs a revised airline policy which promotes effective competition not one which results in destructive competition and is simply characterized as another "tough" decision.

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