Virgin Atlantic: Once in a generation
slot reform November 2019

Virgin Atlantic’s announcement in September that it planned to operate up to 84 new routes from London Heathrow, assuming the third runway is eventually built, certainly caught the headlines. The plan, according to Virgin, is to challenge British Airways’ dominance at the airport by operating 37 new European routes, 12 new UK routes and 35 new long-haul routes. At present Virgin Atlantic serves just 19 intercontinental destinations. It is proposing that it should be awarded, presumably at no cost, over 40% of the new slots which will become available with the construction of a new runway.

This isn’t the first time that Virgin Atlantic has threatened to challenge BA’s dominant position in UK aviation in general, and at Heathrow in particular. Indeed, throughout its existence, since 1984, Virgin has been engaged in a running battle with its larger competitor, although the confrontation’s intensity (and headline grabbing) has declined in recent years, coinciding with Delta’s purchase of a 49% stake in the UK carrier. Unlike other would-be challengers to BA, Virgin Atlantic has at least survived, but it never really made the break-through it sought to establish itself as a major threat to the larger carrier.

Key to Virgin’s new plans at Heathrow is the reform of the airport slot allocation rules. Only by adopting a radically different approach, it argues, can more competition be introduced, and therefore fares be reduced. Virgin points out that the UK Government’s own recent Aviation Strategy Green Paper argued that increasing competition to the benefit of consumers should be one of the prime objectives of government policy.

A new Heathrow runway will permit some 280,000 additional annual aircraft movements (up from 476,000 to 756,000), about 350 more slot pairs each day. At present, BA and its associated airlines dominate the airport. IAG carriers control 55% of all Heathrow slots (51% for BA, 3% for Aer Lingus and about 1% for Iberia and Vueling).

This may be significantly less than the dominance achieved by other major airlines at their home hubs, but still means that no other carrier can come remotely close to matching BA’s position at Heathrow. Virgin Atlantic has just 3% of the slots at the airport and ten other airlines each have between 1 and 3%, accounting for 23% in aggregate (including Virgin). This leaves a long tail of 72 other carriers using the remaining 22% of slots, each with less than 1%.

The rules governing the allocation of slots at Heathrow follow EU law and IATA’s Worldwide Slot Guidelines. Central to them is the principle of grandfather rights, under which an airline can keep a seasonal slot at a capacity constrained airport in perpetuity as long as it uses the slot at least 80% of the time. Grandfather rights have been controversial, but they have benefits, not least allowing carriers to plan their networks over the longer term. They create an element of certainty and without them, it is argued, airlines would be less willing to invest in and develop routes.

The downside is that grandfather rights cement into place the current industry structure, characterised by national flag carriers dominant in their home markets. They provide a major barrier to market entry. Where airport capacity is restricted, such as at Heathrow, new entrants find it difficult, often impossible, to gain access. The result is less competition and higher fares. It is significant that there are no easyJet or Ryanair flights from Heathrow. Neither the growth of low-cost carriers nor the adoption of secondary slot trading has significantly changed the situation at London’s premier airport.

Between 2013 and 2019, according to an analysis carried out by the UK Competition and Markets Authority (CMA), only some 50 Heathrow slots have been bought in the secondary market, and many of these were traded between alliance or joint venture partners. This does not suggest a liquid market. It is not surprising, therefore, that slot holdings have remained remarkably constant. Perhaps the point that stands out most from the table is the fact that Virgin Atlantic’s share of Heathrow slots has actually declined from 5% in 2014 to 3% in 2018, which opponents have not been slow to suggest is hardly consistent with its new demands. BA has pointed out that had Virgin taken advantage of, and been able to afford, the Heathrow sales which have arisen over recent years, it would now have almost 20% of the airport’s total slots.

Virgin and slot access

To a large extent both the structure and growth of Virgin Atlantic have been dictated by its access, or lack of it, to airport slots. Launched as a Gatwick operator, Virgin was transformed, maybe saved, when UK government policy changed in 1991 to permit Heathrow services. Without this decision it is unlikely that the carrier would still be around today. However, the difficulty in obtaining Heathrow slots throughout its existence meant that Virgin was never able to operate more than a tiny handful of short-haul services and therefore create hub feed.

Of necessity, it became a specialised long-haul operator, with a relatively small number of routes. Some have even suggested that this limitation, while in many ways making life more difficult, may actually have saved the company, especially with a majority owner like Sir Richard Branson, known for his willingness to enter new markets in the face of fierce competition.

In the early 1990s, Virgin launched a campaign to obtain more Heathrow slots. Essentially its argument was quite similar to the one it is advancing today: we will provide competition to BA, but need more Heathrow slots to do so. Given the influence which BA still had in Whitehall at the time, it is not surprising that the campaign failed to make any progress. Later Virgin adopted a more sophisticated approach, directing attention towards the need to reform grandfather rights and thereby increase the availability of slots for new entrants.

Virgin argued that access to slots for airlines such as itself would be much easier if instead of being granted effectively in perpetuity, slots were allocated only for a limited period, say 10 years at a time. 10% of slots at an airport could be returned to the pool each year and re-allocated, with the original ‘owner’ having the opportunity to bid for them again, but of course having no guarantee of getting them. It is easy to see why such an approach was attractive to an airline such as Virgin Atlantic, desperately trying to establish itself at Heathrow. But it failed to attract support from a single other carrier, let alone governments and regulators, although it did generate interest from academics and think tanks. (See, for example: ‘A Market in Airport Slots’, Institute of Economic Affairs, London, 2003.)

Challenging the status quo

Having been relatively quiet on this front for some time, Virgin Atlantic has now decided to challenge the status quo again by campaigning for new slot allocation rules. In the words of Shai Weiss, Virgin’s CEO: “We have a once-in-a-generation opportunity to transform the market.” Essentially it has reverted to its original proposal, demanding more slots to enable it to compete with BA, rather than tinkering with the Regulation itself. The chances of success may be no greater than previously given the relatively crude nature of its demands, despite the decline in BA’s political support. But there are some interesting omens to suggest that at least with respect to more general reform of the slot rules, all may not be lost. And some of the ideas being floated are really quite radical.

Interestingly, Virgin has received support from Heathrow Airport. According to John Holland-Kaye, Heathrow CEO: “The new runway presents a massive opportunity to lower fares, but we need a scale player that can compete with BA…. To do that there has to be a change in the slot rules.” There is no love lost between Holland-Kaye and IAG’s Willie Walsh. The Guardian recently reported that Heathrow has accused BA of acting against “the consumer and national interest” by attempting to slow down the expansion of the airport, while Walsh has argued that Heathrow is an inefficient monopoly building a far too expensive runway which eventually the airlines will have to pay for.

The new runway at Heathrow, on the optimistic assumption that it will ever be built, will add a substantial number of slots, virtually all of which will quickly be taken up. The EU Slot Allocation Regulation is designed essentially to deal with little more than a trickle of new slots each season, not the situation likely to be found at Heathrow.

Ironically, one particular problem involves the clause in the Regulation designed specifically to improve airport access for new entrants. Such airlines, defined as carriers with less than five daily slots at the airport in question or less than 4% of the slots at the relevant ‘airport system’, are given priority for 50% of any new slots which become available each season.

Few airlines currently serving London, including non-Heathrow carriers such as easyJet and Ryanair, would satisfy these criteria, with the result that a large proportion of the new slots are likely to go to small airlines with very limited market presence. It is not obvious that this will lead to a significant increase in effective competition and challenge the dominant carrier at the airport.

There is also the issue of how the new runway capacity will be financed. The regulator, against the wishes of the airlines, is supporting the airport’s proposal for pre-funding. This will mean that the current Heathrow carriers will be paying for the new runway long before it becomes operational. If the EU Regulation is applied, therefore, those paying for the runway will essentially be subsidising their future, new entrant competitors, with no guarantee of receiving additional slots themselves.

Heathrow expansion and slot allocation

There seems to be a growing acceptance that Heathrow expansion requires a very different approach to slot allocation. Brexit provides an opportunity for the UK to take unilateral action in this regard, unless the Government commits to applying European rules even after (if?) the country has finally left the EU. The Government’s Green Paper on future aviation policy, now out of its consultation period, openly discusses reform of the slot allocation system, with options ranging from relatively modest changes to its administration to a more radical market-based approach. Reserving slots for additional domestic routes to increase Heathrow’s connectivity seems very likely to form part of any reform.

A very significant intervention in this debate came with the submission to the Green Paper consultation by the influential CMA, the body charged with regulating competition in the broader economy. In a lengthy and well-argued paper, the CMA highlighted many of the shortcomings of the current Slot Regulation, particularly when applied to an airport such as Heathrow. According to the CMA, “there is a clear case to reform the slot allocation mechanism to maximise efficient use of scarce capacity and promote competition between airlines. Without reform to the current system, the potential benefits arising from competition from new capacity at Heathrow may be lost.”

Much of the CMA analysis will be music to Virgin’s ears, not least the comment that “the current administrative allocation mechanism has made it difficult for a second network carrier to establish a significant presence at London Heathrow because they cannot get a sufficient portfolio of slots….[C]arriers with significant slot holdings can restrict competitors’ access to slots. This constrains competition between airlines and therefore the resultant benefits to consumers, businesses and the economy.”

However, what Virgin will probably be less keen on is the CMA proposal to add primary to the current secondary trading of slots. In other words, the Authority wants to see the sale of slots as they become available, either from the addition of new capacity or as a result of being returned to the pool. At present slot sales are allowed only between airlines with respect to slots which already exist. Primary trading has attracted the support of many economists for a long time. It is, they would argue, the best way to ensure that slots are used in the most economically efficient way. They point to other industries which have had to allocate scarce resources where successful auctions have taken place, such as spectrum sales.

The CMA is very critical of the current administrative mechanism for allocating slots, calling it “inherently flawed” and an approach which will always result in inefficient outcomes. “Auctioning slots provides an opportunity for airlines to have a direct input into how they shape their networks and how best to respond to the demands of their passengers over time, according to their knowledge and strategic direction. There is no clear rationale for why these important commercial decisions should be made by a third-party administrator…”

Nevertheless, the CMA accepts that a market-based approach is not without its risks, something with which no doubt many airlines will be quick to agree. The most obvious such risk is that carriers with market power will be better placed than new entrants to buy slots, thereby leading to an increase rather than a reduction in slot concentration. There is also the related problem of State-subsidised airlines not encumbered by the need to make commercial decisions and willing to pay whatever is needed to gain access to slot-constrained airports. There is already evidence of this in the secondary market for Heathrow slots.

The CMA’s rather weak solution to such problems, which it readily acknowledges, is to “strongly encourage the government to consult and engage experts in the field of auction design.” This seems to be the equivalent of saying: “We don’t know what the answer is, but surely someone out there has it.” A similar degree of fence sitting is seen in the CMA’s criticism of grandfather rights, where it says only that “a balance needs to be found between airlines’ commercial and operational imperatives while ensuring that enough slots are made available for airlines wanting to enter or expand services.”

There is also the issue, of course, of who will receive the considerable funds likely to be generated by primary slot trading. There has never been a definitive conclusion on who actually owns airport slots. Under single till airport price regulation, if the sale receipts went to the airport, they would presumably be used to off-set airline charges. Alternatively, at Heathrow they could be used to meet at least some of the cost of the construction of the new runway, with funds provided before the runway’s opening, thereby giving airlines time to prepare to use the increased capacity at the earliest opportunity. On the other hand, the Government might not be able to resist another source of revenue.

Likelihood of reform?

Are any of these radical proposals likely to be implemented? The answer may be no, not least because the main driver for reform, the construction of a third runway at Heathrow, is still stuck in a political quagmire. It is particularly the third runway which has highlighted the shortcomings of the current EU/IATA slot allocation rules. Anything other than a clear Conservative majority in the December General Election is likely to see yet more delay to the expansion of Heathrow, if not outright cancellation (again).

At the same time, however, there is certainly growing pressure to reform the slot rules. Even the European Commission has recognised this. Commenting in July this year, for example, Filip Cornelis of the Commission noted: “We believe that the existing rules must be improved, in particular in view of recent market developments (eg bankruptcies) [and] new practices affecting the allocation and use of slots.” Unfortunately, reform of the Slot Allocation Regulation has been on the EU agenda for a long time, with no clear consensus emerging on what to do. Certainly, the Commission is unlikely to be attracted by the radical CMA proposals (it has struggled to accept secondary trading, let alone the primary sale of slots). It will be faced with considerable opposition from the airline community to any major changes to the slot rules.

In June, IATA announced new governance rules for its slot guidelines. In future, airlines, airports and slot coordinators will play an “equal role” in determining what the rules should be. “This fully reformed governance sets the ideal ground to regularly review the slot allocation process.” Somehow this seems unlikely to satisfy those looking for a more radical initiative. On past experience, the chances of serious proposals for reform emerging from IATA and the vast majority of its members are remote.

Brexit should make it easier for the UK to go its own way in reforming the slot allocation rules, and there does seem to be some interest in doing so. Speaking at the Airlines 2050 conference in London in October, Dan Micklethwaite, Director of Aviation in the Department for Transport, said that the possible expansion of Heathrow presented a “unique scenario” in this respect. “We believe there is a case for change here, and we want to work with the industry and IATA to start a debate on what it looks like.” He went on to note that the current slot rules are not designed for the “once-in-a-generation moment where you get a significant amount of slots at a very constrained airport.”

‘Once-in-a-generation’ seems to be the phrase of the moment for those looking to reform the slot allocation rules in the UK. Whether the enthusiasm for change would survive further delay in the construction of a third Heathrow runway remains to be seen, as does whether Virgin Atlantic’s demands will come anywhere near to being met. Perhaps not something to bet your house on.