The Hindu Business Line : Rescuing the airline industry

There is no justification to subsidise fuel costs but reducing the gap between domestic and international prices would bring costs down by about 30 per cent, reduce break-even loads, lead to competitive pricing and increase demand. However, the government should look at the flip side before acting, says RISHIKESHA T. KRISHNAN.

The Indian airline industry is projected to lose $2 billion this fiscal. The airlines have been quick to blame spiralling fuel costs and have, with the support of the Civil Aviation Minister, Mr Praful Patel, sought relief from the government to help the industry survive. The Government has set up a committee to investigate this demand. But should the Government intervene?

To answer this question, we need to investigate the drivers of performance in the airline industry.

While the demand for civil aviation in India historically grew in line with GDP growth, the inflection point in its growth occurred around 2003, with the launch of Air Deccan, followed by other discount carriers such as SpiceJet, GoAir and IndiGo.

Between 2003 and 2008, the demand for civil aviation services (as measured by domestic passengers carried) grew at a compounded rate in excess of 30 per cent.

Evidence suggests that this demand growth came as a result of lower fares, release of pent-up demand, shift of upper-class rail travellers to air for journeys of 750 km and more, the upwardly mobile aspirations of India’s middle class, and better connectivity.

Recent developments such as the negative growth rate of the airline industry in the most recent quarter (after airlines increased fares sharply) only underline the steep price elasticity of demand for civil aviation services.

Profitability

However, even during the peak growth phase, India’s domestic airlines were not profitable. (In fact, in 2006-07, the latest year for which comparable figures are available, only one domestic airline, Paramount Airways, reported operating profits.) There were several reasons for this.

Some were outside the direct control of the airlines — crowded infrastructure (resulting in congestion in the air and on the ground), shortage of qualified pilots and maintenance engineers, leading to inflated compensation packages, route guidelines that necessitated services on uneconomical routes, and high tariffs on fuel, all these strained the financial performance of the airline industry.

On the other hand, the airlines themselves have to shoulder a part of the blame. Even before fuel prices went up, at the fares charged by discount carriers, the break-even load was well in excess of 80 per cent (and often closer to 90 per cent). Actual industry-wide load factors hovered around 70 per cent.

The villain was capacity — as demand increased, airline capacity soared as well, preventing increases in the load factor of individual airlines.

And, in an industry with a perishable product and high fixed costs, the overhang of increased capacity kept prices low.

The low fares charged by discount carriers affected full-service carriers as well, leading them to offer 75 per cent of their seats at prices below the “normal” fares.

To make matters worse, full-service airlines Jet and Kingfisher were also making major investments on international expansion and domestic brand-building respectively

At the same time, it is clear that the doubling of fuel costs within a year’s time has overshadowed all the other problems faced by the industry.

The country’s most efficient discount carrier, SpiceJet, which was profitable in Q1 FY2007-08, is today deeply in the red.

Following the increase in fuel costs, the break-even load factor of the largest domestic carrier Jet Airways has increased from about 70 per cent to 90 per cent, while its capacity utilisation remains at around 72 per cent.

What govt can do

Does the government need to do anything? While there is no justification or need to subsidise fuel costs for the airline industry, current handling fees imposed by the oil companies and taxes imposed by the Centre and the States have resulted in pushing fuel prices as much as 70 per cent higher than international benchmarks.

Reduction of this gap to a more reasonable figure (say, a maximum of 20 per cent) would bring down fuel costs by about 30 per cent, reduce break-even loads, result in more competitive pricing and a corresponding increase in demand, and improve the airlines’ viability.

A concern of the government would be whether the benefit of lower costs would translate into customer benefits in terms of lower prices or simply be pocketed by the airlines. The former is more likely.

Though there has been consolidation in the airline industry, it is still a competitive industry. The five major players — Jet + JetLite; Kingfisher + Deccan, Air India, SpiceJet and IndiGo — are under different ownership, and have different competitive strategies, business models, and cost structures.

There is no clear “industry leader”, under whose umbrella other carriers might shelter. Though there have been some efforts to create a floor price across the industry through the adoption of common fuel surcharges, efficient discount carriers such as IndiGo and SpiceJet continue to offer significantly lower total fares. This is because they have substantially lower costs than the full-service carriers and it makes business sense for them to convert this cost advantage into lower prices.

There is as much of a competition between formats (full service vs discount) as between carriers, and the fundamental assumptions of these formats are different. Under these conditions, sustained cartelisation is not sustainable, and price-based competition will ensure that the benefits of lower costs are passed on to consumers.

The flip side

At the same time, there are three arguments against reducing the cost structure for airlines by lowering the taxes and duties on ATF. One is on the grounds of environmental sustainability. The airline industry is already being targeted globally for its large carbon footprint. It could be argued that rapid growth of the Indian airline industry would be against the long-term ecological interests of the country and the world.

The second is on questionable benefits to the larger economy — while before the entry of the discount carriers, business travellers comprised more than 80 per cent of the users of airline services, the boom in the use of airline services was driven by travel for either leisure or “visiting friends and relatives”, leading to a decline in the proportion of business travellers to around two-thirds.

Thus, keeping fares low may drive leisure spending rather than productive activity!

Finally there is the issue of lost welfare due to foregone tax revenues by the State and Central governments.

The Government must weigh these costs in taking a decision on a bailout plan for the airline industry.

(The author is Professor of Corporate Strategy, IIM- Bangalore. Response to blfeedback@thehindu.co.in)