The impact of secondary slot trading at Amsterdam Airport Schiphol

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1 The impact of secondary slot trading at Amsterdam Airport Schiphol

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3 Amsterdam, March 2007 A report for The Netherlands Ministry of Transport, DGTL The impact of secondary slot trading at Amsterdam Airport Schiphol Jaap de Wit Guillaume Burghouwt

4 SEO Economic Research carries out independent applied economic research on behalf of the government and the private sector. The research of SEO contributes importantly to the decision-making processes of its clients. SEO Economic Research is connected with the Universiteit van Amsterdam, which provides the organization with invaluable insight into the newest scientific methods. Operating on a not-for-profit basis, SEO continually invests in the intellectual capital of its staff by encouraging active career planning, publication of scientific work, and participation in scientific networks and in international conferences. Contact persons at the Directorate General for Civil Aviation and Freight Transport (DGTL): Ronald van Gerven Cor van Wijk Ronald.van.Gerven@minvenw.nl Cor.van.Wijk@minvenw.nl SEO-rapport nr. 957 ISBN Copyright 2007 SEO Economic Research, Amsterdam. All rights reserved. Permission is hereby granted for third parties to use the information from this report in articles and other publications, with the provision that the source is clearly and fully reported.

5 Contents 1 Executive summary Research question The impact of secondary slot trading: General observations Impacts at Amsterdam Airport Schiphol Recommendations Introduction The current slot-allocation mechanism in Europe The EU system Why change the current slot-allocation mechanism? The European Commission and slot reform Inefficiencies in the current slot-allocation system The current allocation system and future airport capacity The contribution of secondary trading to slot efficiency and social welfare improvements Conclusions The impacts of secondary slot trading Introduction Impacts of slot trading Impact on slot mobility Impact on competition Impact on the efficient use of airport capacity Impacts on airlines and airline networks Impact on consumers The environment The values of slots Conclusions Conclusions from the literature review Additional regulation Experiences with secondary trading Experiences in the UK The UK grey market within the EU system The example of Heathrow The US experience The slot-allocation system under the buy-sell rule...45

6 5.2.2 Air Lessons learned Lessons learned from the UK Lessons from the US experience Primary slot allocation in combination with secondary trading Reasons for a market-based primary allocation Possible amendments to administrative primary allocation Market-based primary allocation Auction design in the primary allocation of slots Design requirements Elements of auction design Impacts of primary auctioning Compatibility with IATA procedures Impact on slot mobility and slot efficiency Impact on airline competition Impact on the environment Impact on regional accessibility Distributional impacts of costs and revenues Conclusions and recommendations The slot-allocation problem at Schiphol The demand for and supply of slots at Schiphol Summer 2006 and winter Dynamics in slot allocation: Excess demand for slots Day, early-morning, and nighttime slots Slot transfers, trading, and leasing Conclusions The consequences of secondary slot trading at Amsterdam Airport Schiphol Introduction A hypothetical format of a secondary trading system to survey the impact of secondary slot trading Impact on slot mobility Size of secondary market should not be overestimated Liquidity of the market Which airlines are potential buyers? Potential sellers...91

7 8.2.5 Conclusions on slot mobility at Schiphol Impact on competition SkyTeam dominance Should we worry about more concentration at Schiphol? Other competition concerns Concluding comments on competition Impacts on the efficient use of the capacity at Schiphol Historical developments Perspectives Conclusions on the efficient use of Schiphol s capacity Impacts on the competitiveness of the hub carrier The opportunities Other impacts Impacts for consumers Environmental impacts The impact of secondary trading together with primary trading of newly created slots Conclusions and recommendations Conclusions Recommendations Recommended guidelines for a trading system Final observation References Appendix A: Interviews Appendix B: Selected results Mott MacDonald study (2006) Appendix C: Estimation of the network value of slots in terms of connectivity

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9 THE IMPACT OF SECONDARY SLOT TRADING AT AMSTERDAM AIRPORT SCHIPHOL 1 1 Executive summary 1.1 Research question In order to facilitate a strategic positioning of the Dutch government in the Community decision making on the future of the slot-allocation process, the Directorate General for Civil Aviation and Freight Transport (DGTL) requested SEO Economic Research to investigate the impacts of the introduction of a secondary trading mechanism at Amsterdam Airport Schiphol. The objectives of this study were twofold: To explore the potential that the EC objectives will be met at Schiphol (to enhance slot mobility, competition, and the efficient use of airport capacity); To explore the effects on the competitiveness of relevant Dutch stakeholders (home-based carriers, airport authorities). These objectives were fulfilled by answering the following questions: General questions: Why change the current slot-allocation mechanism? What are the likely impacts of secondary slot trading in general? What are the lessons from secondary slot trading in the UK and the US? What are the likely impacts of secondary slot trading together with primary slot trading of newly created slots? Specific questions with respect to Amsterdam Airport Schiphol: What are the likely impacts of secondary slot trading on slot mobility at Schiphol? What are the likely impacts of secondary slot trading on competition levels at Schiphol? What are the likely impacts of secondary slot trading on the efficient use of Schiphol s capacity? What are the likely impacts of secondary trading on the competitiveness of the hub carrier at Schiphol? What is the likely impact of secondary slot trading on consumers? What is the likely impact of secondary slot trading on the environment at Schiphol? What will be the impact of secondary trading together with primary trading of newly created slots at Schiphol? What recommendations can be made with respect to the strategic positioning of the Dutch government in the EU decision-making process?

10 2 CHAPTER The impact of secondary slot trading: General observations Why change the current slot-allocation regime? The European Commission believes that a slot-allocation system should result in efficient use of airport capacity, and should facilitate competition at Community airports. The current administrative slot-allocation system is not able to comply fully with these objectives, for various reasons: As the current EU slot-allocation system is an administrative system in which the slot coordinator allocates the slots to the airlines and no monetary transactions are involved in the primary or secondary allocation of slots, trading of slots between airlines is not possible and opportunity costs of slots are lacking. Since trading is not possible and there are no opportunity costs for the airlines (i.e., the revenue foregone by not trading the slot), slots are not always used by the airlines that attach the highest value to them. This results in airlines holding on to slots as the real price of the slots is not felt It is extremely difficult or even impossible for the slot coordinator to judge who can use the slots most efficiently from an economic point of view. If the congestion costs of an airport are internalised in the pricing system (for example, by means of secondary slot trading), the scarcity of the slots involved will be matched by the willingness to pay of the bidding airlines. In that case, the priority rules of the slot coordinator can be substituted by the pricing system in a more efficient way. Slot trading may result in a social welfare growth owing to a net increase in consumer surplus and, possibly, a net increase in producer surplus. What are the likely impacts of secondary slot trading in general? Slot mobility Secondary slot trading is the trading of slots between airlines, in which monetary compensation is involved. Slot trading introduces opportunity costs to slots. Hence, airlines face the revenues foregone by not trading the slots. Airlines formerly not able to acquire new slots are able to increase their slot holdings at congested airports through secondary slot trading since monetary compensation is allowed. However, a number of factors may reduce slot mobility: Airlines hold on to slots because they do not want to trade with competitors Potential buyers and sellers are not able to identify each other (lack of transparency) There is a risk of decreasing slot values if airport capacity is expanded Slots have option value: slots give airlines flexibility with respect to future network developments Airlines do not trade because of uncertainty about the stability of the slot regime The most likely buyers are hub carriers and 2 nd -tier long-haul airlines, in particular with respect to peak-hour slots. Low-cost, charter, cargo, and independent regional carriers

11 EXECUTIVE SUMMARY 3 qualify as the most likely candidates to sell slots and move operations to off-peak hours or less congested airports. Impact on airline competition Secondary slot trading has the potential to enhance competition as it facilitates market access. It is widely recognised, however, that there is a risk of market concentration as slots become concentrated among relatively few suppliers. Nevertheless, market concentration at hub airports can also reflect the network economies of hub-and-spoke systems and an efficient use of airport capacity. It is important to consider potential competition concerns on the level of the relevant market. Market concentration at the airport level may increase, while competition levels at the city-pair level are unaffected. The way market concentration concerns are dealt with is, therefore, an important issue in the design of a secondary trading regime. Impact on efficient use of airport capacity Secondary slot trading offers scope to improve the efficient use of airport capacity by confronting the use of slots with the true opportunity costs of the slots held. The efficient use of airport capacity is likely to be demonstrated through the use of larger aircraft, longer average stage lengths, and higher passenger throughput for traded slots. What are the most important lessons from the experience with secondary slot trading in the UK? Experiences with secondary trading in UK market show that the level of slot trading should not be overestimated. Secondary trading has helped the dominant carrier (BA) to increase its slot share at the airport. Secondary trading may also open up the market for other carriers, such as strong 2 nd -tier carriers, and allow these carriers to compete effectively with the dominant carrier (the Virgin Atlantic effect of slot trading). Traded slots at Heathrow are used for flights with higher average seat capacities and longer average stage lengths. This might be an indication of a more efficient use of the airport s capacity. Some sellers have transferred their operations to Gatwick or other airports in the London airport system. Since Heathrow is an entirely different airport than Schiphol (no wave-system of homebased carrier(s), large share of origin-destination traffic, and heavily congested), care should be taken in transferring the results of secondary trading at Heathrow to Schiphol on a oneto-one basis. What are the most important lessons from the experience with secondary slot trading in the US? Secondary trading at high-density airports in the US has had mixed results.

12 4 CHAPTER 1 On the one hand, it has resulted in a more efficient use of airport capacity at heavily congested airports. It has generated a relatively fluid and dynamic market. It has clearly enhanced slot mobility, although leasing of slots has become more common than the outright sale of slots. It has allowed airlines to fine-tune their schedules. The slot portfolio has become a valuable asset, which can be used for loans, mortgages, and other financial facilities. In particular during economic downturns, a slot portfolio at a highly congested airport can be the way to avoid bankruptcy. Secondary trading may also deliver such benefits for European carriers. On the other hand, secondary slot trading in the US is associated with: Consolidation. Slots have become more and more concentrated in the hands of a few airlines under the secondary slot trading regime, especially at the Chicago O Hare hub of American Airlines and United Airlines. Limited slot efficiency, particularly at Chicago O Hare, owing to extensive use of regional jets in the hub & spoke systems of both hub carriers. This is contrary to the expected general impact on the efficient use of slots. We have argued that the relationship between secondary trading and market concentration at the high-density hubs is not straightforward. Nor is high market concentration essentially a bad thing from a social welfare point of view. In particular at hub airports, it may reflect the higher willingness of airlines to pay for slots owing to network economies. In this respect, European competition policy will be an important issue under a secondary trading system. Following the introduction of such a policy, market concentration concerns should be considered on a case-by-case basis. Experiences with slot trading in the US are not directly comparable with Europe, given the differences in the slot regime and market structure. Additional rules have now been imposed by the FAA to compensate for market concentration (Air-21). The impact of slot trading on competition and slot efficiency (aircraft size) can be remarkably different in different types of airport. Chicago O Hare is a double hub for two major US carriers, whereas New York LaGuardia is a domestic airport, served by many US carriers. The first airport continued to accommodate a large share of small regional jets following the introduction of secondary trading, whereas the aircraft size at LaGuardia further increased after introduction. This is an important lesson for Schiphol airport. Market concentration at a dominated hub reflects the efficient scale of the hub operation. The hub airlines increase their slot shares to benefit optimally from network economies. What are the likely impacts of secondary slot trading together with primary slot trading of newly created slots? The beneficial effect of slot auctions on slot efficiency is not expected to be dramatic in the long run as slot trading on its own is expected to result in a similar outcome, although it might take a few years longer.

13 EXECUTIVE SUMMARY 5 Where there is only a marginal increase in capacity, the costs of administering an auction for a small number of slots may not be justified. In this context a simple format of either a sealed bid auction or a simultaneous ascending clock auction may be sufficient. Auctioning might be particularly appropriate where there is a substantial capacity increase, which is nevertheless well below market demand. If excess demand disappears, coordinated airports no longer need to be coordinated and auctioning becomes superfluous. The alternative of annual slot withdrawals seems to be far beyond existing EU slot-allocation rules and IATA Guidelines. Not only the new-entrants rule would have to be put aside, but also the use-it-or-lose-it rule and (partly) the grandfather rights rule. This approach seems to be relevant only to exceptional situations of extremely heavily congested airports like London Heathrow and New York LaGuardia. It is clear that a uniform one-size-fits-all model can not be applied at coordinated EU airports. 1.3 Impacts at Amsterdam Airport Schiphol What are the likely impacts of secondary slot trading on slot mobility at Schiphol? Slots are starting to become an increasingly scarce resource at Amsterdam Airport Schiphol. Without substantial expansion of the declared capacity at the airport, the excess demand for slots will only increase in the years to come. Hence, as new slots cannot be obtained through the primary, administrative allocation, it can be expected that airlines with a high willingness to pay will use a possible system of secondary trading to increase their slot portfolios Similarly, some airlines will decide to sell slots as they face the opportunity costs of the slots they currently hold. This is particularly true for peak-time slots and night/early morning slots. However, the size of the secondary market at Schiphol in terms of the number of transactions should not be overestimated. A number of specific factors can be distinguished that have the potential to reduce the liquidity of the secondary market at Schiphol. Major uncertainty about the future environmental capacity will reduce the willingness of airlines to trade. Therefore, a reliable and stable governmental policy on environmental capacity is likely to be an important local condition for a liquid secondary market at Schiphol. Planning of new airport capacity in a multi-airport system or by means of a new runway may result in anticipating behaviour of airlines. This kind of behaviour reduces the liquidity of the market as airlines wait for the new capacity to become available at no cost. However, as soon as a multi-airport system with new capacity (or a new runway) has been put in place, liquidity will be stimulated since there will be more options-out for slot-selling airlines (which is currently not the case). The same holds true for the transfer of the current 2+1 runway system to the 2+2 runway system, which will affect hourly capacities. Potential buyers are the hub carrier and its partners as well as strong long-haul carriers. However, the potential for the latter at Schiphol is small compared to at Heathrow, owing to

14 6 CHAPTER 1 the smaller origin-destination market. Likely selling candidates are in particular financially distressed airlines, non-home-based leisure airlines, and cargo airlines. What are the likely impacts of secondary slot trading on competition levels at Schiphol? It can be expected that KLM will increase its slot holdings at the airport and will become more dominant. Mainly on short-haul routes, competition levels might be reduced as shorthaul (leisure) airlines sell their slots. Long-haul markets may become somewhat more competitive because of the entry of new long-haul carriers and already existing indirect competition via other hubs. The KLM hub operation requires a certain level of airport concentration to support efficiency. Although the potential competition concerns are acknowledged, the hub operation is also considered beneficial to society because of the large range of destinations, high frequencies, and short transfer times. The competition issue should be taken care of by the responsible competition authorities on a case-by-case basis. What are the likely impacts of secondary slot trading on the efficient use of Schiphol s capacity? Generally speaking, secondary trading may contribute to a more efficient use of capacity at Schiphol, as the distribution of slots will increasingly reflect the willingness of airlines to pay. Hence, slots will be used by those carriers that can use it most efficiently. At Schiphol, however, the relationship between secondary trading and higher productive airport efficiency is not straightforward. Owing to the nature of the hub operation (frequency-focused) of KLM and its partners, the extent to which the carrier can use larger aircraft on slots it has bought on the secondary market is generally limited. The developments at the hub airport of Chicago O Hare are in this respect much more illustrative for Schiphol than those at the origin-destination airports London Heathrow and New York LaGuardia. Note that efficient use of the slots by the dominant hub carrier is not necessarily the most efficient use from the airport s viewpoint. However, the positive network externalities brought about by hub-and-spoke operations are to a certain extent beneficial to society as a whole as they deliver more direct flights, shorter connection times, and higher frequencies to the consumer. What are the likely impacts of secondary trading on the competitiveness of the hub carrier at Schiphol? Secondary trading offers the hub carrier an instrument to increase its slot-holding portfolio. The opportunities of KLM and its partners to further develop the hub operation during the peaks are currently very limited, and will become more limited in the future. In this respect, slot trading can be beneficial to the airline in strengthening its competitive position. This benefit will come at a certain cost as the airline will have to pay a price for the (peak) slots. The airline is likely to improve its position mainly on the short-haul markets, since especially low-cost competitors and charters may leave the market.

15 EXECUTIVE SUMMARY 7 What is the likely impact of secondary slot trading on consumers? Prices paid for slots are not likely to be noticeable in the ticket prices at Schiphol. Increasing market concentration in a secondary trading regime could eventually result in a mark-up on the ticket prices of the hub carrier. A downward pressure on fares due to intensified long-haul competition is less likely at Schiphol than at Heathrow, owing to the much smaller origin-destination market at Schiphol. Secondary trading could result in the reallocation of specific services to other airports or the cancellation of certain air services altogether, as airlines face the opportunity costs of the slots and decide to sell. This is particularly true for leisure (charter/low-cost) and cargo operations. The use of the slots bought on the secondary market is likely to better reflect consumer needs. What is the likely impact of secondary slot trading on the environment at Schiphol? Secondary slot trading has little scope to pursue environmental objectives In theory, secondary slot trading could result in a negative impact on Schiphol s declared capacity as up-gauging towards larger aircraft takes places, which are generally noisier than small aircraft. However, Estimations of Mott MacDonald (2006) have shown that the impact of secondary trading on ambient noise will be marginal, if at all noticeable, since airlines will operate not only larger aircraft but also newer aircraft, which are quieter. Increases in aircraft size at Schiphol are less likely than, for example, at London Heathrow because of the nature of the hub operation of KLM. NOx and carbon dioxide emissions can be expected to increase, whereas hydrocarbons levels should remain neutral. What will be the impact of secondary trading together with primary trading of newly created slots at Schiphol? Primary auctioning in combination with secondary trading will not increase the efficient use of slots more than will secondary trading. It will only bring forward the same improvement. The impact, therefore, on competition, the environment, and regional accessibility will not differ from the impact of secondary trading at Schiphol. It is likely that the net welfare effect of primary auctioning earlier efficiency gains, elimination of windfall gains and speculative behaviour, and the costs of administering a yearly auction in relation to the small annual increments of new slots at Schiphol- will not be positive. If a substantial number of new slots becomes available -because of a new runway, for example- the net welfare of a primary auction will definitely be positive, if excess demand continues to exist after the capacity increase. This may be an important issue for Schiphol in the longer run. If a primary trading system for newly created slots were to be introduced, it would be necessary to decide who would be the recipient of the revenues. Airlines at Schiphol generally prefer to keep the revenues of primary trading in the system, for example, via a reduction in the airport user charges (if a primary system should be introduced). In their opinion, this money should not go to the government, where it would be spent on society at large.

16 8 CHAPTER Recommendations SEO Economic Research has formulated the following policy recommendations: Irrespective of the outcome of the possible amendments to the EC slot-allocation rules, we recommend first that the Dutch government optimally utilize the possibilities provided in the EC rules with respect to the development of local rules at Schiphol Airport. These rules should stimulate the optimal use of new slots that become available, either through more operational efficiency or through more efficient use of environmental capacity. If the EC is not inclined to amend the EU slot-allocation rules in the foreseeable future, use of the fall-back position of tailor-made local rules is recommended. If the EC decides to amend the EU slot-allocation rules to enable the introduction of secondary slot trading, the Dutch government should aim to acquire maximum discretion for the individual Member States in deciding on the basis of local conditions whether or not to apply secondary slot trading. It is of paramount importance that slot trading be made a possibility and not an obligation at slot-coordinated airports. This is because of the specific situation at Schiphol airport, which is described extensively elsewhere in this report. If the EC decides to introduce market-based primary allocation as well as secondary slot trading, the Dutch government should aim to acquire maximum discretion in the decision whether or not to use auctioning to allocate new slots. Especially in the event of a substantial number of new slots becoming available, for example, because of a new runway, this allocation method may be relevant if well tested in advance. If a secondary trading regime is introduced, SEO Economic Research recommends, on the basis of the findings of the literature review and the case analyses, the following guidelines for the design of such a system: Build upon the current IATA-based system of slot allocation Opt for a flexible system, which can be tailor-made to suit the local situation Does not introduce any additional regulation such as slot-holding caps, an obligation to sell to the highest bidder, or a need to publicly disclose trades and prices. We assume a secondary trading system that allows the market to work. Prohibit trade-restricting actions like covenants Create post-sale transparency of details of the slot transactions, since pre-sale transparency could result in a less liquid market. Pre-sale information on slot transactions should be made available to the slot coordinator only. Make secondary trading complementary to the existing administrative primary allocation. Take into consideration the possibility that the competition authorities will deal with competition issues brought about as a result of secondary slot trading ex post or if necessary, ex ante- and on a case-by-case basis. Limit trade to airline entities Do not oblige parties to trade slots on a one-for-one monetary basis -as in the UK- in order to stimulate liquidity of the market. A secondary trading system will be a stable and long-term policy measure PSOs are still allowed under a secondary trading regime Maintain the 80/20 rule on allocated slots, and the new-entrants rule

17 EXECUTIVE SUMMARY 9 Oblige new entrants to operate a newly acquired slot at least for two years before trading in case secondary slot trading occurs.

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19 THE IMPACT OF SECONDARY SLOT TRADING AT AMSTERDAM AIRPORT SCHIPHOL 11 2 Introduction Early in 2006, the EC launched an invitation to tender for a study on The impact of the introduction of secondary trading at Community airports. The aim of the study was to explore in depth the likely effects of the introduction into Community legislation of secondary slot trading at congested airports. The objectives of the study were fourfold: 1. To ensure mobility of slots and efficient transport for passengers and cargo 2. To strengthen competition at Community airports 3. To match secondary trading with overall EU air transport policy (optimum/efficient use of existing capacity) 4. To ensure compatibility of secondary trading with worldwide procedures The final report of the study was published early in Based on the outcome of the study, the EC intends to draft amendments to Council Regulation that include provisions for secondary trading at community airports with excess demand. In order to facilitate strategic positioning of the Dutch government in the Community decisionmaking process, the Directorate General for Civil Aviation and Freight Transport (DGTL) requested SEO Economic Research to investigate the impacts of the introduction of a secondary trading mechanism at Amsterdam Airport Schiphol. The objectives of this study were twofold: 1. To explore the potential that the first three EC objectives will be met at Schiphol 2. To explore the effects on the competitiveness of relevant Dutch stakeholders (homebased carriers, airport authorities) In addition, DGTL requested the consultant explicitly to focus primarily on secondary slot trading, and -as a possible variant- secondary trading with primary trading of newly created slots to consider the impacts for Amsterdam Airport Schiphol only, and not for other slot-coordinated airports in the Netherlands to address the objective of the study primarily in a qualitative way not to address the impact for local residents in the Schiphol region To give answers to the questions of how and to what extent secondary trading may have an impact on slot mobility, competition, efficient use of capacity, and the competitive position of the relevant stakeholders, the report of this study is outlined as follows. We briefly introduce the current slot-allocation system in Europe in section 3.1. We elaborate the arguments used to revise the current regime of slot allocation in section 3.2. In Chapter 4, a state-of-the-art overview of the current insights into the consequences of secondary slot trading is given. We pay attention to insights from the academic literature and other studies. In Chapter 5, experiences with secondary trading in the UK and the USA are discussed. In Chapter 6, we discuss the insights into secondary trading together with primary trading of newly created slots. Chapter 7 introduces the current situation with respect to the demand and supply of slots at Amsterdam Airport Schiphol. We provide a survey of the impacts of secondary trading at Amsterdam Airport Schiphol in

20 12 CHAPTER 2 Chapter 6, based on the results reported in Chapters 4, 5, 6, and 7, and a number of expert interviews with the most important relevant stakeholders in the Dutch aviation industry. Finally, section 1 contains the conclusions and recommendations.

21 THE IMPACT OF SECONDARY SLOT TRADING AT AMSTERDAM AIRPORT SCHIPHOL 13 3 The current slot-allocation mechanism in Europe In this chapter, an overview is given of the current slot-allocation system in Europe. In addition, an analysis of the inefficiencies of this system is provided. The discussion on inefficiencies provides an understanding of why the European Commission may come with a proposal for reform of the current system and introduce a more market-based slot-allocation mechanism. 3.1 The EU system A slot is the right to use a bundle of airport infrastructure at a certain date and time to operate an air service. The mechanism currently used to allocate slots at Europe s congested airports (the slot-coordinated airports) is governed by the European Commission s regulation on airport slot allocation (Council Regulation No 95/93 of 18 January 1993), which was amended by Regulation 793/ Definition of a slot The entitlement [..] of an air carrier to use the full range of airport infrastructure necessary to operate an air service at a coordinated airport on a specific date and time for the purpose of landing and take-off as allocated by a coordinator in accordance with this Regulation (Council Regulation 793/2004). These Regulations are broadly based on the IATA slot-scheduling process (see Matthews & Menaz 2003; Sentence 2003). In theory, the objective is to encourage efficient use of airport capacity through optimal allocation of slots. The efficient use of airport capacity means that slots are efficiently allocated when used by those carriers that generate the greatest overall social welfare from them (DotEcon 2001) (see also section 3.2.4). When demand exceeds supply at an airport, this airport may be designated as a slot-coordinated airport, for which the slots are then allocated by the slot coordinator according to the EU slotallocation rules. The coordinator should handle the slot-allocation task in a neutral, nondiscriminatory, and transparent way. 2 The general principles of the slot-allocation process in the EU are summarised below. 1 Amongst other things, the 2004 technical revision reinforced the power of the Slot Coordinator, made clear that slots do not represent a property right but a user right, and took into account interests of both established carriers (e.g., by retiming of slots) and new entrants (new-entrant definition was broadened). 2 A coordination committee assists and advises the coordinator. The coordination committee is open to at least the air carriers or their representatives, the airport authority, and representatives of air traffic control (CEC 1993).

22 14 CHAPTER 3 The slot-allocation process If not all slot requests can be accommodated at the airport, the slot coordinator gives preference to: 1) Historic or grandfather rights. Slots are allocated through grandfathering, based on historic precedence and a use-it-or-lose-it rule: the incumbent has a grandfather right if the slot was used in the previous equivalent season for at least 80% of the time (Sentance 2003; Czerny & Tegner 2002). If the slot is not used for 80% of the time in the specific season, the slot is returned to the slot pool. 2) The most valuable services: commercial, all-year-round services, in particular scheduled and programmed non-scheduled services. 3) Priorities set in the so-called local rules, which are recommended by the coordination committee allowing for local conditions. The slot pool also contains newly created slots, slots returned voluntarily, and slots otherwise unclaimed. Slots in the pool are allocated free of charge by the slot coordinator in a twice-yearly coordination process. In order to encourage competition and new entry, up to 50% of the slot pool is set aside for new-entrant airlines. A new entrant is defined as a carrier having less than 5% of the slots at a fully co-ordinated airport on the day in question or less than 4% of the slots in an airport system of which that airport forms part (Publicatieblad van de Europese Unie 2004). Slots may be freely exchanged from one air carrier from one route, or type of service, to another, by mutual agreement on a one-for-one basis, or as a result of a total or partial takeover, or unilaterally as long as the exchanges are transparent and feasible. Slots allocated to new entrants may not be exchanged for a period of two seasons. The slot-allocation time schedule at Amsterdam airport Half a year before the new schedule is introduced, a check on the 80% rule is executed by the slot coordinator and, if this rule is applicable, the historical slots are allocated to the individual carriers for the next season. The carriers may then change the timing of these historical slots for operational reasons. (These so-called retimings have preference over new requests for the same slot.) The following month, the slot coordinator determines which slots will go into the pool, by establishing the differences between the available slots and the requested historical slots. (The available slots are based on the capacity declaration plus overbooking plus unused slots in the previous season.) The following month, all allocated slots are sent out to the individual carriers, and after the initial allocation the slots in the pool are divided among the new entrants and incumbents according to the priority rules described. One month before the new schedule starts, the slots not to be used have to be returned to the slot coordinator. After notification, carriers may swap slots on a one-to-one basis, they may transfer slots from one route to another, between parent companies and their subsidiaries, and between subsidiaries, and they may transfer slots in the case of code-sharing, franchising, joint operations, and contracts.

23 THE CURRENT SLOT-ALLOCATION MECHANISM IN EUROPE Why change the current slot-allocation mechanism? The European Commission and slot reform The European Commission has stated that it aims to reform the current slot-allocation system, described in section 3.1. The EC aims to introduce a market mechanism in the slot market because the current system is considered to be inefficient (Gremminger 2006). The objectives of a slot-allocation reform are the following: To achieve efficient use of airport capacity by ensuring slot mobility. Note that slot mobility is not an aim in itself, but a means to achieve efficiency. To facilitate access to, and strengthen competition at, Community airports To match (secondary) trading with the overall EU air transport policy, and To ensure compatibility of (secondary) trading with worldwide procedures The EC commissioned an impact study by Mot McDonald on secondary trading and auctioning (primary trading). Based on the results of this study and those of the NERA study (2004), the Commission staff working document of 2004 and the CAA/OFT (2005) paper, the Commission may come up with a slot-reform proposal in Why does the European Commission consider the current slot-allocation mechanism to be inefficient? Inefficiencies in the current slot-allocation system It is impossible for a slot coordinator in the existing slot-allocation system to judge which airline can make the most valuable and beneficial use of a slot. (DotEcon 2001). New and incumbent airlines may be unable to gain the slots that they require, even if they can use those slots more efficiently than the carriers using their grandfather rights. The other way around, airlines using their grandfather rights do not take into account the opportunity costs of a slot: the benefit that might be generated if a slot were traded with another airline (Lévêque 1998). In addition, various researchers mention other reasons related to inefficiencies of the administrative procedures for revision of the current slot-allocation system. First, some researchers, as well as new entrants, claim that grandfather rights deny newcomers the opportunity to enter the market and compete against major carriers (Matthews & Menax 2003). In addition, the current slot-allocation mechanism restricts established second-tier carriers in competing against the hub carrier and increasing market shares at severely congested airports. On the other hand, established airlines argue that grandfather rights maintain stability and continuity of scheduling, which also facilitates long-term planning of airport capacity (Sentence 2003). In addition, IATA argues that newcomers also get to appreciate the grandfather arrangement as the child becomes a grandfather in two seasons. Second, the use-it-or-lose-it rule is a powerful incentive to hold on to slots, even if they are not optimally used: the airline can generate scarcity rents by adding more quasi-capacity demand to

24 16 CHAPTER 3 the shortage of capacity supply. Airlines maintain the slot, sometimes by using small aircraft at a relatively low cost, even if this involves a loss-making flight. This behavior is also known as slotsitting or baby-sitting (DotEcon 2001). Sometimes, a partner airline baby-sits the slot, since alliances tend to make it easier for incumbents to swap slots and stay above their 80% occupation rate limit in order to keep out newcomers (Transport & Mobility Leuven, 2005). Third, the new-entrant rule in the current slot-allocation system is believed to be of little value. In the current Regulation, 50% of the pool slots are set aside for new entrants. However, various researchers (e.g., Barbot 2004; CAA/ OFT 2005; DotEcon 2001; Matthew & Menax 2003, p.4) have concluded that a large percentage of slots in the pool is of limited commercial value because the slots cover commercially unattractive times. The possibility of slot retimings by the incumbents before the remaining slots are transferred to the slots pool further contributes to the unattractiveness of these pool slots. In addition, the number of slots available is often not sufficient to secure the scheduling of a new route. It permits new entrants to offer low-frequency services only, which are not sufficient to compete with the incumbents or let demand materialise 3. On the other hand, some (Matthew & Menax 2003) have posed the question whether it is really desirable to encourage new entry at already congested airports. It might be a much better idea to encourage existing players to make more efficient use of the infrastructure (DotEcon 2001; Matthew & Menax 2003, p.4; Starkie 1998). Mid-sized carriers are much more effective in challenging established carriers than are new entrants. However, opportunities to increase services are limited in the current system owing to the 50% allocation to new entrants and lack of formal trading opportunities. In addition, if competition on a route is restricted by the bilateral air service agreement, the current new-entrant rule limits the possibilities of existing carriers to increase service and competition levels The current allocation system and future airport capacity The common view among airlines outside the UK and airline representative bodies such as the AEA (e.g., Egerer 2006) and ERA (Clarke 2006) is that changing the current slot-allocation system is not a solution to the problem the air transport industry faces: a shortage of airport capacity (see also Chapter 4). The obvious way of alleviating capacity problems is to expand infrastructure and make more slots available. In the view of many airlines, more airport capacity makes the discussion on slot allocation obsolete. There are many reasons, however, why expansion of infrastructure fails to keep pace with demand for flights: financial constraints, political whims, planning requirements, and environmental concerns result in very long lead times for new airport infrastructure. 3 Owing to the so-called S-curve effect in the relation between market share and frequency on a specific route (see, for example, De Neufville (2006), small operators with a less than 50% frequency share on a route tend to capture a disproportionally smaller share of passengers than the operators whose frequency share is larger than 50%.

25 THE CURRENT SLOT-ALLOCATION MECHANISM IN EUROPE 17 Figure 3.1 Average airport capacity shortages per airport capacity group in 2025: Highgrowth scenario 4 Source: Eurocontrol 2004, p.34 As a consequence of the above, European airports will be increasingly congested in the future, given the current growth rate in travel demand and airport capacity expansion. Eurocontrol (2004) has estimated that the capacity shortage at the seven largest airports in Europe will be 91 movements/hour on average (Figure 3.1). In addition, Eurocontrol (2004, p.2) states that more than 60 European airports will be congested in 2025, and the top-20 airports will be saturated at least 8-10 hours per day. With demand growing rapidly and a need for capacity to be added far in the future, the need to ensure a more efficient allocation of slots amongst competing airlines is becoming increasingly urgent (Matthews & Menaz 2003) The contribution of secondary trading to slot efficiency and social welfare improvements As the mismatch between airport capacity demand and supply increases, the need for more efficient demand management will also increase in order to maximise slot efficiency. To maximise the efficient use of slots, Mott MacDonald (2006) distinguishes between two concepts of economic efficiency: Allocative efficiency of slots, i.e., slots are used for those destinations which are most highly valued by society (in other words, social welfare cannot be improved by changing the set of destinations served from an airport). Productive efficiency, which means that the total number of slots at an airport is maximised, and that each slot is used to move the maximum number of passengers possible or the maximum number of revenue passenger kilometers. 4 IFR: Instrument Flight Rule aircraft movements. IFR movements are shown per hour and per airport size category IFR: 7 airports; IFR: 12 airports; IFR: 21 airports; IFR: 63 airports; 0-19 IFR: 30 airports.

26 18 CHAPTER 3 If the use of slots is allocatively and productively efficient, slot allocation can be considered economically efficient. The introduction of secondary slot trading stimulates both productive and allocative efficiency, and it thereby creates more value for society. For example, a market for secondary slot trading creates incentives for allocative efficiency by providing price signals as to the value of different slots as well as by incentivising sellers with lower valuations to trade their slots with buyers that value them more highly. In this way, if the value an airline places on the slot is lower than the opportunity costs of the slot, the airline will enter the market to trade its slot. When an airline either pays for the slot directly or becomes aware of the opportunity costs of a slot, it is incentivised to use the slot fully by using it for bigger aircraft to more distant destinations, and productive efficiency is thereby encouraged. These improvements in economic efficiency contribute to greater social welfare. Although maximum slot efficiency contributes to social welfare from the point of view of capacity utilisation, it may to a certain degree simultaneously run counter to social welfare improvement. This is, on the one hand, because airline competition may decrease under a slottrading regime owing to reduced opportunities for new entrants or increased hub dominance of an incumbent carrier. On the other hand, improved productive efficiency may have a negative impact on social welfare because larger aircraft and longer flights per slot go hand in hand with more external environmental and noise effects. How would the introduction of secondary slot trading affect social welfare in terms of consumer welfare (measured in terms of consumer surplus) 5 and producer welfare (measured in terms of producer surplus)? At a congested airport an L-shaped supply curve of flights can be assumed, i.e., a fairly elastic supply is elastic up to the limit imposed by the maximum slot supply; above that, flight volume supply becomes completely inelastic. If the slot constraint bites, there is excess demand in the market and the price will exceed marginal cost. If the slot constraint does not bite, price will be set at marginal cost (including normal profit) and there will be no producer surplus. If the slot constraint bites and secondary slot trading is introduced, two mechanisms play a role in affecting welfare (Mott MacDonald, 2006): A move along the demand curve as a result of an increase in the capacity supplied for an existing route type. This change in supply results in a shift of price P, i.e., the generalised cost of travel time and travel cost. Consumer welfare increases owing to a combination of price reduction for existing consumers (rectangular area between the two price lines) and the attraction of new passengers now willing to pay the lower price (the triangle between the two price lines). The producer surplus falls as a result of the same rectangular area since existing passengers pay less per flight. However, producer surplus also increases as a result of the shift of the supply curve to the right, but only after compensation of the slot price paid to increase the volume supplied (see Figure 3.2). 5 Consumer surplus is derived from the value of output to the consumers, as indicated by their willingness to pay for different levels of output (demand curve), less the value paid in terms of generalised costs to the airlines. Producer surplus is equal to the price earned, less the value they require, as reflected by their willingness to sell at different levels of output (supply curve). In the airline industry, the supplier frequently applies price differentiation using a yield management system enabling him to cream the consumer surplus and add it to the producer surplus.

27 THE CURRENT SLOT-ALLOCATION MECHANISM IN EUROPE 19 Figure 3.2. The impact of buying slots on social welfare resulting from a movement along the demand curve Source: Mott MacDonald 2006 Figure 3.2 illustrates that there is a shift from producer surplus to consumer surplus, which does not affect net social welfare. However, social welfare increases owing to the additional consumer surplus of new passengers. Whether social welfare also grows as a result of additional producer surplus depends on the price of the slots. Furthermore, a shift of the demand curve occurs owing to a change in the mix of flights (new destinations, for example, or greater frequency on existing routes, making them more attractive in terms of generalised costs). If the demand curve shifts out, then it is possible that the price P will not move at all. In this case, the additional consumer surplus resulting from the demand curve shift fully contributes to a social welfare increase. The producer surplus may be positive as well, but this depends on the slot price (see Figure 3.3; source: Mott MacDonald, 2006). Figures 3.2.and 3.3 illustrate the impact of slot trading on social welfare as far as slots are bought and new flights are supplied as a consequence. This, however, also requires the selling of slots, resulting in a decrease in the number of other flights. If we assume that the producer surplus of the selling airline is zero before the slot trade, the L-shaped supply curve will move to the left and the price will increase. This implies a transfer of consumer surplus to producer surplus with respect to the demand remaining in the market. Social welfare will diminish, however, for the loss of consumer surplus in the triangle under the demand curve owing to the reduction in demand. All in all, slot trading results in social welfare growth owing to a net increase in consumer surplus and possibly a net increase in producer surplus.

28 20 CHAPTER 3 Figure 3.3 The impact of buying slots on social welfare resulting from a movement of the demand curve Source: Mott MacDonald Conclusions The EC believes that a slot-allocation system should result in efficient use of airport capacity and facilitate competition at Community airports. To that end, it may want to reform the current slotallocation mechanism and introduce mechanisms which are more market based, since the current system is not believed to result in an efficient outcome from a social welfare perspective. It may be concluded that the current system of slot allocation in Europe is not able to comply fully with these objectives. At the congested airports, the current system is likely to restrict slot mobility because of grandfather rights and because the opportunity costs of slots are lacking. This results in airlines holding on to slots because their real market value is not felt. Moreover, with respect to the competition objective, the new-entrant rule has not proven to be effective, and leaves few opportunities for mid-sized carriers to grow. Since trading is not possible, airlines are not faced with the opportunity costs of slots. Hence, the airline using a slot is not always the airline that attaches the highest value to it. This can be seen as an inefficient use of airport capacity. Formally, the slot coordinator is responsible for the allocation of slots in a transparent, neutral, and non-discriminatory way. It is extremely difficult, however, for the coordinator to judge who can use the slot most efficiently. By internalising the congestion costs of an airport in the pricing system, the scarcity of the slots involved can be matched by the willingness-to-pay of the bidding airlines. In that case, priority rules of the slot coordinator can be substituted by the pricing system in a more efficient way. Note, however, that we discussed social welfare impacts only from the point of view of slot efficiency. Other impacts should be considered as well to enable final conclusions to be drawn on social welfare improvements. For example, slot trading may have a negative impact on airline competition at a congested airport owing to reduced opportunities for new entrants or increased hub dominance of an incumbent carrier. Furthermore, improved productive efficiency may not

29 THE CURRENT SLOT-ALLOCATION MECHANISM IN EUROPE 21 only result in positive impacts on social welfare: larger aircraft and longer flights per slot may also generate additional negative external environmental and noise effects.

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31 THE IMPACT OF SECONDARY SLOT TRADING AT AMSTERDAM AIRPORT SCHIPHOL 23 4 The impacts of secondary slot trading 4.1 Introduction In section 3.2.4, we concluded that the slot-allocation mechanism currently used at slot-congested airports does not necessarily contribute to an efficient outcome from a social welfare perspective. In line with this conclusion, the European Commission has stated that it aims to reform the current slot-allocation system and introduce a market mechanism in the slot market (Gremminger 2006). Various mechanisms are available to allocate slots, which are based on a reflection of their value as a scarce resource: slot pricing, primary slot trading (slot auctioning) and secondary slot trading. In this study we considered only secondary trading of existing slots and, as a possible alternative, secondary trading together with primary trading of newly created slots. Both primary trading and secondary trading allow users with the highest willingness to pay to receive the slot and, therefore, guarantee an efficient allocation. The basic difference between primary trading and secondary trading is that secondary slot trading is a secondary mechanism to improve the initial allocation of airport slots, initially allocated either administratively or through primary trading (Figure 4.1). To what extent does the introduction of a market mechanism in the slot market achieve these objectives? And what are the likely impacts of such a mechanism? This chapter gives an overview of the current state-of-the art knowledge on the impact of secondary slot trading as a market mechanism. The focus of the impact study was on the three most important objectives of the EC: to enhance slot mobility, to improve efficient use of airport capacity, and to increase competition. At the end of this chapter the value of slots is addressed in more detail. Figure 4.1 Primary and secondary markets Primary allocation Secondary allocation Regulator, airport, slot coordinator Airline A Airline B Source: adapted from Czerny & Tegner 2002, p.4

32 24 CHAPTER Impacts of slot trading Impact on slot mobility Slot mobility is not an aim in itself, but a means to achieve a more efficient use of airport capacity and to promote competition. In the many studies conducted on secondary trading, slot mobility is expected to increase as slot mobility to increase as airlines were faced with the opportunity costs of their slots, i.e., the revenue foregone by not trading the slot. If the secondary market is sufficiently free of constraints, the level of slot mobility can be expected to depend on the efficiency of the allocation of airport capacity. The larger the allocation inefficiencies in place, the larger the corrective power of secondary trading can be. In addition, NERA (2004, p. 138) expects those airlines that are most cost conscious to respond more readily to opportunity costs of slots. NERA (2004, p.143) expects the number of scarce slots traded each season to be around 5 to 10 percent 6. NERA estimates that, in 2007, such activity will have an ongoing cost of 0.02 per passenger and 0.05 per extra passenger generated by secondary trading in 2007 for EU Category 1 airports. A number of constraints may reduce slot mobility in the secondary market; that is, the willingness of airlines to buy or sell slots. In many cases there is no necessity for airlines to trade slots. They may simply continue to use their slots and forego the revenue that could have been earned by selling some of their slots (NERA 2004, p. 135). There are several reasons for an airline to hold on to slots: Airlines attach a high value to the slot relative to its opportunity costs. Airlines may view the continued use of a slot as an asset holding and recognise the option value of the slot as a result of delaying any sale of the slot. Delaying the sale gives the airline flexibility in the light of future network developments and changes in the prices of slots This applies mainly to airlines in a comfortable financial position (NERA 2004). If airlines pursue non-profit objectives, they may hold on to unprofitable slots because, for example, they are operated at prestigious airports. Holding on to slots may not be a deliberate action. Airlines may have overly optimistic views about their ability to increase route profitability. Imperfect information: airlines may not be aware of the presence of potential buyers of their slots, with the result that potentially beneficial trades do not take place. A formally organised market ( slot exchange ), publication of realised slot prices, and the presence of intermediaries can reduce this constraint. In addition, if airlines underestimate the value of their slots, they may not want to sell. This may apply in particular to airlines with small operations at an airport. There may be an unwillingness to trade with competitors. Yet, in the long run, it is unlikely that an airline could prevent its competitor from obtaining slots (NERA 2004). First, it is likely that substitute slots are available for the competitors. Second, a non-competing buyer may sell the slot to a competitor in a later stage. 6 However, Mott McDonald has pointed out that the actual number of traded slots at Heathrow is lower.

33 THE IMPACTS OF SECONDARY SLOT TRADING 25 Airlines may not have necessary aircraft equipment to use the slot. Airlines may not want to trade because of uncertainty with respect to the stability of the slot regime. For the above and other reasons, airlines may be unwilling to buy slots on the secondary market: they may attach a low value to a slot relative to the opportunity costs of not buying the slot, they may have inadequate information about the secondary market to identify potential sellers, they may hesitate to buy slots in case of potential airport capacity expansion plans (slot value would drop), or they may not be able to use the slots owing to a lack of a suitable aircraft to fly the routes. In addition, large slot holders may have sufficient flexibility within their own schedules to obtain the necessary slots by reducing frequency elsewhere in their schedules Impact on competition How may secondary trading affect competition, according to existing findings? Market concentration concerns The European Commission states that a system of secondary slot trading facilitates access to the market and has the potential to have pro-competitive effects. It is widely recognised, however, that there is a risk that private benefits (to airlines) might include excessive profits for airlines resulting from distortions of competition, which would tend to reduce rather than enhance social welfare (DotEcon 2001; Gremminger 2006). There is a risk that slots would become concentrated amongst relatively few carriers. A high level of market concentration is likely to translate into higher airfares for consumers (Borenstein 1989; Lijesen 2004). For example, looking again at the US experience, a number of researchers state that the buy-sell rule in the US appears to have had the effect of reinforcing the dominant position of leading airlines and leading to higher average airfares (Pagliari 2001; Starkie 1998) (see also section 5.2). Why would secondary trading result in market concentration concerns? Larger carriers are in a much stronger position financially to acquire existing slots from other airlines. New destinations and frequencies at a hub generate substantial network economies for the hub carrier. Newcomer airlines are not able to generate such network effects and for this reason their willingness to pay for a slot at a congested hub airport is bound to be lower compared to that of established airlines (Czerny & Tegner 2002). In addition, the more profitable incumbent airlines are likely to be able to expand their slot shares. According to the findings of Sened and Riker (1996) (in Czerny & Tegner 2002), the higher the percentage of occupied seats in each of its planes, the more likely a carrier was to purchase new slots. 7 The secondary slot market will lead to an efficient outcome only if certain conditions, in particular with respect to a large number of buyers and suppliers, are met (Lévêque 1998). At congested hub airports where the home carrier has a dominant position (for example, at Frankfurt, Amsterdam, and Paris CDG), the dominant carrier may strategically try to obtain more slots to limit competition. This is because the opportunity costs of a slot for the home carrier not only cover the foregone benefits of not trading the slot, but also include the reduced revenue 7 For the period for Washington Dulles and Chicago O Hare.

34 26 CHAPTER 4 resulting from increased competition from the slot buyer (Lévêque 1998). So the dominant airline may use slots inefficiently to limit downstream rivalry (CAA/OFT 2005, p.12). Dominant carriers might pursue discriminatory practices among potential buyers of the slot (Gremminger 1996; Lévêque 1998). A dominant carrier might: Not want to sell to carriers it is competing with. However, this is not an effect of secondary trading itself, but of the dominant position the hub carrier built up before the introduction of secondary trading (CAA/OFT 2005, p. 12). Sell only at excessive prices. According to CAA/OFT, an observed high price may also reflect scarcity rents when demand for flights is high relative to capacity. Scarcity rents are reflected in the price of a slot. That a potential new entrant does not want to purchase at this price does not mean anti-competitive behaviour is taking place. Include non-compete clauses. Sell only at unattractive times or to certain airlines. Sell at higher prices to stronger competitors. Sell on condition that the buying airline uses other services of the seller. The outcome depends to a large extent on the characteristics of the airport involved (traffic structure, number of airlines selling and buying) and on how the slot market is organized. Considerations The issue of market concentration is not as clear-cut as first appears. A number of factors should be considered: the definition of competition, an efficient level of competition, and empirical evidence on increasing slot concentration. First, it is important to define the relevant market when analysing competition levels. Is it the relevant market at the airport level that is important, or that at the route level? Say that hub X has 4 carriers with a 25% market share at the hub but with a monopoly at all routes they serve. Now, consider hub Y with 4 carriers, again with a 25% market share at the hub, but competing vigorously at each of the routes each airline serves. Is it competition at the airport level or at the airport system level that counts? Services from one airport may to some extent substitute for services from another airport, and the potential of anti-competitive behavior at hubs might be overstated (CAA/OFT 2005; Sickmann 2006). Moreover, is it the intra-hub competition that is important, or the inter-hub competition? Consider, for example, KLM having a monopoly on a direct, long-haul route from Schiphol, but encountering fierce competition from Lufthansa, which serves the same route indirectly via its hub in Frankfurt. In short, the level at which overall hub dominance is passed on to consumers depends also on the interaction between hub dominance and route dominance, the presence of a multi-airport system as well as the presence of inter-hub competition. In line with DotEcon (2001), we conclude that it is, therefore, difficult to use simple quantitative limits on slot holdings to control for market power. This is particularly true when attention is paid to the definition of the optimal level of competition (see below).

35 THE IMPACTS OF SECONDARY SLOT TRADING 27 Second, it is important to consider the optimal level of competition. Pagliari (2001), Starkie (1998), and the European Commission (Gremminger 2006) doubt if new, large-scale entry at capacityconstrained hub airports is desirable from an economic efficiency perspective. The immediate effect of entry in oligopolistic and monopolistic markets is that the increased capacity offered by new services depresses the load factors of incumbent airlines in the short to medium term. Is over-capacity at the route level efficient while the airport s slots are in short supply? In addition, a concentration of slots at hubs in the hands of a few airlines is beneficial to society: connectivity externalities increase the value of the network for the consumer (Starkie 2006). On the supply side, network economies of hubs result in cost advantages. On the demand side, they result in more direct destinations, higher frequencies, and shorter transfer times. For transfer passengers, hub domination may be beneficial since they prefer online to interline connections (between different carriers). 8 In a hub network, however, passengers at the spokes have fewer direct services, longer journey times, and the inconvenience of changes of flights. Moreover, there is evidence that the domination of airport slots by the hub carrier do translate into higher airfares (hub premiums) at local routes (Borenstein 1989; Lijesen 2004). At dominated hub airports, furthermore, 2 nd -tier carriers may be much better able to provide effective competition to the dominant hub carrier than a range of smaller (new-entrant) carriers. Hub domination may pose fewer problems if strong 2 nd -tier carriers operate from the airport and can use the secondary trading system to increase their slot holdings. Because of the so-called Scurve effect (see footnote 3, p.16), small operators tend to receive a smaller share of passengers relative to their share of flights, and larger operators a larger share of passengers relative to their share of flights. As one airline representative stated in an interview: 9 Look for example at London New York. It s not about allowing 8 new airlines to fly on this route; it s about increasing competition with BA, with their huge slot portfolio and their operating 10 flights a day to New York. We [airline] provided them with decent competition and now we re flying 6 times a day, because of the slot trading. Without slot trading we would be operating a maximum of 3 or 4 flights a day. The new-entrant rule allows new carriers to fly on a particular route, but it doesn t establish a better position for the 2nd or 3rd carrier. The current new-entrant rule in combination with grandfather rights leaves few opportunities for such airlines, potentially effective competitors, to increase their slot holdings in the current EC Regulation: We only have like 3% of the slots at Heathrow and 2% at Gatwick. We are too big to get anything out of the new-entrant rule. We are at such a disadvantage. We think we would do better out of that process than the current one. 10 Third, although it is generally agreed that increasing hub domination leads to higher average airfares, the relationship between the introduction of secondary trading and growing hub domination is not clear-cut. Kleit and Kobashi (1996) found no evidence of slot hoarding by dominant carriers to prevent low-cost entry. In line with their conclusions, McGowan and 8 In theory, concentration is not a conditio sine qua non for connecting services. However, service quality improves if transfer times are minimised. Owing to information asymmetries between airlines, it is not possible for each airline to know the necessary details of other carriers networks so as to minimise transfer times. 9 Interview with an airline representative. 10 Interview with an airline representative.

36 28 CHAPTER 4 Seabright (1989) concluded that airlines with market power do not engage in predatory bidding for slots to preempt competition. In a financially difficult market, it is an unnecessarily expensive way to drive out competitors. Incumbents with market power are more likely to direct entrydeterring behaviour to the route-specific service they operate (by means of predatory pricing of services) than to hoard slots. 11 Overall The overall impact of secondary trading on competition seems to be a mixed blessing. NERA (2004, p. 143) expects that hub carriers and their alliance partners will indeed increase their slot holdings at congested airports. However, strong competitors will also increase their holdings. These competitors can be divided into two groups. First, there may be scope for the entry of competitive long-haul carriers on particular routes, in particular at congested airports with highdensity catchment areas. These carriers may be able to benefit from the withdrawal of less valuable slots used for short-haul and less profitable long-haul services. 12 Such 2 nd -tier carriers may be able to provide effective competition to the dominant carriers. Second, there may be scope for low-cost airlines. Cost-minimising low-cost carriers (such as Ryanair) generally choose uncongested, secondary airports for their operations. Yet, more yieldoriented low-cost carriers such as easyjet compete directly with full-service airlines at the major airports. This is mainly the case at congested non-hub airports and hub airports where there are no other airlines which value the slots more highly than the low-cost carrier. From the literature review, it clearly follows that concentration concerns should be taken into account when introducing a secondary trading regime in Europe Impact on the efficient use of airport capacity Legitimisation of a monetary secondary trading market in slots offers scope to stimulate efficient allocation of scarce airport capacity by confronting the use of grandfather slots with the true opportunity costs of slots held (Matthew & Menax 2003, p. 10). The allocation of slots will increasingly reflect the willingness of the airlines to pay. It has been stated already (in section 3.2.4) that, from the point of view of social optimal use of airport capacity, slot trading is a step forward since the congestion costs will be internalised in the market price. Slot trading, therefore, contributes to a more efficient use of airport capacity, be it partly, since other steps with respect to other external costs have to be taken as well. Secondary trading is likely to have the following effects, which can be considered indicators of a more efficient use of airport capacity: 13 Increasing use of larger aircraft: secondary trading leads airlines to use larger aircraft 11 This is because the slots are much closer substitutes than the services themselves. The predatory airline would need to overbid a large number of slots to drive out competition. 12 The value of a slot purchase for a dominant (hub) carrier is related to the value of its least profitable existing service at those slot times. It must consider redeploying slots within its own portfolio. A nondominant carrier does not have alternative slots. Therefore, non-dominant long-haul carriers may value slots more highly. The Heathrow market supports this. It is telling that BA has been consistently outbid for slots since competition for slots increased. 13 These expectations are supported by the UK experience (section 5.1).

37 THE IMPACTS OF SECONDARY SLOT TRADING 29 Increase in the number of long-haul routes for valuable slots, since the value of the use of the slot per passenger kilometer is higher. As one airline representative 14 put it, If you spend 10 million pounds on a pair of slots, it s much easier to get that money back on a long-haul flight than, for example, on a flight from London to Paris. Higher passenger throughput per slot: NERA (2004) modeled different forms of slot allocation. NERA expects secondary trading to result in an increase in passenger numbers of 4% at Europe s category 1 airports (NERA 2004, p. 142). Better utilisation of slots during the day: airlines with a lower willingness to pay may shift their operations to off-peak times. Some remarks should be made in this respect. First, if airport capacity is scarce and slots can be traded between airlines or non-airline entities, there is a risk of speculation -for example, by anticipating the opportunity to bundle a set of slots and thereby increasing the slot prices- which might stimulate inefficient use of airport capacity. For this reason, Stockmann (2006) argues that it is important that no third parties be allowed in the trading system and that whoever buys slots shall have the obligation to use them for a minimum of two schedule periods. Second, if primary allocation remains unchanged, including the new-entrant rule, secondary trading will result in windfall profits for new entrants. When new chunks of airport capacity become available and are allocated for 50% to new entrants, these airlines will be able to sell their slots to others after a few years without having paid for them. 15 In addition, when these new entrants start to use the slots, they are not necessarily the most efficient users. An important issue with respect to the efficient use of airport capacity is the definition of a slot. If a slot remains a usage right in a possible new Regulation of the Commission which introduces secondary trading, the new slot regime will simply build on the current regime. If, however, a slot is defined as an ownership right, the question arises whether the use-it-or-lose-it rule can be maintained. If a slot is owned by an airline, a carrier should also be free to use its slot over a shorter period of time. This brings into question the use-it-or-lose-it principle in relation to the efficient use of airport capacity. Finally, efficient use of airport capacity is not necessarily the most efficient use from the perspective of each individual (group of) airlines or individual (group of) consumers. From the point of view of a Pareto optimum, the possibility always exists that the welfare position of some individuals or groups will deteriorate while that of others improves. However, the net welfare becomes optimal for society. For example, as a consequence of the introduction of slot trading, market failures may emerge in other markets, for example, the air transport markets. In that case, some airlines may be able to generate monopoly power and reduce competition with other airlines, which would tend to reduce rather than increase social welfare. This also explains how secondary trading may affect the welfare of some individual consumer groups negatively: for example, those living in peripheral regions would no longer be provided with air services unless the traded price of envisaged slots were included in a PSO regime. We refer to section for a 14 Interview with an airline representative. 15 Interview with an airline representative.

38 30 CHAPTER 4 discussion on the efficiency of dominated hub airports, and to section for a discussion on consumer impacts Impacts on airlines and airline networks Impacts on hub carriers A potential response for a hub carrier when faced with increasing opportunity costs of slots is to move flights outside the waves, or widen the waves. Scope to do so is limited, however, as such actions would leads to longer transfer times and loss of transfer passengers. Nevertheless, the depeaking strategies of American Airlines at Dallas and Lufthansa at Frankfurt show that opportunities do exist to widen the banks. Furthermore, hub carriers have limited opportunities to sell the slots they use for short-haul services. Unless the slots concern services with primarily OD demand, short-haul services are needed to generate sufficient demand for long-haul flights. Instead, hub carriers can be expected to increase their slot holdings when excess demand for slots restricts them in acquiring new slots in the current slot-allocation system (NERA 2004, p. 86). Given the network value attached to each new service, hub carriers can be expected to have a relatively high willingness to pay. The experiences with BA at Heathrow and at the high-density airports in the US support this hypothesis (Chapter 5). Potential impact on short-haul services other than those of the home carrier and partners Feeder services that feed hubs at the other end of the route (AMS-FRA by Lufthansa, for example) can be expected not to change radically as a result of secondary trading. The value of the slots is relatively high owing to the contribution to the entire network. Opportunities for offpeak frequency cuts might exist (NERA 2004, p. 83) as the carrier can decide to concentrate on the services in its wave-system (peak period) using larger aircraft. Potential impacts on low-cost carriers and charters There may be scope for low-cost airlines. Cost-minimising low-cost carriers (such as Ryanair) generally choose uncongested, secondary airports for their operations. Yet, more yield-oriented carriers such as easyjet compete directly with full-service airlines at the major airports. This is mainly the case at congested non-hub airports and hub airports where there are no other airlines which value the slots more highly than the low-cost carrier, and which are attractive OD markets. NERA (2004) expects yield-oriented low-cost airlines to be able to increase their slot holdings at airports other than hyper-congested airports, such as Orly, Gatwick, and Vienna. In general, charter airlines are less captive in a geographical and temporal sense than the hub carrier and its partners. They may change their home base more easily to another airport, in particular when the coordinated airport involved is part of a multi-airport system. When faced with the opportunity costs of their slots at congested airports, charter airlines may decide to cash in and re-allocate their flights to other airports in the system, or even move to off-peak hours. Potential impacts on long-haul airlines other than the home carrier and its alliance partners There may be scope for the entry of competitive long-haul carriers on particular routes, in particular at congested airports with large catchment areas. These carriers may be able to benefit

39 THE IMPACTS OF SECONDARY SLOT TRADING 31 from withdrawal of less valuable slots used for short-haul and less profitable long-haul services. The value of a slot purchase for a large home (hub) carrier relates to the value of its least profitable existing service at those slot times. It must consider redeploying slots within its own portfolio. A non-dominant carrier does not have alternative slots. Hence, non-dominant longhaul carriers may value slots most highly. The Heathrow market supports this. It is telling that BA has been consistently outbid for slots since competition for slots increased. Potential impacts on regional carriers Since regional carriers generally use smaller aircraft on shorter distances for flights which are generally operated at peak times, the opportunity costs of their slots are high compared to the value of those slots. Regional carriers operate flights at peak times because, first, the business travel peaks generally coincide with the peaks of the hub carrier. Second, regional carriers benefit from traffic feed to and from the hub carrier s services in the peak periods. Given their dependence on the peaks and the hub carrier, there are few opportunities for regional carriers to move their operations to off-peak hours. One might expect existing regional carriers not to sell their slots or to disappear completely from congested hub airports, depending on the slot prices. Other impacts Trading of existing slots may lead to so-called windfall profits for established airlines: they obtained scarce slots through grandfathering without making an adequate payment. The introduction of slot trading causes money to be automatically donated to established airlines; new entrants who have to pay for their slots are discriminated against (Stockmann 2006). Moreover, when new chunks of airport capacity become available and are allocated for 50% to new entrants, these airlines can sell their slots to others after a few years without having paid for them. In addition, secondary trading can be expected to lead to a slight increase in business-planning costs. First, there are operational questions: secondary trading leads to complexity in the scheduling process: a newly acquired slot is only valuable for an airline if it can obtain a matching slot at another arrival/departure airport. This is more difficult for small airlines with smaller slot portfolios, and thus with less internal schedule flexibility, than for larger airlines with large slot portfolios (Barbot 2004; Geens 2006). Second, proposed transactions would need to be subject to a financial valuation (NERA 2004). NERA (2004) expects transaction costs associated with high-value trade to be of the order of 1 percent of the value of the trade. (see also Table 4.1) Stockmann (2006) has expressed the fear that opinion on airport-capacity expansion might change after secondary trading has been introduced and airport congestion has further increased. Until now, airlines have been in favour of extending airport capacities with the goal of creating more slots. Secondary trading might change this, as growth in the number of slots will reduce the value of their slot portfolios. Finally, slots are allocated from the pool no more than 5 months before the start of the season. Aircraft orders have lead times of months. Airlines cannot bid for slots without an aircraft, but it is difficult to commit to the purchase of an aircraft without certainty regarding the availability of the slot. For large airlines with large slot portfolios, this problem is manageable, since they have sufficient flexibility within their portfolios. The problem is greater for smaller airlines. Baby-sitting is then the only option.

40 32 CHAPTER Impact on consumers Effects of slot trading on the consumer appear to be quite diverse. Referring to the earlier discussion on the Pareto optimum, the welfare of some groups or individuals may worsen under optimal pricing conditions. The optimal use of airport capacity, for example, implies selective use of available slots. This means the substitution of some air routes by other air routes that favour a number of travelers over other travelers. CAA (2006) indicates that passengers benefit from airlines offering services and routes that most closely match their preferences and willingness to pay. A system of slot trading is the best way to ensure that slots go to the airlines that will meet passenger needs best. For example, if traffic rights are available, consumers will benefit from more long-haul services, as a slot-trading regime stimulates a shift from short-haul to long-haul operations, generating a larger consumer and possibly also producer surplus. NERA (2004) underlines the consumer benefit from slot trading, as it results in decreasing fares and increasing service levels owing to more competition from second-tier, long-haul, full-service carriers. Secondary trading can, therefore, be expected to exert a downward pressure on fares. However, the perspectives for new entrants under a slot-trading regime and their positive impact on competition should not be exaggerated. For example, the positive competitive impact NERA (2004) expects from improved slot holdings of yield-oriented low-cost carriers (see above) is likely to remain limited, referring to the willingness to pay of, for example, long-haul operations of the hub carrier. A contrary effect on competition levels may, therefore, become even stronger if not countered by the competition authorities: secondary trading allows incumbent airlines to create or enhance a dominant position at the airport. A dominant position may lead to abuse of monopoly power, resulting in higher fares and lower service quality. This is, however, not an inevitable consequence of slot trading. It can be countered by adequate (European) competition policy and close market investigation on a case-by-case basis. Nor is the relationship between market concentration, secondary trading, and a negative outcome from a social welfare perspective straightforward, as discussed in section Besides these general considerations, specific groups of consumers may be negatively affected by slot trading, i.e., customers in remote areas, mainly dependent on travel by air. (Clarke 2006). These customers may be the losers of secondary trading. However, secondary trading does not interfere with the right of governments to impose a Public Service Obligation. In that case, the slot price would become an indispensable part of the PSO arrangement. Consumers can further benefit from slot trading if this regime is applied at an airport that is part of an airport system serving the same region, but only if congestion levels substantially differ between the various airports in the system. In that case, operators with a lower willingness to pay are likely to move to less congested or secondary airports in the system, like regional and charter services, and low-cost carriers. In this respect, a liquid secondary market helps the operation of an airport system, as it makes it easier for airlines to switch services between airports (NERA 2004, p. 133). The other way around, a multi-airport system helps to maintain (part of the) service

41 THE IMPACTS OF SECONDARY SLOT TRADING 33 levels to regional or charter destinations as secondary trading may force these services out of congested airports. In that case, the consumer continues to have access to the same wide range of air transport services in his region, but the different operations are provided at the various airports according to the willingness to pay of the operators involved and the congestion levels at the airports in the system The environment Although secondary trading does not necessarily conflict with environmental limits at airports, it has little or no scope to pursue environmental objectives (NERA 2004, p. 133). Slots are traded according to the highest willingness to pay of the bidding airlines. In these circumstances, it is likely that long-haul services with larger aircraft will be preferred (see, for example, section 5.1on the UK experience). Average aircraft size, therefore, is probably stimulated by slot trading. This may imply increased noise and emission levels given the same number of slots, although the noise category of the aircraft types used are, of course, also important in this respect. Ewers et al. (2001) also argued, c.f. that the introduction of market mechanisms in slot allocation would have a negative impact on the overall ecological performance of the air transport system, since market mechanisms stimulate profit maximisation of airlines through substituting shorthaul services by long-haul services. Mott McDonald (2006), however, concludes from modelling efforts that hydrocarbon emissions can be expected to increase, although not significantly, as short-haul flights are replaced by longhaul flights, whereas hydrocarbon emissions are expected to decrease, although not significantly, if market concentration by dominant incumbents takes place and if these incumbents employ cleaner aircraft than other market participants. Across Europe as a whole, secondary trading is expected to have a broadly neutral impact on hydrocarbon emissions. At the airport level, these emissions are expected to be reduced. Note, however, that the net effect of NO X emissions is not insubstantial since the effect of the switch from short-haul to long-haul flights is not compensated for by cleaner aircraft. Carbon dioxide emissions of larger aircraft and longer flight distances are only compensated for by cleaner aircraft when cargo aircraft are substituted by passenger aircraft. Therefore, a net increase of carbon dioxide emissions can be expected from the introduction of secondary slot trading. Finally, the net impact of slot trading on ambient noise is expected to be marginal and not of a noticeable amount, according to the estimations of Mott MacDonald (2006). Although it is expected in general that the introduction of slot trading will have a negative impact on noise and emissions, two arguments caution against the mixing of slot trading with environmental objectives. Firstly, according to NERA (2004), environmental measures should apply to all services, not only the slots traded on the secondary market. Environmental regulations on secondary trading would only affect the slots that happened to be traded in a particular year. Furthermore, it would be relatively easy for airlines to circumvent slot rules on dirty services, for example, by using the new slot for an environmentally-friendly service and using an existing slot for a dirty service. Secondly, this is an example of two conflicting policy objectives that require two different policy instruments to optimise them the Tinbergen principle. If slot trading is the instrument to stimulate efficient use of airport capacity, emission-trading schemes should be introduced to

42 34 CHAPTER 4 internalise the external emission effects of the air transport system and thereby optimise emission objectives, while noise-differentiated airport charges focus on noise-abatement objectives. 4.3 The values of slots What factors determine the value of slots traded in the secondary market, and what can be said of empirically observed slot values? According to Gillen (2006), the monetary value of a slot is influenced by a range of factors that may play a role in each individual case. The scarcity of a slot can be influenced, for example, by: The time of the day, or more specifically, whether it concerns a peak or an off-peak period; especially at larger hubs, connecting waves create strong traffic peaks and congestion periods, in which the value of a slot may increase substantially; The number of slots held and the adjacency of slots considered for trading; the availability of a slot enabling a carrier to create a series of slots may create additional value. Use restrictions at an airport, for example, night curfews, may result in limited capacity and increased slot scarcity. ATC constraints may reduce hour capacity and thereby scarcity of slots during the same period. Airline regulation or airline deregulation may result in frequency competition increasing the demand for slots, but also market access of new entrants owing to deregulation may require substantial series of slots that put an upward pressure on the value of the slots envisaged. The availability of neighbouring airports and spare capacity may relieve the upward pressure on slot prices The perspective of capacity expansion (the planning of extra runways and taxiways, for example) may reduce slot prices in anticipation of reduced scarcity of airport capacity. Actual or expected growth acceleration of transport demand can put upward pressure on slot prices. New route rights put extra pressure on the designated carrier to start operations to the new destination. Especially a hub carrier will try to find extra slots within the connection waves. The role of intermediaries, for example, financial institutes leasing series of slots, may directly influence the price, and may also have an indirect influence by keeping extra slot inventories and thereby increasing slot scarcity. 16 Accessibility to the apron/gates. Often the value of the slot is determined not only by runway capacity but also by the scarcity of gates and jetties (see Table 4.1). 16 An additional advantage of the ability of US airlines to buy and sell slots on the secondary market is the possibility of using the slot portfolio as collateral for loans, mortgages, and other financial facilities (Mott MacDonald 2007, p.5-31). For airlines, the slot portfolio can be a way out of bankruptcy.

43 THE IMPACTS OF SECONDARY SLOT TRADING 35 This non-exhaustive enumeration of possible influences clearly illustrates that the drawing of generic conclusions on the value of slots is impossible. Each individual market situation and individual set of influences determines slot prices. Financial valuation of slots Gillen (2006) points to various methods of valuating a slot or a set of slots, including: - Market price valuation, using an average price per slot by time period based on a number of individual factors mentioned above. Market value studies resulted in 4-6 million per slot at London Heathrow and $ 1 million per slot at DCA, though the values were much lower for commuter slots. - Earning potential valuation, based on stage length, yield, and average RPK per movement. This income approach value when a slot was leased when a slot was leased resulted in $ 114, ,000 per slot at LGA and $ million per slot at DCA. - Operational network opportunity values, i.e., the network contribution of the flight concerned. In particular in hub-and-spoke systems, the total revenue of a single spoke depends on the revenues from the consecutive legs. Table 4.1 illustrates some market prices realised for slots in the past in the US and in Europe (UK). In addition to this list, Balfour (2004) reports 40 million for six slot pairs in Heathrow in the case of Air UK/KLM UK s transfer to British Airways in Table 4.1 Prices realised for slots in the past Date Airline Airport Number of slots Cost (millions unless noted) 1990 UA National 14 $ AA LaGuardia 14 $ DL National 9 $ DL LaGuardia 7 $ DL Hatsfiled 18 $32.50 (Eastern) 1991 UA ORD 21 slots, 3 gates $ CO LaGuardia 64 (6 A380) $ USAirways LaGuardia 62 jet, 46 commuter $ USAirways National 6 $ UA LHR? $ AA LHR? 18 per slot 1992 AA ORD gates $ BA LHR 8 $ BA Gatwick Cityflyer purchase VA Gatwick 7 2 per slot 2000 CO LHR 119 jet commuter $215 (offer) 2001 AA TWA 173 $500

44 36 CHAPTER 4 Table 4.1 Prices realised for slots in the past (continued) Date Airline Airport Number of slots Cost (millions unless noted) 2001 AA USAirways 36, 14 gates, 66 aircraft, 20 $1.2 B leased aircraft 2001 VA Gatwick M 2002 BA LHR BA LHR BA Swiss loan 8 slots at LHR BA LHR Alitalia CDG Gandolf Co 7.1 M 2004 Qantas LHR 2 pair VA LHR 4 pair from Flybe? 2004 AirTran National, 14 gates + 8 slots National, $87.50 LaGuardia 19 slots LaGuardia 2004 SWA Chicago airports, National and LaGuardia 6 gates + slots $ Republic Holdings Source: Gillen (2006) National, LaGuardia 113 National, 24 LaGuardia $ Conclusions Conclusions from the literature review Above, we have given a state-of-the-art literature review with respect to the likely impacts of secondary slot trading. A number of conclusions can be drawn from this review. Slot mobility First, we conclude that slot trading introduced opportunity costs to slots. Secondary trading increases slot mobility as airlines are faced with the revenue foregone by not trading slots. In addition, airlines formerly not able to acquire slots are now able to increase slot holdings at congested airports since monetary compensation is allowed when transferring slots from one airline to another. A number of factors may limit the scope for slot mobility in a secondary market, including the following: Airlines may hold on to slots in order not to trade with competitors. An insufficiently transparent market is likely to lack liquidity as potential buyers and sellers are unable to identify each other. Transparency is, therefore, an important issue in the design of a secondary trading mechanism. Lack of slot mobility under secondary trading can simply reflect a lack of need to trade because there is market equilibrium (airlines attach a high value to the slot relative to its opportunity costs) The risk exists of decreasing slot values if airport capacity is expanded, which can only be countered by the introduction of primary trading (see Chapter 6)

45 THE IMPACTS OF SECONDARY SLOT TRADING 37 Airlines may delay the sale of slots as they give the airline flexibility for future network developments. Airlines may not want to trade because of uncertainty in relation to the stability of the slot regime. Competition Second, secondary trading facilitates access to the market for airlines with a high willingness to pay. Secondary trading, therefore, has the potential to enhance competition. It is widely recognised, however, that there is a risk that private benefits (to airlines) might include excessive profits for airlines resulting from distortions of competition, which would tend to reduce rather than enhance social welfare (DotEcon 2001; Gremminger 2006). There is a risk, therefore, of slots becoming concentrated amongst relatively few carriers and of opportunities becoming limited for new entrants. A high level of market concentration is likely to translate into higher airfares for consumers. In the US, domestic slots at congested airports became concentrated among a few hub carriers under the regime of secondary trading. A premium on the airfares was the result (see Chapter 5). Other researchers, however, have expressed doubts about the inefficiencies of market concentration: a high level of market concentration can also reflect the network economies of the hub-and-spoke system, i.e., allocative efficiency. The way market concentration concerns are dealt with under a regime of secondary trading is, therefore, an important issue in the design of the trading mechanism. Efficient use of airport capacity Third, legitimisation of a monetary secondary trading market in slots offers scope to improve the efficient allocation of scarce airport capacity by confronting the use of grandfather slots with the true opportunity costs of slots held. From the point of view of social optimal use of airport capacity, slot trading is a step forward because congestion costs are internalised in the market price in a marginal sense. The efficient use of airport capacity is likely to be demonstrated through larger average seat capacity for traded slots, longer average stage length, and better slot utilisation throughout the day, i.e., productive efficiency. Other impacts Fourth, slot trading is an additional instrument in an airline s strategic toolbox that adds flexibility to its network strategy. Airlines do not necessarily have to use this tool; they can simply continue to use their slots. Within the heterogeneous airline portfolio of congested airports, hub carriers are likely to increase their slot holdings in the peak as they have the highest willingness to pay and the deepest financial pockets. Second-tier long-haul carriers can also be expected to increase their slot portfolio. Low-cost airlines, charters, and regional carriers are more likely to move their operations to off-peak hours or non-congested airports, and may have limited opportunities to buy slots in peak hours since their willingness to pay is lower than that of other airlines. Finally, airlines that already have slots may benefit from so-called windfall profits: when slot trading is introduced, money is donated to established airlines, whereas new entrants who have to pay for their slots are discriminated against. Fifth, for consumers, the effects of secondary trading seem to be quite diverse. On the one hand, secondary trading may reduce airfares through enhanced competition and may reflect more

46 38 CHAPTER 4 closely passenger needs with respect to the network on offer. On the other hand, secondary trading may exert upward pressure on airfares through market concentration, or leave consumers in peripheral regions without air service at all. For the latter, national governments may impose a Public Service Obligation to mitigate these negative impacts. Finally, secondary trading is likely to have an environmental impact because it influences traffic mix and aircraft size. However, it is not a suitable mechanism for mitigating environmental impacts: secondary trading is a mechanism that helps to internalise congestion costs in the market price in a marginal sense. It is not a mechanism that helps to internalise the marginal environmental costs Additional regulation As follows from the previous section, market concentration is related to an insufficiently transparent market, and windfall profits seem to be critical issues in the design of a secondary trading system. How can a new EC regulation on secondary trading deal with these and other issues? Slot mobility To optimise slot mobility, it is of paramount importance to create a stable system, i.e., a trading system in which the rules are not easily changed. Airlines would become less and less willing to purchase slots if it became possible for a change in the trading system to affect the value of the slots, either upwards or downwards. In the first case, sellers would keep their slots until prices were expected to increase as a result of a system change. In the second case, buyers would wait to purchase slots until prices decreased as a result of regulatory measures. All in all, the numbers of slots traded may diminish substantially if there is uncertainty about the continuation of the trading system. Another impact on slot mobility can be expected from the planned provision of substantial new capacity at a slot-coordinated airport, because of a new runway coming available or a move from single to mixed runway use. If these new and substantial numbers of slots are not awarded in the primary allocation to the highest value user, the winner of the slot can realise a windfall gain from secondary trading. There may be an additional knock-on effect of the creation of incentives for parties to apply for new slots speculatively in the hope of selling them on. Furthermore, the price of the existing slots in the secondary market may go down. As a consequence, slot mobility may be stimulated, but not the efficient use of slots. All in all, secondary slot trading and slot mobility can be affected by a substantial capacity expansion. Such a one-off event of primary allocation of new slots would definitely affect mobility, but the side-effects on efficiency would require careful regulatory measures. The possibility of introducing primary slot trading as an additional instrument to secondary trading is discussed in Chapter 6. Transparency is another important issue in the design of a secondary trading mechanism to stimulate mobility and efficiency. Transparency is discussed below. The more formalised the market place becomes, the more transparency can be expected, but at the same time the less mobility is likely.

47 THE IMPACTS OF SECONDARY SLOT TRADING 39 Competition and transparency Various researchers have proposed measures that could minimise the competition concerns and maximise transparency: The design of the trading mechanism: o Prohibition of certain activities, such as restrictive covenants (CAA/OFT 2005) o Transparency: publication of achieved prices and slot-trading volumes by an independent authority (CAA/OFT 2005, p. 19). The requirement to publish the details of slot trades post-sale would help to encourage transparency and trading. In line with this argument, the risk that the dominant hub carrier would have to pay excessive prices for peak slots might be reduced in a transparent market. However, pre-sale transparency could reduce the liquidity of the secondary market. o Creation of a formal market using a Slots Stock Exchange with the Coordinator as the exchange supervisory authority could make it easier for airlines to find willing traders and create greater transparency about prices and volumes (Stockmann 2006). However, such a formal marketplace may also reduce liquidity of the market as it would limit the airlines choices of trading options (such as bilateral deals), as CAA/OFT (2005), Gremminger (2006), and NERA (2004) point out. A less formal system may also be sufficiently feasible to signal airlines potential willingness to trade without requiring that they commit themselves in any way to do so (CAA/OFT 2005; Gremminger 2006; NERA 2004, p. 129). In addition, a formal market place would impose additional costs on the industry. o Another issue in this respect is whether such a central authority should ensure that slots are to be sold to the highest bidder to avoid discriminatory practices (Stockmann 2006). Such a regulation may, however, reduce slot mobility as some carriers may only want to sell to their alliance partners or may want to refuse to sell to competitors (CAA/OFT 2005, p. 23). o Controls aimed at limiting the actions of specific airlines, such as slot-holding caps. Yet, given our discussion on efficiency and market concentration in section 4.2.2, it is an arbitrary decision for a regulator to determine the maximum slot-holding percentage of an airline. CAA/OFT (2005) advised against introduction of any slot controls. o Non-airline entities should be excluded from the secondary market to reduce the risk of speculation and upward pressure on slot prices. Extending the remit of EC competition policy: make slot trades qualify as relevant mergers and evaluate slot trading as such. According to Gremminger (2006) and CAA/OFT (2005, p. 28), however, competition law does not provide an adequate safeguard because it is a lengthy, costly, and time-consuming process. Other options may be much more effective and simpler. Sectoral investigations by the national competition authority or DG Competition (ex-ante or ex-post). CAA/OFT (2005, p. 30) considers this policy option to be feasible if competition is considered not to be working well. New entrants may be in a negative starting position as they have to pay for new slots, whereas incumbents already have slots without having made an adequate payment. One way of dealing with windfall profits is to introduce time limits to

48 40 CHAPTER 4 slots before the introduction of secondary trading. These grant that after a certain period all air carriers are obliged to buy their slots (Czerny & Tegner 2002, NERA 2004). 17 Another way is to transfer windfall profits to investments in airport capacity. Moreover, introducing restrictions on sales by new entrants or other carriers (e.g., slot sale is only possible after three years operation) is a way to reduce windfall profits and the risk of speculation. Some oppose to the argument that airlines have obtained slots without making an adequate payment. According to the AEA (Egerer 2006), airlines with grandfather rights have invested money in product development at specific airports, and airlines pay for access to the infrastructure by means of the airport visit costs. Efficient use of airport capacity DotEcon (2006) indicates three sources of secondary market inefficiencies that may require additional regulation: bargaining inefficiencies; transaction costs, and search costs. The last two sources are closely related to market transparency (see above). The first, bargaining inefficiencies, concerns a problem that is intrinsic to markets that are based on bilateral transactions. Bilateral bargaining may end in failure to agree a price at which both seller and buyer are willing to trade. This problem can only be avoided if trading volumes increase. In that case, for example, a market-clearing price can be set. It is, however, highly unlikely that sufficient volumes of secondary trading in airport slots would occur to support these more efficient forms of market organisation. Although measures have already been discussed to stimulate slot mobility, this is expected to have only a marginal impact on the total number of trades. As such, secondary slot trading will inevitably be associated with bargaining inefficiencies. In summary, many of the additional regulations to correct for market failure with respect to slot mobility, competition, and efficient use of airport capacity seem to have negative side-effects, a conclusion also drawn by CAA/OFT (2005). The findings of the empirical research reported in Chapter 7 also show that when a secondary trading regime is introduced, airlines, airports, and other stakeholders tend to opt for a light-handed approach to secondary slot trading. This implies a need for some basic trading rules to guarantee transparency (publication of information on slot trades), prohibition of restrictive covenants, and studies/remedies by National Competition Authorities if serious competition concerns arise. 17 See also the discussion on limiting grandfather rights for annual vintages of slots in Chapter 6.

49 THE IMPACT OF SECONDARY SLOT TRADING AT AMSTERDAM AIRPORT SCHIPHOL 41 5 Experiences with secondary trading 5.1 Experiences in the UK The UK grey market within the EU system Slot trading (exchange with monetary compensation) is not intended by the EU regulations, but the Regulation does not explicitly prohibit slot transfers accompanied by money exchanges either (see, e.g., Balfour 2006). This grey area of the Regulation has given rise to the current slot-allocation system in the UK, where monetary exchange of slots does take place. In 1997, Air UK gave up its Heathrow- Guernsey service and exchanged it with BA; it is highly probable that this transaction was accompanied by financial compensation. BA intended to re-deploy the Guernsey slots to other destinations. In 1999, the UK Court rejected a complaint from the States of Guernsey Transport against British Airways following this slot exchange and the intended re-deployment of the slot (DotEcon 2001). The Court s decision legitimised a backdoor route for airlines to exchange slots without going to the seasonal allocation procedure, and by making payments to the current user of the slot. In the UK, all transactions are done as one-for-one swaps. This means that airlines can only engage in swaps if they already have a slot for this purpose. If an airline does not have a slot for this purpose, a so-called artificial exchange is arranged by the slot coordinator (ACL): if airline A wishes to swap its slots with Airline B (which has no slot), with or without payment, then the slot coordinator allocates off-peak slots to Airline B, purely for the purpose of the exchange. After the exchange Airline A, which now holds the off-peak slots, hands the slot back to the pool. Slot trading with monetary payment applies only to grandfather slots. Only airlines can hold and trade slots. Trading transactions are quite transparent, but there is no requirement for price disclosure. The Slot Coordinator must confirm the feasibility of the transaction (Cole 2006). It is said that slot trading also takes place on a grey market at European airports outside the UK (Gillen 2006; Morrisroe 2006). Apart from some general statements, data and information about such grey transactions are not available. In our analysis of experiences with slot trading in the UK, we focused mainly on the experiences at Heathrow The example of Heathrow Heathrow is characterised by severe excess demand at almost all times of the day. No charter carriers or low-cost airlines use the airport. BA is the largest slot holder. Slot utilisation is very high.

50 42 CHAPTER 5 Slot mobility Four hundred and ninety-nine slots were traded at London-Heathrow between 2001 and 2006, which is about 6% of the total number of Heathrow slots (8,700 per week according to Mott McDonald, 2006).; therefore, an average of 1.2% of total slots available was traded annually. 18 Slot mobility increased after 9/11 because more airlines were willing to sell owing to financial distress (Sabena, United, for example). In addition, press attention for monetary slot trading increased awareness among airlines at Heathrow. This awareness made the market for slots much more competitive, and resulted in higher slot prices. The slot pool has been declining steadily, indicating that slot trading is becoming more and more important to obtain access to Heathrow (CAA/OFT 2005). A number of slot trades have been disclosed in the press. For example, BA and Swissair were involved in an exchange for eight slots at Heathrow for 35mln. According to CAA/OFT (2005), the fairly small share of slot transfers at Heathrow has to do with the relative shortage of willing sellers. Airlines intending to maintain a long-term presence at Heathrow are unlikely to sell because of the lack of liquidity at the airport. In addition, it has become financially more difficult to buy slots at Heathrow because of the extremely high prices. 19 Gatwick is said to be a much more liquid market, and has shown larger slot mobility in recent years (CAA/OFT 2005). A legalised market may stimulate slot mobility, as airlines would probably no longer be bound to one-for-one slot transfers in a legalised market. Figure 5.1 Slot mobility at London Heathrow: Source: Cole 2006 According to ACL, the types of slot trade include: Sales of slots on commercial terms Lease of slots among airlines on commercial terms Trade as part of bankruptcy restructuring Trade to re-deploy slots within an alliance group: for example, LH has built up a substantial slot inventory at LHR in cooperation with BMA. 18 Note that the number of slot transfers mentioned in Figure 5.1 encompasses slot trades but also includes other types of transfers. 19 Interview with an airline representative.