Transtasman Air Market. Wellington Airport - taking an active role in the debate over the proposed airline cartel 9 S E P T E M B E R

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1 9 S E P T E M B E R Wellington Airport - taking an active role in the debate over the proposed airline cartel Transtasman Air Market

2 Good air services and passenger numbers matter for the region s economic performance and are key drivers of the Airport s business. Index WELLINGTON AIRPORT REVENUE AND PASSENGER FLOWS Total Revenue Aero Revenue Total Passengers INFRATIL UPDATE 2 ISSUE 24 Competition-It Matters When the Commerce Commission found that the Air New Zealand and Qantas alliance proposal of 2003 was harmful to New Zealand it was hoped the matter would go no further. Instead, the airlines have found a loophole in New Zealand s consumer protection laws to push ahead with a cartel on the Tasman. As a reminder, the Commerce Commission rejected the airlines alliance application because they found annual detriments of $195m significantly outweighed potential airline annual cost savings of $40m. The Commission decided that the alliance would result in higher airfares, meaning that each year 189,003 fewer New Zealanders would take an overseas trip while a net 133,414 fewer overseas visitors would come to New Zealand each year. There are compelling reasons for Wellington businesses to take an active role in the debate over the proposed airline cartel. Wellington s aeronautical charges are determined on a per passenger basis. It gains no income from empty seats on aircraft. Terminal services income is also a function of passenger numbers. Because of its role as the region s gateway and the income link with passenger numbers, Wellington Airport spends millions of dollars every year to promote travel to and from Wellington. It has partnered with tourism agencies and airlines to stimulate travel volumes and is committed to continuing to do so, as long as airline markets make growth genuinely possible. Airline competition drives innovation, efficiency, enhanced services and lower cost fares. Market Regional Market Structure Air NZ Dominant (now a monopoly) Wellington Passenger Growth % Domestic Trunk Air NZ Dominant 3% Transtasman Modest Competition The New Zealand market illustrates the direct relationship between competition and travel growth. 6%

3 Aspects Jointly Managed and Agreed Proposed Code Share Air Share (Old Tasman) Seat Blocks Eg: Air NZ/JAL Freesale Eg: STAR Retail Pricing X Routes X X Frequency X X Aircraft Type X Capacity X Available Seat Kilometres X X Net Revenue X Revenue Risk Sharing X Defined Blocks of Seats (limited) X X Freesale of Seats (unlimited) X X Wholesale Price or Pro-rate X X Typical Code Shares Code Share in name only There is nothing normal about the code share proposed by Air New Zealand and Qantas. The airlines intend to establish a committee to meet weekly to jointly set prices, determine which routes should be flown, how often they should be operated, what aircraft will be used, what service standards will apply and to share the revenues in a pre-determined manner. In their own words, they seek to operate as a joint business and make decisions as one. They want the Commerce Commission to have no say whatsoever. It is quite unlike any other code share currently in operation or proposed in the past. A comparison of the current proposal with more typical code shares is provided in the table above. Airline jargon sometimes clouds the proposal, so a hypothetical analogy with another sector is informative. In the example below, we use grocery retailing. Supermarkets to Share Customers Today, New Zealand s two dominant supermarket chains announced plans to jointly set prices, product ranges, opening hours, service levels and store locations. They also agreed to jointly determine payment terms to suppliers. It is madness that we both have stores across the road from one another, and open pretty much the same hours and sell the same products, said a spokesperson. The supermarkets have advised that their stores are on average only 20% full of people across the course of a week. It makes sense to close some of the stores, reduce the number of lines carried and reduce opening hours to get efficiencies. Of course, those savings will be passed on to consumers. And when there is only one store, we will be able to offer customers longer trading hours, better service, a better product range and more access to our loyalty programme. The two supermarket companies will set up a joint committee that will meet each week to decide what products will be offered, the price for each item, which stores will be closed, what hours the remaining stores will be open and how many check-out and stocking staff will be rostered. Responding to fears of price increases from the price-fixing arrangement, a spokesperson said that there are thousands of convenience stores in New Zealand. In fact, it is one of the most intensively competitive in the world and the major supermarkets cannot compete with small convenience store operators, often recently arrived in New Zealand, who do not properly cost their own time. Acknowledging that not all towns have a convenience store, a spokesperson said that people in those towns can take comfort from the fact that there are lots of convenience stores in Auckland. If we put up prices, restrict discounted items or cut service in small towns, people will no doubt go to Auckland to shop. While the total number of stores is expected to be reduced from more than 260 to 218, a spokesperson for the supermarkets insisted that customers will in fact have more choice of store. Customers will now be permitted to go to both supermarket chains instead of just one, he said. INFRATIL UPDATE 3 ISSUE 24

4 No Need for a Cartel There is no financial case for an airline cartel submissions to the Australian version of the airlines concede that they face no financial with Air New Zealand, the National Flag Carrier, But if there are no numbers to support the case, INFRATIL UPDATE 4 ISSUE 24

5 on the Tasman. In their code share Commerce Commission, the ACCC, the crisis. Many people reflexively sympathise and the airline naturally promotes that emotion. the cartel should not be approved by Government. INFRATIL UPDATE 5 ISSUE 24

6 INFRATIL UPDATE 6 ISSUE 24 No Need for a Cartel Speaking in the Australian Financial Review in May, former Air New Zealand Managing Director, Ralph Norris, described Air New Zealand as one of the strongest in the world from a financial perspective. That sentiment has been supported following the recent announcement by Air New Zealand of its year end results. It would be fair to summarise analyst responses as, not a perfect result, but pretty good for a year when the airline says it is absorbing higher fuel prices, unusual one-off costs of restructuring and new fleet capacity. Air New Zealand s EBITDAR return on assets was 14.4%, and return on equity before tax and unusuals was 9.7%. This is not enough in the long run. However, the airline faces a number of potential upsides and most commentators anticipate an easing in fuel prices, at least over the medium term. Not only are the two airlines in good shape, but the Tasman itself has all the elements for a profitable operation: There is limited competition on most routes, restricted mainly to that between Qantas and Air New Zealand. High levels of customer loyalty through corporate travel, frequent flyer programmes and the dominance of Australian and New Zealand travellers. Other airlines, including Pacific Blue and Jetstar make money on Tasman routes. Very high utilisation of aircraft. Aircraft flying on the Tasman can operate hours per day, which is very high for short haul operations. In Europe, Ryanair, the world s leading low cost fare airline, achieves 12 hours per day. In addition to dedicated fleet, both Qantas and Air New Zealand also use the downtime of long-haul aircraft on Tasman services. Both airlines have low cost subsidiaries which they can deploy on lower yielding routes. Public information suggests that yields and load factors on the Tasman are similar to those in other profitable markets.

7 Load Factors It has been a principal premise of the airlines case that there is unusual excess capacity on the Tasman. They have quoted the impressive figure of 6,300 empty seats per day, implying that it is possible to expect 100% seat occupancy or something close to it. Put in context, it is clear that Qantas and Air New Zealand s load factors on the Tasman are perfectly normal. The following graph compares Tasman load factors with those of other routes in and out of Australia for 2005, using data from the Australian Bureau of Transport & Regional Economics and the airlines submissions to ACCC. International Load Factors - Tasman & Other Australia 1 00% Tasman 80% 60% 7 5% 7 1 % 67 % % 7 0% 7 6% 7 4% 7 3% 57 % 68% 60% 60% 62% To/From Australia 40% 20% 0% Emirates (UAE) Thai (BKK) Garuda Air Pacific (Fiji) Pac Blue (Fiji) Cathay Sing. Airlines QF- All All Australia Qf/NZ Combined Pac Blue Air NZ Qantas For further comparison, Air New Zealand s overall short haul load factor (which includes its domestic, Tasman and South Pacific services) was 72% in the year to June The Tasman loads are quite normal. In their submissions to the ACCC, the airlines themselves suggested that, even with the cartel in place, they would increase load factors by only 3 points over three years. Yields Similarly, yields on the Tasman are comparable to those that prevail in other profitable markets. Yields are generally expressed as cents of revenue passenger kilometre (RPK). That is, divide the average fare by the route length and you get average yield for that route. Airline/Segment NZ c/rpk Source Air NZ-Tasman 15.1 WIAL Estimate from MIDT * Data Qantas-Tasman 16.3 WIAL Estimate from MIDT Data Air NZ-Short Haul 16.0 WIAL Estimate from Air NZ 2006 Results Air NZ-Long Haul 9.1 WIAL Estimate from Air NZ 2006 Results Virgin Blue-Short Haul 13.2 Virgin Blue 9 Months to June 2006 * MIDT means Market Information Data Tapes information sourced from airline booking systems. All yields expressed in NZ cents per revenue passenger kilometre Currency conversions at NZD1.00 = AUD0.83 and NZD1.00 = USD0.64 Are these yields profitable? It helps that Jetstar and Virgin Blue release their unit cost statistics for their short haul operations. Using the costs and load factors published by the two companies, and currency conversion at NZD1.00 = AUD0.83, their respective costs per RPK are: Airline Jetstar Full Costs (NZ$ c/rpk) 12.8 The Tasman should be profitable at those costs. Even the cheaper fares on the Tasman generally represent yields of 12 cents to 13 cents per RPK. Obviously Virgin Blue 12.3 average yield will be higher than those fares. If Air New Zealand and Qantas are not making money at typical load factors and typical yields, there may be an issue with the cost base and product being offered on some routes. It does not create a case for a dominant cartel.

8 Airline Innovations and Cost Savings There is no question that airlines are active in pursuit of product innovations and cost savings. In Australia, competition is stimulating an extraordinary degree of innovation among airlines. Virgin Blue is attempting to pull off the seemingly impossible to maintain genuinely low costs and a low cost culture, while increasing its offer to premium passengers, interlining with long haul airlines and considering long haul flights of its own. It continues to offer very affordable fares and it is making money. Qantas is aggressively pursuing its Jetstar and Jetstar International models for sustainable low costs. The Qantas CEO, Geoff Dixon, has promised to transform the company, and he is clearly on the way. The airline is moving to a genuine two brand approach. While there is plenty of public debate in Australia about protecting Qantas on some routes, it is obvious that Qantas is a successful, innovative company that has genuinely adopted affordable fares and market stimulation as part of its strategy, and it has a good record of profitability. Competition between Qantas/Jetstar and Virgin Blue has generated some incredible stories of regional growth. Passenger numbers at Sunshine Coast Airport have been growing at 45% annually and at Newcastle, growth has been running at 80% per annum. Air New Zealand is also demonstrating resolve and innovative thinking when it comes to its long haul services, and it is set to reap the rewards of investments and initiatives in the next few years. It is transitioning routes to more cost effective aircraft, such as the Boeing 777 and 787, and is upgrading its product on those routes. It has been very decisive on its selection of new routes and has withdrawn from routes it cannot make work. The airlines deserve credit for responding to a competitive environment with product innovation and cost savings. Will this competition-driven innovation be applied to the Tasman and the New Zealand domestic market? The code share proposal is a step in the entirely opposite direction. It is simply a collusive arrangement, which can only be contemplated because of a legal loophole. It means less capacity and higher fares. Over the medium term it will forestall airline innovation and any efforts to grow the market. The allocation of benefits from the arrangement is difficult to estimate, but it can be noted that Air New Zealand s redemption of its convertible loan from Qantas (a left over from the failed alliance) is effectively the equivalent of Air New Zealand paying Qantas a $48 million fee.

9 NZD excl GST $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 Domestic Charge per Pax $9.32 $11.42 $8.80 Domestic Jet $5.24 $11.42 $8.80 Domestic Prop (ATR) $5.34 $5.24 $8.80 Domestic Prop (B1900) Since July 2002 domestic air travel costs have risen 14% Wellington Airport s charges have not changed since Airport Charges Wellington Adelaide Cairns Charge per International Pax $ 25 $ NZD excl GST $ 15 $ 10 $ 5 $ 0 Wellington Adelaide Cairns In a campaign to deflect attention from the code share proposal, the airlines have recently been very high profile in their criticism of airport charges. In fact: Aeronautical charges at Wellington compare well with other airports of a similar scale, amenity and quality of facilities. Since July 2002 domestic air travel costs have risen 14% Wellington Airport s charges have not changed since Wellington Airport s after tax return on aeronautical assets in the year ended 31 March 2006 was 6% per annum. Wellington Airport has an agreement with Air New Zealand on charges. Wellington Airport has an ongoing investment programme to support airline operations and passenger comfort, in addition to its work with tourism agencies and airlines to promote passenger growth. INFRATIL UPDATE 9 ISSUE 24 The figures set out above compare Wellington with Cairns and Adelaide airports. Those two airports have 3.5 million and 5.5 million passengers respectively (Wellington has 4.5 million), good quality facilities and, like Wellington, are close to their respective cities. The Board of Airline Representatives Australia has accepted charges at these airports as reasonable. Currency conversions are at NZD1.00 = AUD0.83. Wellington charges include the costs of airport fire and rescue, but those charges are additional at Cairns and Adelaide. We have assumed a load factor of 70% for the Beech 1900 comparison as Cairns charges are not passenger based for small aircraft. Provided they do not mislead or deceive customers, airlines are at complete liberty to change fares and impose charges without consultation or detailed scrutiny, even on routes where they have a monopoly. Wellington Airport gets to reset aeronautical charges once every five years after extensive consultation with airline customers. Recent fare increases are far more significant than airport charges. For example, a 10% fare increase between Wellington and Sydney would add to between $28 and $66 each way. By comparison, Wellington Airport s average charge per international passenger is $24. Booking a Tasman seat by phone rather than via the internet can entail an extra airline charge of $25 each person, each way.

10 200 NZ Domestic Air Travel Costs 150 Airport Charges Index INFRATIL UPDATE 10 ISSUE 24 Mar 95 Mar 96 Mar97 Mar 98 Mar 99 Mar 00 Mar 01 Mar 02 Mar 03 Mar 04 Mar 05 Mar 06 Future Prospects Emotive claims about airport charges are not unique to New Zealand. In Australia where similar claims are made regularly, the Productivity Commission has just released its draft findings after an inquiry into airport charges initiated by the Treasurer. The Commission concluded that: The light handed approach works (noting that the Australian regime is more light handed than New Zealand s because in Australia there is no legislative compulsion to consult). Price control is not justified. Price monitoring should continue for some airports for the next five years (which is the Australian equivalent of what already occurs in New Zealand where annual accounts of aeronautical activities are produced pursuant to the Airport Authorities Act). Asset revaluations should be allowed to be included in price setting (at least revaluations up to 2005). Compulsory arbitration is unnecessary and could be counterproductive. There are opportunities for the parties to improve in some areas. The situation may be reviewed again after the next round of price setting. To quote The Australian newspaper, Airports have not proven to be the price-gouging monopolists airlines say they are. In so far as the Productivity Commission report touches on New Zealand, it shows New Zealand airport prices are comfortably within the range of comparable international and Australian airports. What Happens if the Code Share Proceeds? Each week the two airlines will meet to jointly determine schedules and the supply and prices of seats. As Adam Smith once put it People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. To assess the actual scale of the price rises, Wellington Airport used independent economists, LECG. They forecast: 19% average price increase; 21% fall in passenger volumes; $34 million fall in tourism spending per annum.

11 There would be readily available fares between Auckland and Wellington of $55-$70 if the low cost New Zealand domestic fares were the same on a per kilometre basis as those in Australia. In Australia there is a competitive, and profitable, domestic airline market. Cents per kilometre (NZD) Wellington - Auckland Fares vs Virgin Blue Australian Average 13 Virgin Average 24 $114 Saver Fare 26 $127 Saver Fare 29 $138 Saver Fare 31 $149 Saver Fare 38 $182 Semi Flexi 39 $186 Semi Flexi 56 $269 Semi Flexi 59 $282 Flexi For a family considering a holiday in Australia, a 19% price increase could mean paying $500 more for air fares. For a Wellington business with occasional marketing visits to Australia, it means potentially several thousands of dollars of additional costs per annum, as well as significantly fewer services to choose from. The cost of New Zealand domestic air travel highlights what happens when there is little or no competition. Fares increased 33% between 2003 and was the high water mark for domestic airfares, prior to a shake up in the airline sector. However, fares are now back above that peak. A simple observation of yields is telling. The chart above compares Virgin Blue s average yield for Australasian short haul with examples of Air New Zealand and Qantas yields on the Wellington Auckland sector. Even the lower fare categories on Auckland Wellington appear to be double the average yield achieved by Virgin Blue in Australia. If the low cost New Zealand domestic fares were the same on a per kilometre basis as those in Australia there would be readily available fares between Auckland and Wellington of $55-$70. In Australia there is a competitive, and profitable, domestic airline market (as opposed to limited specials, as tends to be the case in New Zealand). It is the scarcity of low fares that is the main difference between Australian and New Zealand domestic operations. It is good that Air New Zealand operates a successful domestic business and it is also not surprising that as a network carrier some parts of the network are more profitable than others. INFRATIL UPDATE 11 ISSUE 24 The risk is that customers on parts of the network with limited competition do not get the benefits of innovation and cost efficiency. An Opportunity Forgone? Apart from the immediate consequences of higher fares and less capacity, the cartel is likely to forestall improvement and innovation on the Tasman, and probably in the NZ domestic market. Orderly marketing and jointly managed markets are part of a protectionist mentality that suits the code share. Consumers will be the losers. If the code share were not to progress it is likely that the Tasman market will change. Air New Zealand has said that it intends cutting services on the Tasman regardless of the outcome of the code share. Perhaps so. But as long as there is genuine competition, no one company gets to determine the direction the market will take. The airlines that thrive and lead will be those that recognise the full range of markets on the Tasman with strong potential for profitable growth. That will require products and cost bases that reflect each of those markets and a willingness to see profitability in market stimulation. When airlines take that approach, they will find many willing partners.

12 Whilst all reasonable care has been taken to ensure the facts stated are accurate, neither Infratil Limited, Morrison & Co Infrastructure Management Limited, nor any of their directors, officers or employees guarantee the accuracy or completeness of the information stated herein.