Entry of Low-Cost-Airlines in Germany - Some Lessons for the Economics of Railroads and Intermodal Competition -

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1 Entry of Low-Cost-Airlines in Germany - Some Lessons for the Economics of Railroads and Intermodal Competition - Juergen Antes Deutsche Bahn Strategic Network Management Guido Friebel University of Toulouse EHESS, IDEI, CEPR Marko Niffka Deutsche Bahn Strategic Network Management Dirk Rompf Deutsche Bahn Strategic Network Management Presentation at Second Conference on Railroad Industry Structure, Competition, and Investment Evanston, Oct. 9th, 2004 Recent changes in European passenger transport market - LCA entry Effects of LCA on DB demand - case studies & market research Possible reaction strategies and their effects Summary & concluding remarks 2 1

2 Strong LCA-growth in Germany in late Highest market shares in UK and US Recent market trends - Low-Cost-Airline-growth UK France Germany LCA doubled market share in Germany from US estimate 2003: up to 25% market share Source: for US: 3 In 2003 Germany experienced some of the strongest LCA-growth in Europe - Important partner countries also with strong growth 1) Ranking of DB cross-border turnover by country, ) Switzerland Austria Netherlands France Italy 1) 2) turnover from incoming and outgoing traffic, including night trains 4 2

3 DB long distance services under pressure from two sides - Original LCA and aggressive pricing on part of Lufthansa Competitive environment Positioning of Low-Cost-Airlines Competitive response of incumbent Domestic LCA Services Low-Cost-Airlines Market entry of new players Incumbent Lufthansa New pricing system with Tickets for 92 (r/t)* Domestic LH Services Cherrypicking: Point-to- Point services on core O&Ds Tickets available for all routes, incl. regional partners ( Team LH ) Aggressive pricing with frequent "special promotions" On some routes high availability of cheap fare quotas 5 On some parts of the DB-network revenue service of low-fare airlines amounts to 70% of DB revenue service Passengers LCA / LH Low Fares vs. DB Estimates Cologne - Berlin Dusseldorf - Berlin Cologne - Hamburg Hamburg - Munich Dusseldorf - Munich Cologne - Munich 34% 21% 10% 36% 63% 57% Airline volume as a percentage of DB volume Berlin - Munich Berlin - Stuttgart % 64% Passengers per day (both ways)* LCA / LH-Low Fares DB (direct only) * DB: Only direct links (no connections) included in capacity calculation Assumption for Lufthansa - 25% of tickets in low-fare category; load factor: DB 40%; LCA 80% Sources: DB: schedule 2003 Airlines: Current Schedules (06/2004) 6 3

4 Polycentric network structure in Germany - Strong dependence on connecting traffic for both rail and incumbent network airline Network structure rail, air Domestic network of DB Lufthansa s domestic network Berlin Berlin Frankfurt Frankfurt Munich Munich 7 Recent changes in European passenger transport market - LCA entry Effects of LCA on DB demand - case studies & market research Possible reaction strategies and their effects Summary & concluding remarks 8 4

5 Case studies clearly illustrate effects of low-cost airline entry on rail volume Effect of LCA entry on DB volume case studies Cologne - Hamburg Pkm 1) Jan Feb March Apr May July Aug Sep Oct Nov Dec Jan Feb June Market Entry December 3rd, 2002 March Apr » - 30% International Destinations # of Travellers (01-04/2003 vs /2002) Cologne - Vienna Hamburg - Vienna - 56,8% - 34,0% 1) 3 months - moving average 9 Market research further supports significant intermodal substitution effects Substitution rates for selected O&Ds Route Domestic (n=1186) Berlin-Cologne (n=429) Berlin-Munich (n=201) Hamburg-Cologne (n=163) Dusseldorf-Berlin (n=133) International (n=986) Direct Substitution* Would have chosen rail Would have considered rail 18,5% 33,5% 21,2% 36,4% 12,1% 25,1% 23,5% 38,2% 20,1% 36,7% 3,9% 10,9% Airports w/ revenue > ,- (n=560) 5,5% 14,9% to Vienna (n=123) 5,7% 15,5% to Zurich (n=104) 10,9% 26,8% Source: Grunberg et al (07/2003); 2,408 individuals surveyed at six German LCA airports * day trains only 10 5

6 Market research indicates strong inverse correlation between trip duration and substitution rates Substitution rates and trip duration What proportion of LCA-travelers would have chosen the train instead? DB travel times mean range 0% 10% 20% 30% 40% 50% < 4 hours 4 to 5 hours 5 to 6 hours 6 to 8 hours 8 to 10 hours. > 10 hours Source: Grunberg et al (07/2003) 25,0 33,2% 41,3 19,3 26,7% 34,1 11,3 11,8 18,0% 18,4% 24,7 24,9 6,4 11,1% 15,7 0,6 2,8% 5,0 xx % xx mean values; day trains only Upper and lower range 11 Recent changes in European passenger transport market - LCA entry Effects of LCA on DB demand - case studies & market research Possible reaction strategies and their effects Summary & concluding remarks 12 6

7 Raising load factors is major challenge for rail - seat-km costs almost 30% below airline competitors levels Cost comparison - DB vs. EasyJet Cost per available seat-km 0,16-28% 0,12 0,08 0,04 0,071 0,051 Load Factor DB» 40% EasyJet» 85% On seat-basis rail with clear cost advantage compared to LCA - but LCA with much higher load factors Rail needs to raise load factor to lower per-passenger costs 0, EasyJet Long Distance Key Question: How to go about it? Sources: EasyJet costs - Urs Binggeli / McKinsey: "Revolutionary or just Specialist - The low-cost concept in Europe" - Presentation at 6th Hamburg Aviation Conference, 13. Feb (1 = 1 USD); DB: DB FernverkehrAnnual Report 2003 (costs) + DB Environmental Report (LF) 13 Railways employ Yield Management - But open system nature of rail traffic limits viable pricing options while airlines are more flexible Constraints of rail network operators - case study Airline Example: Germanwings Paris Cologne Railway Example: Thalys Brussels Aachen Liege Cologne Paris Lead price: 19 one-way Paris - Cologne Once aircraft door closes, everyone on board is going to Cologne (completely local traffic Paris - Cologne) = Closed System Assumption: New lead price 19 o/w Paris - Cologne Fare automatically applies to any O&Don Thalys line - e.g. Paris - Brussels as passengers may board and exit anywhere = Open System Any pricing activity has strictly local effects Aggressive pricing can be used to attract more passengers and raise load factor Pricing activities may affect yields on other O&Ds Unless railways screen customers according to their origin and destinations, there is a price-floor 14 7

8 As railways are unable to match aggressive LCA lead prices, consumers consider rail more expensive Cologne - Berlin Fares in per Person, one-way Actual airfare 61,47 price diff. + 42% price diff. - 28% Perceived DB fare 87,03 price diff. + 97% actual DB fare 44,26 Sources: Grunberg et al (07/2003); 2,408 individuals surveyed average DB fare from sales data 15 In a closed system, DB emulated LCA pricing model - volume rebounded Pricing mechanism and its effects on volume Cologne - Hamburg Pricing Approach before and after LCA-entry Volume o/w 100 Initial New Fare levels Pkm 1) 14 Market Entry Fare Change ,90 39,90 49,90 59, Discrete 5 fare Lower price hurdle and levels more upselling opportunities Jan March May July 2002 Sep Nov Jan March May July 2003 Sep Nov Jan Source: - all fares are Traveler Class ; BahnCard rebate 25% Old Pricing: Weekend Special; Return Special (both fares require r/t purchase; Full Fare (all each way) 1) 3 months - moving average 16 8

9 In an open system with several intermediate stops aggressive pricing may create inconsistencies DB - pricing Cologne - Berlin Price one-way, in 60 Airline Fares from Cologne to... Hamm Bielefeld Hannover Wolfsburg Stendal Berlin DB SP 50 (50% off full fare) Aggressive lead priceto compete with LCA may quickly cause inconsistencies in pricing - public perception may be negatively affected e.g. LCA lead price 19 : - what price to quote someone going to Hannover? - how to deal with someone boarding in Hannover? - how to deal with sum of locals - ticketing? Source: SP 50: 3-day advance purchase; weekend stay requirement 17 Contract design and screening key components of reaction strategy - implementation nevertheless difficult Theoretical reaction strategies Description Evaluation Contract Design Design ticket contract as such that passengers pay the highest applicable fare first and later receive a bonus when it is determined that they traveled on the contested O&D Difficult to implement (communication; passenger handling) Bonus may be more appealing to customers Screening Implement screening devices such as gated access to platforms at all stations Passenger has to present ticket at beginning and end of journey to check validity of fare paid Significant infrastructure investments necessary Increase in handling complexity for rail operator Increases system complexity from a customer point of view 18 9

10 Recent changes in European passenger transport market - LCA entry Effects of LCA on DB demand - case studies & market research Possible reaction strategies and their effects Summary & concluding remarks 19 Summary Intermodal competition is effective - impact larger than expected Asymmetric physical network constraints limit action space for efficient reaction of open (rail) vs. closed (airline) systems Reaction possible - but significant financialimpact remains Potentially interesting: bounded rationality of consumers - influence of different pricing schemes 20 10

11 Conclusions Functioning of Markets In the past intermodal competition in passenger traffic less important than for freight - market conditions are changing with LCA entry German case study shows significant substitution effects Classic question: What is relevant market? Increasingly, market is intermodal! Regulators in the past mainly looked at rail market alone Regulation Regulations that may have small positive effect on intramodal competition may have large negative impact on intermodal rail competitiveness Example of benefits of international cooperation of railroads: Thalys 21 Thank you! Marko.Niffka@bahn.de 22 11