Civil Aviation Policy and the Privatisation of British Airways Mark Ashworth and Peter Forsyth The Institute for Fiscal Studies 180/182 Tottenham Court Road London W1P 9LE Published by The Institute for Fiscal Studies 180/182 Tottenham Court Road London W1P 9LE Distributed by Woodhead-Faulkner (Publishers) Ltd Fitzwilliam House 32 Trumpington Street Cambridge CB2 1QY The Institute for Fiscal Studies 1984, 1985 ISBN 0-902992-41-4 First edition 1984 Second impression 1985 Printed and typeset by Parchment (Oxford) Ltd 60 Hurst Street Oxford OX4 1HD 2 PREFACE This report presents the results of the IFS project on the Regulation and Privatisation of British Airways, which has been financially supported by the Economic and Social Research Council. The authors are grateful to many people for their help with the study, in particular to Nicola Spencer for assistance with the empirical part of the study, and to Christopher Beauman, Andrew Dilnot, Christopher Findlay, John Kay, Mick Keen, Andrew Likierman, Stephen Littlechild, Tom Sharpe, Stephen Shaw, David Starkie, David Thompson and Martin Wolf for advice and comments on earlier drafts of the report. They would also like to thank participants at seminars at the Australian National University, Brunei University, Macquarie University, Monash University and Sydney University for helpful comments, and executives at British Airways and British Caledonian for discussions of the issues. Peter Forsyth is indebted to Professor Fred Gruen and the Research School of Social Science at the Australian National University for giving him time to visit IFS in July and August 1984, and to the Department of Economics at Warwick University for the use of its facilities during an earlier part of the study. Finally, the authors would like to thank John Hills, Janette Palmer, Cathy Pearcey and Sian Turner for preparing the manuscript for publication. 3 CONTENTS Page Preface 1. Summary and Recommendations 7 1. The Regulatory Scene 7 2. The Performance of British Airways 8 3. Preparing British Airways for Sale 10 4. Civil Aviation Policy 11 Part A Background 2. Privatisation, Efficency and Regulation 17 1. Privatisation and Efficiency 1 7 2. Privatisation and Regulation 21 Appendix: The Efficient Markets Approach 26 3. Assessing British Airways' Markets; Competition and Regulation 29 1 . Regulation and its Relevance 29 2. Markets and Regulation in General 30 3. The European Market 32 4. The North Atlantic Market 36 5. The Domestic Market 39 6. The Other Markets 40 7. Price Setting in British Airways' Markets 41 8. The Scope for Regulatory Change 43 9. Conclusions 44 Part B Performance 4. Efficency and Productivity Growth of British Airways 46 1. Introduction 46 2. International Comparisons of Airline Efficency 46 3. The Recent Productivity Performance 49 4. Summary: Productivity, Efficiency, and the Scope for Improvement 55 Appendix: Measuring Productivity Change 56 5. How Exchange Rates affect British Airways 59 1 . How Exchange Rates affect Airlines 59 2. Exchange Rates, Airline Costs and Yields 64 4 6. Labour Market Issues: Wages and Superannuation 76 1. Privatisation, Regulation and Wages 76 2. The Superannuation Liability 78 7. Routes as Assets: Regulation, Profitability and Cross- subsidisation 82 1. Introduction 82 2. The Price of a Route 83 3. A Route-by-Route Study 85 4. Why British Airways is not more Profitable 91 Appendix: Measuring Profit on Routes 93 8. British Airways' Financial Structure 97 1. Assets and Liabilities 97 2. Valuing British Airways 101 3. Comparative Airlines Capital Structures 104 4. Extraordinary Accounts? 108. 9. Taxation Issues 113 Appendix: Estimating Tax Liabilities 119 10. British Airways' Profitability 122 1. Introduction: the Paradox 122 2. The Recent Profit Performance 122 3. Profits: the Immediate Future 125 4. Profitability in the Long Run 128 Part C Policy 11. Airport Questions 133 1. British Airways and Heathrow 133 2. How British Airways Gains 134 3. Airline Competition and Airport Pricing 136 12. Promoting Airline Competition: The Implications for British Airways 140 1 . Airline Networks 140 2. Route Transfers 143 3. Market Dominance and Predation 145 4. Civil Aviation Authority Policy and Route Transfers 148 5. Selling Airlines, Routes and Networks 151 5 13 0 Selling British Airways 157 10 The Irrelevance of the Balance Sheet 157 2 0 The Subsidy Question 160 165 References 6 1 SUMMARY AND RECOMMENDATIONS 1 . The Regulatory Scene British Airways (BA) operates within a regulatory framework (see sections 3.2 and 3.8) which is only partly under the control of the British Government. Privatisation of BA will not, of itself, affect this regulatory framework. If competition is desired, on the grounds that it will foster efficient performance of the industry, it is possible for the Government to increase it; though it is constrained by its overseas partners. There are several options such as dual designation, domestic deregulation, route transfers and airport price changes which may affect competition. We discuss the most desirable pattern of changes at the end of this chapter. These changes would be desirable whether or not BA were privatised. The general case for privatisation of BA lies with its potential effect on productive efficiency (see 2.1 ). At present it is not a very efficient airline, and there is considerable scope for improvement (see 4.4). A privately owned airline, oriented towards profit, has a more direct incentive to improve efficiency than a government airline. The extent to which privatisation actually achieves this objective depends on how effective the new management is, and the extent to which it actively seeks profit. If the airline is insulated against takeover, a private management's performance may be no better than that of the public management. Privatisation may therefore yield advantages even in the absence of changes in the regulatory framework. The gainers from the expected improvement in efficiency will be the Government, and ultimately the taxpayer. Few of the benefits of improved efficiency will be passed directly onto the customer in the form of lower fares or better services, at least in the immediate future, as a result of regulatory agreements made with overseas governments. Improvements in efficiency will be largely reflected in increased profits and the UK Government will receive a price for the airline which is based on possible and expected improvements in productivity and profit performance (see 2.1 ). If the market is unduly pessimistic about this at the stage of buying, then the new owners will gain as actual performance outstrips expectations. Regulation, by excluding or reducing competition, is valuable to the airline (see Chapters 2,3, and 7). To maximize the overall benefits from operation of the industry, it is desirable that competition also be maximized. This will reduce profits and reduce the price received for the airline. To the extent that the Government has the option of 7 increasing competition, it will be reducing the price it receives. From Britain's overall viewpoint, it is desirable that competition be encouraged, even though this means a lower price received. To this end, it is of crucial importance that regulation be liberalised bifore rather than after BA is sold (see 2.2). If this happens, the Government takes the loss. Since selling BA involves selling an airline and rights to regulated routes, it will be very difficult for the Government to remove regulation and lower the profits of the owners to whom it has sold the airline. This is especially true if the regulatory changes are not expected, but it is still true if liberalisation is foreshadowed at point of sale. The new owners will always have an incentive to oppose deregulation. Unexpected deregulation after sale could correctly be regarded as a breach of contract which imposes a loss on the buyer (see 2.2). It may be feasible for the government to introduce some competitive incentives short of complete deregula­ tion, without reducing the financial benefits of privatisation, by introducing a system of franchising or leasing routes; we discuss this possibility further below. The regulatory framework may change over the foreseeable future. It may become possible for regulation of air routes from Britain to Continental Europe and elsewhere to be liberalised, as other countries change their attitudes and objectives (see 3.2, 3.8). Britain may take advantage of this and agree to liberalise. It has not always done so in the past. A statement of intent cannot commit the government to liberalisation, but the more clearly it is understood the better. It may weaken the bargaining power of an airline which profits from regulation and will naturally seek to maintain it. If the Government wishes to encourage competition in the airline industry, now is the time. It may be too difficult after privatisation of BA. It ought also to state its intentions on regulation for when its partner countries alter their policies. If competition is to be encouraged, and the benefits that it brings secured, liberalisation must come before privatisation. If complete de-regulation is considered infeasible on the current time-table for privatisation then competition for the market should be encouraged by making routes transferable, ideally through franchising or leasing routes; BA should be sold on this basis. We discuss the proposals made in the recent White Paper at the end of this chapter. 2. The Performance of British Airways BA is not one of the more efficient international airlines. This has been true for some time, .and it has been indicated by a number of 8 studies (see 4.2). It has improved relative to other airlines over the past few years, though it remains a weak performer. Its improvement over the past three years has been good, though hardly spectacular (4.3). Overall productivity has increased much less rapidly than one partial aspect of productivity, labour productivity.