Airline alliances: current status, policy issues, and future directions

_lournul r$Air T~m.vp~,or~~u~u~~?J~~nt, Vol. 3, No. 3, pp. 1X--144, 1991

Q 1997 Elsevier Science Ltd All rights Reserved Printed in Great Britain 0949-6997/97 $17.00 + Cl.00

Pergamon P~l:S~69-6~7(~~21-5

Airline alliances: current status, policy issues, and future directions Tae Hoon Oum* and Jong-Hun Park? *VanDusen Foundation Professor of ~anage~~e~lt. Div. of Transpo~tatio~l

and Logistics, Faculty of Commerce and Business Administrat~a~, The University of British Columbia, 20.53 Main Mall. Vamouver BC, V6T 122. Canada tdssistant Professor, Department of Economics and Finance, School of Business, City University of Hong Kong, Tat Chee Avenue, Kowloon. Hong Kong

This paper describes the current status of and the government policy towards airline alliances, discusses the effects of intercontinental alliances, and makes some predictions on the future direction of alliance network formation. It also presents the areas of collaboration and joint activities between alliance partners based on a survey of forty-six alliances among the world’s top-30 airlines. We conclude that alliances among airlines are not a passing phenomenon but rather a permanent fixture of the industry because they not only create values to customers, but also enhance profit op~rtuniti~ for the partners. Therefore, strategic alliances among major carriers are likely to be strengthened in the future. In addition, the cost of ending a strategic alliance relationship increases as the partners work closely by investing time, energy and resources to enhance mutual benefits. Also, the opportunity cost of finding another partner will increase rapidly as many airlines find durable alliance partners. These factors will provide an increased stability in alliance structures. Airlines have learned to fine-tune alliance relationships to make the gain-sharing more equitable. Governments began to scrutinize alliances with one-sided gain-sharing. Alliances involving unidirectional equity investment tend to be structured in such a way that the investing carrier gets a major share of gains from the alliance. Because of this and the inherent risks involved in investment, equity alliances tend to be unstable. Therefore, in the future there will be less alliances with equity investment. Already, there has been a decline in the growth rate of equity alliances. The balanced gain-sharing could form a basis upon which to create global alliance groups. Each global alliance group is likely to consist of two-tier systems. Different continental markets are linked ~sentially via suer-hubs of anchor carriers (senior partners in the alliance group), one in each continent to form the first-tier of the global alliance group. Several junior carriers in each continent may form the continental network along with the anchor carrier, and route an increasing portion of their traffic through super-hubs of the alliance group. Gain-sharing between anchor and junior carriers could be structured so that junior carriers find incentives to route an increasing portion of its intercontinental traffic via the anchor carrier’s hubs. Since alliances are a positive sum arrangement, and the gains from alliance can be shared equitably among alliance partners as well as between consumers and airlines, it is a matter of time when competing global alliance networks will emerge. Given that there are a limited number of major carriers in each continent that has a good coverage of the continent and thus could become an anchor carrier, a limited number of major global alliance networks (say, five or so) will likely be formed in the near future. These limited number of global alliance groups will be competing for the majority of the world’s air transport traffic. The carriers that are left out of this system may find it necessary to become niche carriers. 0 1997 Elsevier Science Ltd. All rights reserved Fax: 001 604 822 8521. E-mail: [email protected]

Background

and introduction

Significant structural and regulatory changes have occurred in the world’s air transport industry since the mid 1980s. Following the US deregulation of its airline

markets, many other countries such as Canada, UK, Australia, New Zealand, Chile, etc. have deregulated their domestic airline markets. Privatization of some major international airlines also began after the mid

133

Airline alliances: Tae Hoon Uum and Jong-Hun Park

1980s. The intra-EU airline markets are completely deregulated since April 1, 1997, after the three packages of liberalization measures were introduced in 1987, 1990 and 1993. The US and Canada signed their historical ‘open skies’ agreement in February, 1995. The US initiatives for open skies agreements with many European countries have been successfully concluded in the mid 1990s. Since 1996, the US Department of Transportation has shifted their focus to Asia. It has already signed open skies agreements with Singapore, Brunei, Taiwan and Malaysia, and is currently working on Korea and other countries. For a variety of reasons, most travellers prefer to fly with an airline serving a large number of cities.’ Primarily, this consumer preference has provided incentives for airlines to establish extensive domestic, continental and international service networks. The regulatory policy changes stated above have made it possible for airlines to set up efficient domestic and continental networks. For example, the deregulation of the US domestic market have led to consolidation of US airlines into six or seven major carriers, each of which set up efficient hub-andspoke systems. So far, major carriers in Europe have varying success in their race to secure efficient and comprehensive continental service networks. In their attempt to secure North American coverage, United Airlines aligned with Air Canada and American Airlines made an equity investment alliance with Canadian (Oum and Taylor, 1995). In the intercontinental front, until recently some mega carriers such as American Airlines have tried to create global airline networks by adding foreign spokes to their domestic hub cities. However, they found that it is almost impossible for a single airline to create a truly global service network on their own. A non-resident carrier is far more constrained in setting up an efficient service network in a foreign continent than a resident carrier. Even in the absence of such a legal barrier, it is not practical for an airline to try to set up a global service network on their own because of the sheer size of financial resources2 and the amount of time required. Also, there are legal constraints on mergers and acquisitions involving airlines of different nations. Virtually all countries have foreign ownership restrictions of airlines. For example, foreign carriers may not own more than 25% of voting shares of any airlines in the US, Canada, and Australia. The bilateral air services agreements typi-

‘Reasons for this preference are: (i) consumers can minimize their time cost of travel planninn since an airline with an extensive network serve virtually all d&tin&ns; and (ii) large carriers tend to offer a higher quality of service such as increased online connections and more attractive frequent flyer program (see Tretheway and Oum, 1992, pp. 17-18). *Oum el al. (1993) predict that a successful global network will likely generate more than $30 billion in revenue. Creating a single organization for an agency of this size would require financial resources beyond the reach of even the largest existing carrier. Mega-carriersin North America (American, United, and Delta), Europe(British Airways. and Lufthansa), and Asia (Japan Airlines) had an annual revenue ranging between $g billion and %I 5 billion in t 993.

134

tally limits the number of carriers designated to serve a country-pair or city-pair market. For example, the current agreement between the US and UK allows only two US airlines (American and United) to serve London Heathrow airport, a key gateway between the US and both Europe and the Middle East. In this situation, not all of the major US carriers can establish services in that market. In order to set up a ‘seamless’ global service network, therefore, most airlines attempt to form strategic alliances with the airlines residing in foreign countries or continents. As of June 1996, more than 380 alliances have been formed between 17 1 international airlines (Airline Business, June 1996). Every year, a large number of new alliance agreements are signed. As discussed later in this paper, the US and other governments began to pay attention to both competition and gain-sharing aspects of the alliances. Therefore, it is crucial for major carriers to employ proper alliance strategies. It is also important for regulatory agencies to devise proper policy support for their carriers in order to secure long term benefits to their carriers and consumers. The purposes of this paper are as follows. First, it describes the current status of and government policies towards airline alliances. Second, it examines the major areas of joint activities and coordination between alliance partners, and the reasons for alliance formation. In particular, we present survey results of the forty-six alliances formed among the world’s top-30 airlines. Third, it describes major findings of several studies which attempted to measure the effects of alliances on traffic volume, market prices and consumer benefits. Finally, an attempt is made to predict future directions of global alliance network formation. Section 2 reviews the US and European governments’ policy towards airiine alliances. Section 3 summarizes the current status of alliances, and analyzes the areas of joint activities and collaboration between partners. Section 4 examines economic and strategic reasons why airlines have been eagerly participating in the alliance race. Section 5 explains the key findings of recent studies which attempted to measure the effects of alliances. Finally in section 6, our predictions on future directions of alliance network formation are given.

government

policies toward airline alliances

In this section we review briefly the history of airline alliantes and the policies governing them. United States

The first international alliance was formed in 1986 between Air Florida and British Island. Air Florida fed US originating traffic to British Island’s codeshare flights on the London-Amsterdam route. At that time, the US Department of Transportation (US DOT) did not require any

Airline alliances: Tae Hoon Own and Jong-Hun Park

formal approval for international codesharing alliances,3 as long as both US and foreign carriers had underlying route authority to the cities involved (Hadrovic, 1990). The US DOT changed its earlier position in December 1987 when United Airlines (UA) and British Airways (BA) proposed codesharing on the UA’sChicago-Seattle flights as an extension of BA’sLondon-Chicago service. BA already had route authority on the London-Chicago-Seattle route, but the US DOT advised the airlines that it would need authorization for the proposed codesharing alliance. UA responded by filing for an exemption, claiming that the codesharing alliance was consistent with the public interest. In March 1988, the US DOT granted the exemption, recognizing that its regulations had been unclear and that the codesharing alliance was in the public interest. At the same time, the US DOTclarified its position on international alliances, declaring that an international alliance would not be approved under the US DOT policy unless it was covered in a bilateral agreement or otherwise brought benefits to the US and unless the foreign country also allows US carriers’codesharing rights in its markets (Gellman Research Associates (GRA), 1994, p. 29). Recently, permission of international codesharing alliances was used to change some aspects of existing bilateral agreements. For example, the current US-UK bilateral agreement permits only two carriers from each country to operate to/from London Heathrow airport. Initially, TWA and Pan Am had that authority. When American and United purchased TWA and Pan Am’s rights to serve Heathrow airport, the UK government and BA were reluctant to agree with this plan because the new carriers are much stronger competitors than TWA and Pan Am. In exchange for agreeing to amend the bilateral agreement so that American and United could obtain the rights, the UK insisted on codesharing authority in US domestic markets for BA and other British carriers. Consequently, the BAfUSAir partnership was formed in 1993, allowing BA to be able to connect London to the USAir’s domestic network. Initially the US hoped to arrange an open skies agreement with the entire European Union. After failing its initial attempts, however, it changed its approach to negotiate for open skies agreements with individual countries.4 To help achieve this goal, the US DOT have used the granting of immunity from antitrust investigation

‘A codesharing agreement is a marketing agreement between two airline partners whereby one airline’s designator code is shown on flights operated by its partner airline. Codesharing agreements allows each airline involved to provide services with its partner’s Rights, even though it does not operate its aircraft. For example, Canadian Airlines and Qantas have a codesharing agreement on Vancouver-Honolulu-Sydney route where Canadian serves the Vancouver-Honolulu section and Qantas serves Honolulu-Sydney section of the route. 41t has had only limited success, as only some of the relevant countries have agreed to have open skies with the US. These countries are Austria, Belgium, Canada, Denmark, Finland, Germany, Iceland, Luxembourg, the Netherlands, Norway, and Switzerland. Signing with these countries, the US hoped that the increased competition and services would force other surrounding countries to follow suit. The US will continue its efforts as there are some countries that are willing to open up more capacity to US carriers in exchange for increased access to US markets.

(henceforth referred to as antitrust immunity)5 to some international alliances involving US carriers. For exampie, Northwest and KLM were granted antitrust immunity by the US DOT in November 1992, shortly after the US and Netherlands signed an open skies agreement in September 1992. Another example is the granting of antitrust immunity to Lufthansa and United in May 1996 in exchange for the open skies agreement between the US and Germany in February 1996. Also, the US DOT believes that granting antitrust immunity would permit alliance partners to operate more efficiently, provide better services to the US travelling and shipping public, and allow US carriers to compete more effectively. European

Union

Until the mid I98Os,bilateral agreements between individual countries in the European Union (EU) had governed international aviation within the Union as well as outside the Union. Starting in 1987 there has been a gradual liberalization of the EU air transport. Since January 1993, the EU carriers are allowed to fly freely on any transborder routes between any EU countries without restriction. EventuaIly in April 1997, the EU became a single aviation market for the carriers based in any EU country. Foreign ownership regulations of airlines have also been relaxed. This led to a considerable increase in alliances involving equity investment within the Union.6 Unlike the US, the EU does not require approval proceedings for international codesharing and/or block space sales agreements within the Union, but rather examines their impacts on competition, Their carriers are generally free to enter into such agreements anywhere within the Union unless it results in a monopoly (McNeill, 1993). To date EU carriers can also codeshare on intercontinental routes to destinations where both EU and non-EU carriers have route authorities. The European Commission has yet to decide whether to regulate international alliances in the future (Australian Bureau of Transport and Communications Economics (BTCE, 1996, p. 28). However, individual EU states have different perspectives with respect to codesharing operations. For example, the UK and Netherlands have never objected to codesharing agreements as they regard codesharing operation as a private marketing right rather than a traffic right (Feldman, 1988). In contrast, Italy prohibits codesharing operations on fifth freedom routes unless a bilateral agreement

‘The US antitrust hews are designed to protect consumers by prohibiting competitors from colluding and engaging in anticompetitive behaviour such as jointly setting prices. Thus, the antitrust laws limit the level of integration that competing airlines can achieve. However, the Secretary of Transportation has the authority to grant antitrust immunity to agreements in foreign air transportation if the agreements would not result in a substantial lessening of competition and achieve important public benefits. Regarding antitrust immunity, the US DOT has the sole right to decide whether or not to approve the immunity requests by carriers, and the US Department of Justice only has the authority to screen the applications by the alliance partners based on their impact on competition. “For further discussion, see, for example, Button (1996).

135

Airline alliances: Tae Hoon Own and Jong-Hun Park

Table 1

Current status of alliances

Number of alliances Number of airlines With equity stakes Without equity Percentage of equity alliances (%) New alliances

‘96

‘95

‘94

Average annual growth rate (a)

389 171 62 327 15.9 71

324 153 58 266 17.7 50

280 136 58 222 20.7 n/a

17.9% 12.1% 3.4% 21.4%

Source: Compiled from Airline Business (1994-96). Notes: (a) The average annual growth rate is calculated (b) n/a stands for ‘not avaiIabbft?.

n/a

(b)

between 1994 and 1996

provides for change of gauge rights. In the future, EU states will be forced to become supportive of international alliances as their own carriers realize that they need better access to points beyond international gateways in the US and other countries (BTCE, 1996, p. 29). Since the EU has some concerns about anticompetitive aspect of codesharing agreements, the EU has adopted more cautious rules on computer reservation system (CRS) display than the US. The EU limits a codeshared flight to be displayed on CRS screen only twice, i.e., once under each partner’s designator code. The EU also requires alliance partners to clearly disclose the identity of an operating partner (US General Accounting Office (US GAO), 1995, p. 59).7

recipient of investment) gets improved and thus, no longer needs financial assistance. Table 2 shows equity investment alliances among North American, European, and Asian carriers. European carriers tend to have more equity investment alliances than North American or Asian carriers. Table 3 lists the number of alliances each of the world’s top-30 airlines had in 1994, 1995 and 1996. As of July 1996, Air France had the largest number of alliances (31 alliances). I3 of these involved equity investments by Air France. Lufthansa formed 26 alliances, and invested in four of these alliance partners. Malaysian Airlines and KLM joined the alliance race by signing 19 and 18 alliance agreements, respectively. On average, a carrier had 12 alliances in 1996.

Current status of alliances and areas of collaboration

Types of alliances and areas of joint or coordinated activities

In this section, the current status of airline alliances are described, and the major areas of coordinated or joint activities are summarized based on a survey of 46 airline alliances among major carriers.

Tretheway and Oum (I 992) classified airline alliances into three categories: Type I (simple route-by-route alliance); Type II (broad commercial alliance); and Type III (equity alliance). Types II and III can be considered ‘strategic alliances’ as these alliances require corporate-wide and strategic commitment to each other. Table 4 classifies each of the forty-six alliances formed among the top-30 carriers into the three categories.8 There are 28 Type I, 9 Type II, and 9 Type III alliances, indicating that the majority of alliances formed between major carriers are of Type I (simple route-by-route alliance for coordination of activities involving only a few routes). We conducted a survey of these 46 alliances in order to find the areas of collaboration (joint activities and coordination). Since not all airlines returned our questionnaires, our survey results were supplemented by information compiled from the annual reports of the airlines, relevant articles in the airline industry magazines (Airline Marketing News, Asian Aviation News, Aviation Europe, Flight

Current status of alliances Table 1 provides an overview of the current status of alliances. The total number of alliances as of 1996 was 389, an increase of more than of 39% over 1994. During the last few years, airline alliances have extended from Asia/ Pacific, European and North American regions to new regions such as Latin American, the Caribbean and African regions (ICAO Journal, 1994). The percentage of equity alliances has decreased in 1996 by about 5% from 20.7% in 1994. One-way investment alliances tend to become unstable mainly because expectations of the two partners and the financial situations which led to the alliance change over time. An investor airline tries to exercise some control over its partner’s decision making for various reasons. The relationship sours especially when financial situation of the partner (the

‘Although the US DOT proposed regulations in August I994 aimed at ensuring that consumers are notified of which airline is the actual operator before taking a codeshare flight, neither the US DOT’s regulations nor its proposed rules limit the number of times a codeshare tlight may be listed on CRS screen (US GAO, 1995, p. 58).

136

‘US GAO investigated 61 alliances between US and foreign carriers, as of December 1994. Based on the geographic scope of codesharing routes, US GAO categorized these 6 I alliances into three groups: major strategic alliances (3 cases), regional alliances (8 cases), and point-specific alliances (50 cases), It is possible, however, for some alliance partners to have a somewhat stronger relationship even with a smaller number of alliance routes. Thus, it may be better to use a different criterion: the extent of coordination.

Airline alliances: Tae Hoon Oum and Jong-Hun Park

Table 2

Equity

Investor

airlines

investment alliances

(as of July 1996)

(a)

Air Canada Air France Air France Air India Air New Zealand Alitalia All Nippon Airways American Airlines British Airways British Airways British Airways British Airways British Airways Delta Air Delta Air Iberia Iberia Iberia Japan Airlines KLM KLM KLM Lufthansa Malaysia Airlines Qantas SAS Singapore Singapore Swissair Swissair Swissair Swissair

Target airlines

Equity

Continental Airlines Austrian Airlines Middle East Airlines Air Mauritius Air Pacific Malev Airlines Austrian Airlines Canadian Airlines Air Mauritius Deutsche BA Qantas Airways TAT European Airlines USAir Singapore Airlines Swissair Aerolineas Argentinas Ladeco Chilean Viasa Venezuelan Hawaiian Airlines Air UK Kenya Airways Northwest Airlines Lauda Air World Airways Air New Zealand British Midland Delta Air Swissair Austrian Airlines Delta Air Sabena Singapore Airlines

27.5(b) I.5 28.5 8.5 2.0 30.0 9.0 33.3 12.8 49.0 25.0 49.9(c) 24.6 5.0 4.5 5.0 25.0 45.0 8.5 45.0 26.0 49.0 39.7 25.0 19.4 40.0 5.0 2.7 10.0 5.0 49.5 0.6

holdings

Sources: Compiled from Airline Business (1995-96), and Flight International ( 1996). Notes: (a) Investor airlines in North American, European, Asian continents only. (b) Air Canada sold a portion of its shares in Continental in May 1996 and has a plan to sell the remainder by early 1997. subject to its shareholder approval. (c) BA has an option to buy the rest of TAT by April 1997.

International, Air Transport World, etc.), the 1994-96 alliance survey information reported in Airline Business, and the codesharing alliance study by the GRA (1994) for the US DOT and the report published by the US GAO (I 995). Below, a brief summary of our findings are summarized. Details are available in Park (1997, especially Appendix A). Our survey identified the following areas as joint or coordinated activities?

(1) coordination in ground handling; (2) joint use of ground facilities; (3) shared membership for frequent flyer program (FFP); or joint operation; (4) codesharing block space sales (passenger and/or cargo); (5) coordination of flight schedules; (6) exchange of flight attendants; (7) of systems or systems software; (8) joint development (9) joint advertising and promotion; (IO)joint maintenance; and

‘The areas of joint activities are listed in an ascending order of commitment to the alliance required. In general, relationship between alliance partners gets stronger as the areas of coordination are extended to higher levels of joint activities.

(1l)joint purchase aircraft).

of fuel, other

supplies

(and possibly

Table 5 shows, for each type of alliances, the frequency distribution of joint activities being undertaken between partners. The simple route-by-route alliances (Type I) are the simplest form of alliances and involve a lower level of commitment such as codesharing or shared (joint) operations involving a few routes only. At times, Type I alliances involve joint use of airport ground facilities such as gates and lounges, coordination of ground handling, block space sales, and shared frequent flyer programs. One example of Type I alliance is the KLM-Japan Airline (JL) alliance signed in January 1993. They have a codesharing agreement on Tokyo-Amsterdam-Madrid and Tokyo-Amsterdam-Zurich routes where JL operates the Tokyo-Amsterdam segment while KLM operates intra-European segments of these routes. As a result of the agreement, JL could replace its non-stop flights on Tokyo-Madrid and Tokyo-Zurich by these codeshared flights and thereby, increased its flight frequency on the Tokyo-Amsterdam route. The broad commercial alliance (Type 11) is a more advanced form of alliance than the simple route-by-route alliance. A Type II alliance involves linking the two partners’ networks to a substantial degree and feeding traftic to

137

Airline alliances: Tae Hoon Own and Jong-Hun Park Table 3

The world’s top-30 airlines’ alliance race ‘%

‘95

Air France

31(13)

34( 13)

Lufthansa Malaysia Airlines KLM Singapore Airlines Air New Zealand

26 19 18 17

(4) (1) (4) (3)

25 (3) 19 (I) 14 (3) g (3) g (2) 9 (4) 13 (2) 14 (0) 10 (3) g (5) 14 (0) 9 (1) g (1) g (2) 9 (2) 7 (1) 12 (0) 5 (2) g (1) 6 (I) 7 (3) 7 (0) 6 (0) 2 (1) 5 (0) 7 (1) 5 (2) 5 (0) 4 (0) 296(57)

Swissair Delta Airlines Korean Air Japan Airlines British Airways United Airlines Air Canada American Airlines Cathay Pacific SAS Alitalia Varig Continental Canadian Airlines Northwest Airlines Qantas Snudia Philippine Air Sabena Virgin Atlantic USAir All Nippon Air Thai Air Aeroflot TOTAL

17 (2) 16 (4) 15 (2) 15 (0) 14 (3) 13 (5) (0) (2) (1) (2) 11 (0) 10 (1) 10 (0) 9 (2) 9 (I) 9 (1) g (3) g (0) 7 (1) 6 (1) 6 (0) 5 (3) 5 (2) 4 (0) 4 (0) 360(60) 13 12 12 11

‘94 25(12) 25 17 10 5 7 9 14 12 9 11 12 9 6 10 9 9 11 6 5 4 7

(5) (I) (4) (3) (2) (4) (4) (0) (3) (5) (0) (1) (1) (1) (2) (I) (0) (1) (1) (1) (3)

1 (0) 6 (0) 3 (1) 3 (0) 5 (0) 4 (2) 3 (0) 4 (0) 261(55)

Source: Compiled from Airline Business (199496). Note: The numbers in parentheses are equity alliances

each other’s hub airports. As shown in Table 5, it is a norm that Type II alliance partners cooperate via the following activities: coordination of flight schedule and ground handling, joint use of ground facilities, shared frequent flyer programs, codesharing, block seat sale, and joint advertising and promotion. Air Canada-Lufthansa, Air Canada-United, Continental-Alitalia, Lufthansa-United, Lufthansa-Thai, SAS-Lufthansa, United-Air Canada, Delta-Sabena, and Delta-Virgin Atlantic10 are Type II alliances. Type III (equity alliance) is perhaps the most advanced form of alliances. As shown in Table 5, the partners cooperate in almost all areas of joint activities including such as exchange of flight crews, joint development of systems and system software, joint advertising and promotion, joint purchase fuel, other supplies and possibly aircraft. These latter activities take high level commitments and high degree of coordination. The degree of integration can be made much stronger by joint development of operations planning systems, pricing and yield management

“‘Delta (DL) and Virgin Atlantic (VS) signed a broad commercial agreement in April 1994. DL has gained access to London Heathrow airport by buying IO-15’%1 of all seats on VS flights between London and various US cities on which both partners codeshare. Since this agreement also includes a FFP partnership, passengers using VS can accumulate air miles to any of the worldwide destinations being served by DL.

138

systems, and information technology systems.” Some partners jointly promote and advertise. For example, KLM and Northwest share a ‘Worldwide Reliability’logo on the fuselages of their planes, tickets, advertising materials and in-flight service amenities. Some partners further integrate their operations in maintenance, purchasing and inventory management (e.g., BA-Qantas, Delta-Singapore, American-Canadian, and KLM-Northwest alliances). Type III can be further divided into two cases: unidirectional investment case vs. bi-directional investment case. ‘2 American-Canadian, Air Canada-Continental, BA-USAir, BA-Qantas, Qantas-Air New Zealand, and KLM-Northwest alliances are the unidirectional investment cases while Delta-Singapore-Swissair alliances are based on exchange of equity shares (bidirectional investment). Alliances based on unidirectional investment tend to be somewhat fragile because usually the investor airline attempts to exercise control over the carrier in which it

“For example, American airlines conduct these management activities for Canadian airlines on a fee basis. “Over time, alliance partners’ interests change and conflict could arise. In this situation, alliances without an ownership involvement could break up. For example, United-BA and Lufthansa-American partnerships broke up in the early 1990s when the US partners in both alliances expanded their own operations in the tram-Atlantic markets (Lobbenberg, 1994).

X

V

X

V

[Notes] v: simple route-by-route

SR TG TW UA us vs

SQ

& RG SK SN

V

v

X

-

AZ

0

-

BA

-

x

0

CO

CP

V

-

V

0

-

CX

V

DL

-

V

V

JL

alliance; x: broad commercial

V

V

V

V

V

V

KE

0

-

V

KL

X

X

X

”

X

LH

alliance; o: equity investment alliance

X

0

0

X

V

V

V

AF

V

Y

0

-

AC

LH MH NA NW NZ

0

-

AA

Alliances between top-30 airlines

JL KE KL

AA AC AF AZ BA co CP cx DL

Table 4

V

V

MH

V

V

V

NA

NW

NZ

PA

V

0

V

0

V

QF

V

V

V

RG

-

X

X

SK

-

X

V

SN

0

-

0

-

SQ

_ --

-

0

0

V

SR

V

TG

TW

-

V

X

X

UA

-

V

0

US

-

X

VS

Airline alliances: Tae Hoon Own and Jong-Hun Park

Table 5

Degree of coordination for each type of alliance

Joint Activities

Type 1 (a)

5Pe

2

Coordination in ground handing

( ,8%;(b) Joint use of ground facilities Shared Frequent Flyer Program Codesharing or Joint Operation

13 (46%) 9 (32%) 2s (89%)

Block Space Sales (36;;

Exchange of Flight Attendants

4 (14%) I

Joint Development of Systems

(4%) I

Coordination of Flight Schedules

Joint Advertising and Promotion Joint Maintenance Joint Purchase of Aircraft/Fuel TOTAL

(4%) 0 (33%) 0 (II%) 0 (44%) 28

(78%; 9 (100%) 9 (100%) (loo%; 4 (44%) (loo%;

5Pe

3

9 (100%) 9 (100%) 6 (67%) 9 (100%) 3 (33%) 9 (100%)

2 (22%) 2 (22%) 3

(56%; 3 (33%) 4

(44%) 0

I

0

4

9

9

Sources: Compiled from Annual Reports of the airlines, Airline Business 199696, Airline Marketing News, Asian Aviation News, Aviation Europe, Flight International, GRA Inc. (I 994). US General Accounting Office (199s). and a Alliance Survey Conducted by Korean Air. Notes: (a) Type I: Simple route-by-route alliances (28 cases), Type 2: Broad commercial alliances (9 cases). Type 3: Equity alliances (9 cases). (b) The numbers in the parenthesis are the percentage of the joint activity within the type of alliance.

invested money. When the financial condition of the partner who received investment improves, there is a good chance that interests of the two partners may collide with each other. As a result, either the relationship gets strained or the alliance could come to an end.‘3 The Northwest-KLM alliance is such an example. KLM invested in Northwest when the latter had financial difficulty during the recent recession. For a while the two partners worked very well together. However, conflicts started to surface as Northwest became profitable. On the other hand, bidirectional investment cases tend to be durable and long-lasting because neither partner attempts to control the other. The drawback is that when investment levels are small such as the case of Delta, Swissair and Singapore airlines, their commitment to the alliance tends to be weak.

Reasons for alliance formation In this section, formation. Expansion

we discuss briefly the reasons

for alliance

of seamless service network

There are demand factors which cause consumers to prefer airlines serving a large number of cities. In order to attract more passengers in a more competitive environment, an

“American Airlines (AA) and Canadian Airline International (CP) signed their partnership agreement in April 1994. AA invested $190 million in CP for 25X of CP’s voting shares and 8.33X worth of its convertible preferred shares. This alliance was risky to AA. However. once CP improves its profitability it appears that this alliance may last for a long time because AA appears to have a de facto control of Canadian.

140

airline needs to offer services to a wider range of destinations in the world. As alliance partners link up their networks and provide ‘seamless’ services, they will be able to expand their service network beyond their respective territories. For example, the Lufthansa-United alliance allowed the partners to link up European and US networks.14 In 1997, Lufthansa, United, Air Canada, SAS and Thai Airways together announced their so-called a ‘Star Alliance’ plan in order to provide seamless services to about 400 cities throughout the world. In addition, through alliances, the partners can get access to attractive airports and provide services on small and thin markets where a major carrier can not operate its own services profitably. For example, Qantas formed a codesharing alliance with Air Vanuatu on the Australia-Vanuatu route as load factors would not be viable if it introduced its own aircraft into the route (BTCE, 1996, p. 12). Traffic feed between partners

The successful linkage of alliance partners’ networks would allow the partners to feed traffic to each other, and thus increase load factor on their flights. In addition, each partner may be able to increase flight frequency it can offer to their customers without actually increasing its own flight frequency. For example, LH and UA each provided 3 1 non-stop flights on the Washington, DC-Frankfurt route before and after their alliances. However, after the alliance, each partner was able to offer 62 non-stop codeshared flights to its customers.

14As of December 1994, LH codeshared on UA Hights serving 25 US cities beyond UA hubs, while UA codeshared on LH flights serving 30 European and the Middle Eastern cities beyond LH hub.

Airline alliances: Tae Hoon Own and Jong-Hun Park Cost efficiency

Alliance can reduce unit costs by allowing the partners to take advantage of economies of scale, increased traffic density and economies of scope. Economies of scale can be achieved if an alliance partner is able to serve the same amount of traffic at a lower cost, with its network size held constant. Joint use of airport facilities, joint advertising and promotion, joint purchase of fuel and other items, joint development of systems and software and joint handling of baggage transfer, etc. will result in economies of scale. Network expansion and mutual traffic feeding allow alliance partners to achieve higher trafftc density. This will allow partners to operate higher frequency and/or to use larger aircraft, which in turn, reduce unit cost. Economies of scope can be achieved if alliance partners link up their existing networks so that they can provide connecting services for new markets. Improved service quality

Frequency, schedule convenience and convenience of on-line connections are major dimensions of an airline’s service quality. ‘5 A properly executed alliance will surely improve service quality by increasing flight frequencies available to customers, by offering more convenient flight schedules, and by increasing the proportion of on-line connections. The partners also coordinate flight schedules to minimize waiting time for connecting passengers, and ease inconvenience associated with making connections by locating arrival and departure gates for most passengers close by each other. Increased

itinerary choices for passengers

An alliance carrier can offer a far more variety of itinerary and routing choices to its passengers than non-aligned carriers of similar size. For example, consider a passenger who wants to fly from Vancouver, Canada, to Lyon, France on the ‘Star’ alliance network. She can fly VancouverFrankfurt-Lyon on LH flights. She can also fly VancouverLondon-Frankfurt-Lyon on AC/LH flights. Alternatively, she can fly Vancouver-Chicago-Frankfurt-Lyon on UA/LH flights. Without alliances, she would have to use interline flights on several different carriers, which are less convenient services. Advantages

CRS screens. Third, a code-share flight with one connection gets listed three times in CRS screens. For example, the US GAO (1995, p. 5) found that a Lufhansa flight from Berlin to Frankfurt that connects with a United flight from Frankfurt to Chicago listed as (1) Lufthansa throughout, (2) United throughout, and (3) Lufthansa to Frankfurt and United to Chicago. These multiple listings of a same flight and priority displays push other airlines’ flights further down the screen or onto the next screen. Therefore, alliance partners bound to reap a substantial benefits from this CRS display advantage because travel agents tend to book flights that are listed on the CRS’s first screen as often as 90% of the time (US GAO, 1995, p. 6).16

Measured effects of airline alliances Probably because of the difficulty in obtaining consistent route specific data and the difficulty of separating effects of alliances from other changes, we are aware of only four empirical studies which attempted to measure the effects of airline alliances on carriers and consumers. Below, the key results of these empirical studies are summarized. GRA study on North Atlantic codesharing

The GRA (I 994) prepared a report ‘A Study of International Airline Codesharing’ for the Office of Secretary of Transportation of the US DOT. The purpose of the study was to investigate the effects of BA-USAir and NorthwestKLM codesharing alliances on consumers and on airlines. They conducted a counterfactual scenario analysis based on a market share model estimated using data for the first quarter of 1994. The study attempted not only to quantify the aggregate effects on consumers and producers, but also to identify the effects on the US carriers and consumers separately from the effects on foreign carriers and foreign consumers. Although there are several serious data problems, they reported the following key findings: The findings l

of CRS display

Codeshared flights get several advantages in CRS display over other flights. First, a codeshared non-stop flight is listed twice in CRS screens because both partners list the same flight as their own flights. Second, codeshared connetting flights get listed ahead of interline flights on the

“Previous researches have found that a passenger’s schedule delay time, defined as the difference between the passenger’s desired departure and actual departure time, is one of the most important aspects of service quality (Morrison and Winston, 1986). Park and Zhang( 1997) compared pre- and post-alliance schedule delay times on the trans-Atlantic routes for the 1990-94 period, and found that scheduledelay times were reduced by l2-25%. depending on the route, after an alliance.

alliances

l

on the BA- USAir alliance.

British Airways gained an additional profit of $27.2 million while the USAir gained only $5.6 million during the first quarter of 1994. On the other hand, other US carriers’ profit was reduced by $21 .I million by losing traffic to the BA-USAir combination. As a result, US carriers as a whole lost $21.1 million due to the alliance. Therefore, social surplus for the US decreases by $16.2 million while social surplus for the foreign countries

“US travel agents, who book approximately 80% of all flights in the US, generally use one of four CRSs: (i) Sabre (26% market share), which is owned by American Airlines’ parent corporation; (ii) Appollo (30% market share), which is owned by a partnership consisting of United, USAir, BA, KLM, and other foreign airlines; (iii) Worldspan (15% market share), which is owned by Delta, Northwest, TWA, and some Asian airlines; and (iv) System One (9% market share), which is owned by an affiliate of Continental.

141

Airline alliances: Tae Hoon Oam and fond-Ham Park

(mainly the UK) increases by $3 1.8 million. This result means that the US as a nation loses out due to the BA-USAir alliance. The findings on the N W-KLM

alliance.

Due to the NW-KLM alliance, Northwest gained additional profit of $16.1 million while the additional profit for KLM was $10.6 million. Taking into account of the losses inflicted on other carriers, US carriers as a whole gained only $0.4 million additional profit while the foreign carriers as a whole gained only $2.0 million additional profit. However, due to the NW-KLM alliance consumers gained in major ways. US consumers gained $13 million while foreign consumers gained $14.1 million. As a whole (both carriers and consumers) the US gained $13.4million of social surplus while the foreign countries gained $16.1 million of social surplus as a result of the N W-KLM alliance. US GAO (1995) study The US GAO conducted a study on the effects of airline alliances. Their study was based mainly on interviews with US and foreign airline representatives and US DOT officials involved in alliances although they conducted analysis of some data. Their principal findings on the effects of alliances can be summarized as follows: Northwest and KLM were able to increase their annual traffic by about 350 000 passengers as a result of their alliance, and thus, increased their combined transatlantic market share from 7% in 1991 to 11.5% in 1994. Although the traffic gains achieved by airlines through alliances have come largely at the expense of other US and foreign airlines, at least some of the gains have come from new traffic stimulated by increased competition among alliances and between alliances and other airlines. Strategic alliances produce large revenue gains for partners. For example, alliance with KLM produced an additional revenue of $125-$175 million to Northwest in 1994. BA gained revenues primarily at the expense of US airlines because of its arrangement with USAir allows only for it to codeshare on USAir domestic fhghts and keep most of the revenue. Although alliances produce benefits to consumers by improving quality of airline services by increasing flight frequency, coordinating flight schedules closely, and reducing layover times between connections, the US GAO concluded that insufficient data exist to determine the effect of alliances on fares. As such, the US GAO made a series of recommendations to the US DOT for improved data collection involving codeshared flights and passengers. Own

et al. (1996)

on Transpac~~c

alliance

stud}?

Oum et al. (1996) estimated an econometric model on panel data for 57 transpacific air routes over the 1982-92 142

period in order to quantify the effects of codesharing alliance between non-leader carriers on the leader carrier’s behaviour and market outcome. The major finding of the study is that the codeshared service offering by two non-leader carriers makes market leader behave more competitively. As a result, the market price of transpacific travel falls by $84 per person, and as a result, surprisingly, traffic carried by the market leader increases by about 10 000 passengers per year on an average route where codeshared partners enter in order to provide competitive services. Park study (1997) on transatlantic ailiance Park (1997) conducted an extensive investigation of the major airline alliances existing in the transatlantic market. He estimated a number of econometric models on yearly panel data of North Atlantic routes for the 1990-94period. The key findings are as follows: Complementary alliances (BAIUSAir, KLMINW, and LHIUA) have i~ere~sed ~~er~l~ dern~~d on the pierce routes, while parallel alliances such as DLfSNlSR have decreased overall demand on the alhance routes. After the KLM/NW and DLISNISR alliances, equilibrium fares on respective alliance routes have been lowered by 22% and 19X, respectively. Altogether, equilibrium amuudpassen~er volume increased by an average of 36 000 passengers per alliance route, while equilibrium air fares decreased by an average of $41 on the alliance routes. Schedule delay time is significantly reduced only in the case of complementary alliances These results imply that consumers in the North Atlantic markets are generally better off due to the alliances. In addition, most alliance partners have experienced greater traffic increases on their alliance routes than those on their non-alliance routes. Conclusions arising from the empirical studies on alliances The findings of the above four empirical studies on the effects of alliances leads one to draw the following concludions: An alliance, the main purpose of which is to link up the two partners’ complementary (non-overlapping) networks, is certain to benefit both the alliance partners and consumers. An alliance among non-leaders in order to compete with the market leader is likely to increase competition, and thus, benefit both the alliance partners and consumers. Since most alliances involve varying mix of overlapping markets {e.g., inter-continental routes) and complementary markets (e.g., linking the networks in two different continents), the overall effects of an alliance on competition must be evaluated carefully on a case by case basis.

Airline alliances: Tae Hoon Own and Jong-Hun Park

Future evolution of airline alliances So far, most major airlines, especially those in North America and Europe, have been actively engaged in intercontinental alliances as a means to secure access to the markets in foreign continents and provide seamless services to their customers. The empirical studies point out that the alliance carriers were able to increase traffic volumes they carry by both taking away market shares from non-aligned carriers and stimulating demands by offering enhanced services and lower prices. Airlines have realized the benefits of strategically linking each other’s continental network in order to compete successfully in the globalizing airline markets. By now, they appear to have realized that the gains from this positive sum game should be shared equitably between the alliance partners in order to have a lasting relationship. The idea that one partner gains at the expense of the other partner is gradually being replaced by fine tuning alliance relations in order to make the gain-sharing equitable. The clear benefits of alliances and this positive development in gain-sharing will undoubtedly increase airlines’ incentive to engage in alliances. Therefore, alliance is not a fad that will disappear in the future. Rather, it will remain as a permanent fixture of the industry. From 1988, the US government started to require authorization for any proposed codesharing alliance. Now, international codesharing alliances are being stipulated frequently in the bilateral air services agreements between the US and other countries. Given that the international aviation community recognizes the ability to do codesharing alliances as a traffic right, in the future codesharing right is expected to become a regular item in most bilateral negotiations. The US DOT has also been using alliance carriers’ immunity from the US anti-trust investigation as a means to encourage other countries, especially European and Asian countries, to sign ‘open skies’ bilateral agreements with the US. Recently, several studies including those conducted by or for the US government agencies have tried to measure the effects of international airline alliances on carriers and consumers. These studies concluded that a complementary alliance, the main purpose of which is to link up two partners’ non-overlaping networks based in two different continents, is certain to benefit both alliance partners and consumers. In addion, an alliance among non-leaders in order to compete with the market leader is likely to increase competition, and thus benefit both the alliance partners and consumers. However, since most alliances involve varying mix of overlapping markets (e.g., intercontinental routes) and complementary markets (e.g., linking the networks in two different continents), the overall effects of an alliance on competition must be evaluated carefully on a case by case basis. In particular, the US government studies mentioned above were somewhat critical on the benefit sharing aspects of the BA-USAir alliance (as being one-sidedly benefiting BA). Given these findings, in the future both the regulators and the airlines

are likely to push for more equitable alliances than they did in the past. Already, there has been a decline in the rate of growth in airline alliances with equity investment involved. Alliances involving unidirectional equity investment tend to be structured in such a way that the investing carrier gets a major share of gains from the alliance (e.g., the BA-USAir alliance). Usually this does not bode well with the host country’s regulator. Furthermore, as indicated in section 3, alliances involving one partner investing in another tend to be somewhat unstable because of the two reasons. The airline who made an investment attempts to exercise control over its partner. In this case, the investor airline is on a double-edged sword. When the financial condition of the partner who received investment improves, there is a good chance that interests of the two partners may collide with each other. As a result, either their relationship gets strained or the alliance could come to an end (e.g., as in Northwest-KLM case). On the other hand, if the investment-recipient airline continue to lose money, the investor could lose its investment (e.g., as in ContinentalSAS case). Given that there will be an increased government scrutiny on gain-sharing of alliances and the inherent instability in equity alliance, it is expected that in the future there will be less equity alliances and more of broad commercial alliances based on equitable gain-sharing. As gainsharing becomes balanced, alliances, especially strategic alliances involving broad commerical cooperation, are likely to become more stable as the partners find the cost of ending an alliance prohibitive. This is especially true when there is no good non-aligned airlines available. All of these lead to an increasing stability of alliance structure. The balanced gain-sharing could form a basis upon which to create global alliance groups. Each global alliance group is liketly to consist of two-tier systems. Different continental markets are linked essentially via superhubs of anchor carriers (senior partners in the alliance group), one in each continent to form the first-tier of the global alliance group. Several junior carriers in each continent may form the continental network along with the anchor carrier, and route an increasing portion of their traffic through super-hubs of the alliance group. Gain-sharing between anchor and junior carriers could be structured so that junior carriers find incentives to route an increasing portion of its intercontinental traffic via the anchor carrier’s hubs. The recently announced ‘STAR alliance’ group may evolve in the long run as such a twotier global alliance system. Since alliance is a positive sum arrangement, and the gains from alliance can be shared equitably among alliance partners as well as between consumers and airlines, it is a matter of time when competing global alliance networks will emerge. Given that there are only a limited number of major carriers in each continent who have a good coverage of the continent and thus could become an anchor carrier, a limited number of major global alliance networks (say, five or so) will likely be formed in the near 143

Airline alliances: Tae Hoon Own and Jong-Hun Park

future. These limited number of global alliance groups will be competing the majority of the world’s air transport traffic. The carriers who are left out of the system may find it necessary to become niche carriers.

Acknowledgements The authors would like to thank Jason Chuang for his dedicated research assistance. They are also grateful to the Social Science and Humanities Research Council of Canada (SSHRCC) for a research grant support.

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