Davies Commission:
Hub questions October 2015

If the Davies Commission’s Final Report — recommending a third Heathrow runway —  were to have been expected to resolve the very difficult question of airport capacity in London, it has clearly failed. Here Chris Tarry (CTAIRA), as part of an assignment for Gatwick Airport, highlights major areas of contention, specifically the Commission’s analysis of the role of transfer traffic in the future.

Future of London as a connecting hub

The Commission assigns great importance to transfer traffic for the London market in the future. There are, however, a number of disconnects in the arguments and assumptions that it makes.

The Commission appears to assume that the provision of additional airport capacity alone is a sufficient condition, that will result both in more connecting traffic and the operation of routes which were previously not possible from London.

We consider that this to be an heroic assumption as there are a range of other factors that need to be taken into account.

These include: where passengers are flying from and to, given the importance of geography and its impact on direction of flow; whether by the time additional capacity becomes available, transferring via London will be a more attractive option for travellers than via the growing number of alternatives.

More generally, passenger value is of particular importance to airlines, and there appears to be insufficient recognition by the Commission of this basic fact.

The Commission also takes a view that “a key objective for expansion should be to facilitate new connections on more marginal routes to emerging markets”. While this is a laudable objective it appears to neglect the range of the other conditions that will need to be satisfied for this to be the outcome.

The Commission asserts that for Heathrow “to grow its route network it needs to attract significant levels of transfer traffic to supplement local demand. But declining domestic connectivity, pressure on fares and limited resilience are causing difficulties in attracting these transfer passengers”.

One of the key issues is that the only airline group that currently has access to intra-airline/airline group domestic transfers is BA/IAG and this is unlikely to change given the closure of Virgin Atlantic’s Little Red services to Manchester, Edinburgh and Aberdeen.

Even if easyJet were to establish a base at Heathrow post-expansion — made much more difficult by the operating day restrictions proposed by the Commission — that airline’s management is sticking to its view that passengers will self-connect.

Given that the proposal is for easyJet to operate from the current Terminal 4, the minimum self-connecting times are likely to be significant and it is inevitable that there will be more attractive options for connecting at airports elsewhere.

Among the key questions that the Commission fails to address includes where this additional transfer traffic will come from, and go to, not least as London as a connecting point, (particularly for emerging markets), will continue to decline. London is not well placed for new flows, and increased competition is already reducing its importance in established flows as well.

There are unanswered questions relating to the fare levels this traffic will be carried at, and how these compare with current and likely future options both from a traveller as well as an airline perspective.

The reality, as the Commission itself states, is that “the world's economic centre of gravity continues to shift eastwards”. The rather more important issue remains of accommodating the growth in the point to point traffic delivered by “momentum airlines” which see London as either an attractive O&D market rather than as a connecting point.

Some observers might suggest that the Commission’s near fixation with transfer traffic has resulted in it failing to identify what is both happening now and likely to happen in the future.

Travel options for passengers outside London and the South East

We are somewhat bemused by the Commission’s views that: “Links to other hub airports in both Europe and further afield are generally considered a supplement rather than a replacement for connections at Heathrow” and “Passengers to or from other UK nations or regions who are obliged to transfer through other European airports or Middle Eastern hubs... costs time and money”.

Although there are undoubtedly some cases at the margin where this is the case, where there is additional cost and time involved in connecting at a continental hub, for the majority of travellers the services to/from the UK regions that are offered across other connecting airports have dramatically increased the travel options.

Against this background we have examined the travel options that exist to connect Manchester (designated as the core of the proposed Northern Powerhouse) with the Indian Sub Continent and also China and Hong Kong. Our analysis provided few examples where either (let alone both) of the Commission’s statements hold.

Indeed one stop flights via most of the connecting points other than Heathrow are not only competitive in terms of timing (many better than via Heathrow) but also  transferring via another connecting point offers a much greater range of final destinations (for outbound passengers) or origins (for inbound passengers).

This should immediately raise doubts over whether, when additional capacity is added in London, there will be a significant change in traveller behaviour, shifting away from the current routings. We would expect that by the time the capacity in London were to be available there would be both an increase in the number of direct services from eg Manchester as well as in the number of destinations served by one-stop services connecting across non UK airports, reflecting the strategies of non-UK airlines.

The Commission’s view also contrasts with the objectives that IAG has set out for the development of Aer Lingus to 2020. A key opportunity is  increasing the volume of traffic that is connected across Dublin to and from the UK regions and North America, much of which currently connects across London and in particular Heathrow.

Our analysis shows that these traffic flows alone, before taking into account the potential that exists from boosting traffic over Dublin from airports that are not connected to London, represent a significant proportion of the additional 2.4 million passengers that IAG has suggested Aer Lingus and IAG could deliver to an enhanced Aer Lingus transatlantic network by 2020 which would grow from the current six routes to/from North America to ten over the 2015-2020 period.

Further consolidation in the European airline industry is inevitable and we would expect to see IAG playing a leading role. Finnair has stated that it is looking for an investor/partner. Becoming a member of IAG is an option and this would provide the opportunity to connect more traffic from other UK regional airports, in addition to Manchester, across Helsinki to North Asia and China and vice versa.

There will be further developments in terms of connecting opportunities for passengers travelling to/from the UK regions via non-UK connecting points, as well as new direct services when new capacity becomes available in the London area.

This will not only reinforce existing travel patterns but will also mean that a change away from these routings is highly unlikely. This is another conclusion that is at odds with the one reached by the Commission.

Role and development of alliances

As the Commission observes, alliances have grown hugely in importance over the past 30 years, but there is again a need to look at the specifics rather than the generalities. While the Commission notes that all alliances have grown their presence at Heathrow it is necessary to look at why, how and on what routes.

It is only the oneworld alliance that has intra-alliance connecting traffic to/from UK domestic airports; when bmi was sold by Lufthansa to British Airways the Star alliance members lost their domestic intra-alliance feed.

Unsurprisingly,  the European members of Skyteam and Star have focused their attention on their home hubs, as have their partners from other parts of the world, and this is a trend that we expect to continue.

At Heathrow the European members of the Skyteam alliance have reduced their presence while, with a few exceptions, the European members of the Star alliance maintained a broadly similar presence over the period from 2005. Looking to the future it is unlikely, other than in perhaps the case of THY, that any European member of an alliance other than oneworld will increase its presence at Heathrow, and as a result such alliance members cannot be seen as a source of new traffic growth.

The Commission highlights Africa as a potential connecting market; against this background it is of interest to compare the changes in services, for example, to Nairobi where Kenya Airways (a Skyteam member) has reduced its presence on the route to Heathrow yet markedly increased it at both Amsterdam and Paris CDG — providing more evidence that alliances will direct traffic through the airports of their regional members.

Although Terminal 2 has improved the position of Star in terms of its ability to connect passengers across Heathrow, and while connecting traffic is important to these alliance members for perhaps eight months of the year, it is unlikely that there will be a significant change in transfer patterns or volumes for these alliance members at Heathrow.

Over time we are likely to see additional services from some of the long haul members of the Skyteam and Star alliances (not least from China) but this is because London is an attractive destination and origin point for them; any traffic aggregation or disaggregation will occur at the home end of their route. Only some 3% of Air China’s traffic to Heathrow connects to points beyond.

Development of traffic from emerging markets

Throughout the Commission’s report there is a focus on emerging markets, emphasising how the UK needs to be linked with them. Indeed in the foreword the Chairman notes that while “Gatwick is well placed to cater for growth in intra-European leisure flying it is unlikely to provide as much of the type of capacity that is urgently required; long haul destinations in new markets. Heathrow can provide that capacity most easily and quickly”.

However, an increase in airport capacity alone is not a sufficient condition to ensure such an outcome as it is for an airline that will need to be able to operate such routes profitably. Furthermore, as discussed above, in terms of emerging markets London is not well placed for connecting traffic although it will increasingly be a destination city for services operated by airlines based in the emerging markets, from China in particular.

A recent study by IHG and Oxford Economics also provides some very clear views on how (and where) the Chinese outbound market will develop. In terms of importance, China, by the end of 2014, had overtaken the US as the largest source of international travel spending. However, there is a need to keep a sense of perspective in terms of the importance of Europe and the UK for Chinese tourists; they will remain amongst the smaller destination markets for this group of travellers.

In terms of measuring the benefit of tourists it is their value (and in particular what they spend), rather than volume, that is seen as a better measure. Against this background and while in absolute terms the UK might have fewer Chinese visitors than some other European countries, they spend more in London than anywhere else. Paris for example has three times the number of hotel guests from China than London but London hotels sell more room nights to visitors from China than Parisian hotels. In terms of expenditure by Chinese travellers the figure for London in 2013 was $338.3m compared with $254.5m for Paris; by 2023 these totals are forecast to reach $1.85bn for London and close to $370m for Paris.

In the near term changes in UK-China visa arrangements are likely to provide a further boost to the number of inbound visitors; other countries have seen visa changes resulting in a step change increase in visitors of some 20%. However, the reality is that in volume terms the UK is likely to remain a relatively small market for inbound tourists from China given the other opportunities that are open to them.

Against this background an increasing number of inbound passengers will be carried by airlines from the home end of the route and from a growing number of originating cities; but in all cases London will be seen as a destination city.

Importance of airline economics

In various places in its report the Commission appears not to appreciate how important airline economics are to the actual outcomes, how they might work and with what consequences.

At times the Commission argues for more capacity to bring fares down — entirely correct in terms of economic theory but elsewhere in the report there appears to be surprise that new entrants in the first instance are likely to select thick routes on which to compete.

In so doing they will be providing additional opportunities for existing travellers and also growing the size of the market as fares fall; outcomes which accord both with economic theory and what happens in any competitive business.

Indeed in a UK context both bmi and Virgin Atlantic initially cherry-picked what they saw as the most profitable routes operated by their competitors and in particular British Airways; most recently this is exactly the approach that easyJet and Ryanair have adopted as they increase their focus on higher value routes.

Most airlines since 2009/10 have exercised capacity discipline. BA’s strategy has been described as "Fortress Heathrow" with a clear focus on value maximisation; almost no growth in the short haul market after 2017, and measured growth in the long haul market taking advantage of the strength of London’s O&D market.

On the basis of known orders and options, and making reasonable assumptions as to the timing of the retirement of aircraft, we have estimated BA’s long haul fleet development at Heathrow and shown this in the tables on this page.

We have assumed that there will be little change in the short haul fleet given the maturity of the network and that any additional capacity will result from a combination of more seats per aircraft on the current fleet or through the introduction of larger aircraft on the route.

On our estimates the long haul fleet increases from 119 aircraft now to 154 by 2025, which will enable BA to operate some 25-30 additional long haul services by the end of the period. There is an inevitable reduction in short haul services as slots are migrated to use for long haul but we estimate that this will only represent some 10% of BA’s current short haul slot portfolio.

Our analysis also shows that the average number of seats per aircraft will remain broadly similar over the period under review and in the range of 275-280; an outcome which will be yield positive and, when combined with the step change in operating costs delivered by the new generation aircraft, further demonstrates the focus on value rather than just volume.

Another key area that  needs further examination is the impact that the expansion at Heathrow will have on passenger charges and consequently on passenger numbers.

The scenario selected by the Commission reflects an assumption of pre-funding whereby today’s travellers are paying for facilities that future travellers will use; the smoothing effect spreads the recovery of costs over a far greater population and results both in smaller increments, as the charge rises, and a lower ongoing level of charges.

In the case of Heathrow, and the chosen option of the North West runway, the increase the “weighted average charge” is stated to be £9.00 (in 2014 prices) where the increase takes place through a series of increments over the 2019-2025 period.

We have already seen the managements of some airlines make their views known on the proposed cost of Heathrow expansion generally — most recently the CEO of IAG at the time of the company’s interim statement.

More generally, many airline managements have made their opposition to pre-funding very clear too. Their focus of attention is on: the charges, the assumptions made, and the outcomes forecast for the scenarios where there is no pre-funding.

While the level of any charge will have an underlying or ongoing effect on demand, it is the speed of the change in the level of the charge, and the nature of the adjustment to the new level, that are the most important dynamics to be considered.

Where pre-funding is not accepted (in the face of the opposition from the airlines) there are a number of issues that need to be considered: the consequences of the airlines passing on the additional charges (as they will not want to absorb them);  the impact on potential demand;  and the wider consequences for the Commission’s current assumptions and conclusions on the structure and level of short haul traffic to/from the airport.

At the simplest level funding the North West Runway at Heathrow on what the Commission describes as an “operational funding” basis, and on a like for like basis, results in an increase in the average charge on a per passenger basis at Heathrow of some £13.00 (in 2014 prices). This increase takes place in two stages between 2025 and 2028 with one increase of c£9.00 and the other of c£4.00. To put this into context the current level of APD on short haul flights is £13 and this is only levied on departing passengers.

In broad terms the increase in charges resulting from this “operational funding” scenario would appear to represent an increase in the average European economy fare ex-Heathrow of some 12% which will inevitably have an impact on demand if the increase is passed through; it is particularly unreasonable to expect airlines to absorb this.