Industry view: Airline alliances causing turbulence in open skies

The last limp weeks are dragging before the mass fly-out commences. Gatwick to Majorca, Heathrow to Bangkok, Stansted to Florence - holiday flights rather than business travel are weighing heavily on even the most efficient corporate minds at this time of year.

Yet as we dream of "leaving on a jet plane", the jetting market may be about to change shape entirely. British Airways, the biggest airline operator out of the UK, wants to establish an alliance with American Airlines, one of the largest US companies, so they can co-operate and co-ordinate flights. Between them they already fly 61 per cent of passengers between the UK and the US. And if their deal is as advantageous as they suggest, we should expect that market share to rise.

Richard Branson of Virgin is predictably distressed, and has already given evidence to the House of Commons Select Committee on Transport which is investigating the alliance. The Department of Trade and Industry is considering the matter too. And the Office of Fair Trading must decide whether to refer the deal to the Monopolies and Mergers Commission.

Quite right. When companies have substantial market share, it is easier for them to abuse their position (raising prices above the market level or avoiding efficiency improvements) and leave consumers worse off.

But BA has a cleverly constructed economic case as to why its deal need not be bad for competition, or for consumers. It is worth considering its claims in some detail, even if in the end they are not convincing.

BA's case that competition won't be harmed is based on two arguments. First, it claims the relevant market in which competition should be measured is not US-UK, but US- Europe; there the alliance will only hold a 24 per cent market share. Second, it maintains the market structure will change as a result of its deal, allowing the Government to remove some of the obstacles to wider competition.

As far as defining the appropriate market is concerned, BA has an impressive array of figures to back up its point. On the BA117 flight from Heathrow to New York on 12 July this year, 47 per cent of passengers began their journey in London; 33 per cent started elsewhere in Europe; 10 per cent in Asia; and 9 per cent in Africa or the middle east. What airlines call "feeding" passengers comprise a large proportion of BA's transatlantic flights.

The company is clearly competing in a wider market to persuade people onto its London-US flights. The businessman from Frankfurt could equally travel on Lufthansa direct to New York rather than on BA via Heathrow. Airlines that can offer a single through ticket with co-ordinated transfers between flights are bound to be more attractive.

However, that is not much use for British customers. For the Germans, a direct flight on Lufthansa and a BA flight via Heathrow may be roughly comparable. But for passengers starting in Britain, a detour via Paris or Frankfurt to the States is not very appealing. We are still locked into the narrower market of UK-US flights, so that is the market the UK competition authorities must consider. It remains the case that the proposed alliance will take more than half of this market.

What then of BA's second argument? Will the alliance at least be counterbalanced by greater competition in transatlantic flights?

At the moment, international air travel is heavily regulated to prevent airlines flying on any routes they like. Bilateral agreements between governments determine how many companies from each country can fly on particular routes. Between Heathrow and New York, for example, the US and UK Governments have agreed that only two British and two American airlines may operate.

BA argues that its deal with AA would allow the British Government to negotiate an "open skies" arrangement with the US, and open up routes to all comers. This kind of policy already operates across the European Union. Several European countries have already negotiated their own "open- skies" deals with the US - usually predicated on a similar alliance between an American company and their own flag carrier. The German agreement, for example, depended on Lufthansa's new alliance with United Airlines.

BA is terrified the skies might open before it too has the protection of an American big brother to link it up to US domestic connections, and prevent other US companies drowning it out.

Even if we accept that we should indeed provide some protection for our own flag carrier from those big American bullies, that does not justify allowing the alliance to go ahead. The fact is that liberalising air traffic routes as BA suggests is not enough to promote effective competition between airlines.

A recent research paper from the LSE argues there are several additional obstacles to competition. While the liberalisation of European routes has increased the number of airlines operating and competing across Europe, Pedro Marin maintains that the European flag carriers still enjoy a privileged position. Compared to newcomers, they are believed to be higher quality by their home crowd, and have substantial advantages in their home airports.

In an analysis of 18 major European routes, Marin finds the flag carriers have higher variable profits than newcomers on any given route. As a result, even when new firms do manage to get going, they are less likely to survive.

The fact is that it is no good opening the skies if the planes have nowhere to land. Companies need slots at airports, and times when they can take off, land and park their planes. Peak slots are extremely lucrative and highly sought after. In several European airports, it is difficult to get any slots at all. Heathrow and Frankfurt in particular are hard to get into.

Of course, new slots do emerge, and can be deliberately directed towards new entrants. But it is a long, slow cumbersome process to build up money- making slots. So there is no doubt that substantial barriers to entry exist, reducing competition, and giving incumbents an advantage.

So, on balance, we have no reason to believe the BA/AA alliance coupled with open skies will significantly improve competition for UK passengers, and we have every reason to believe it will reduce it.

BA still has one further retort. BA's chief economist, DeAnne Julius, argues that "it is extremely difficult to say that a large market share creates any market power." Because flight prices are quickly and easily compared, and because many passengers are price sensitive, she argues that it will still be difficult for BA/AA to raise prices above the market level, even with a 60 per cent market share.

Possibly so. However, the Civil Aviation Authority, which regulates BA fares, would have to work a lot harder to make sure the two companies were playing fair. A better alternative might be to force the alliance to give up some of their Heathrow slots to new entrants instead. Similarly, Lufthansa should have been forced to give up some of the 59 per cent of slots it has at Frankfurt airport when it made the United deal.

Air travel is not a perfect market and it never will be. The historical structure of the industry matters immensely, but so do its complicated inter-woven international markets. So long as slots are limited, and barriers to entry exist, there will always be a role for regulators and authorities to protect the public interest.

What the BA/AA proposed alliance reveals is that while individual countries need to consider their own consumers, international organisations, including the EU, need to look at the international structure of the industry - from slots to regulations - as well.