SR-highlight. Editorial. Franca PERIN Head of SRI Research. For Professional Investors Only

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1 Editorial The seventh issue of our newsletter, is dedicated to the airline sector, a particularly topical issue as some of our readers may have been affected in their professional or private life during the month of September if they had booked a flight with Air France. Indeed, after two years free of any social conflicts, Air France had to face the most important strike of its young history (beginning in 1999 with its privatization). This strike reminds us that the airline sector is under severe pressure, with on one hand, a severe competition from low-cost companies (LCC) on the short and mid haul flights, and, on the other hand, deep environmental concerns rising as airline carbon and toxic emissions are growing quickly. Franca PERIN Head of SRI Research Having personally faced the strike during a professional trip, it has been for me the opportunity to measure the deep impact of the strike on the brand by this conflict. It is very likely that the immaterial capital of the company has suffered a lot during the strike, as it has been totally misunderstood by the company s passengers. In addition, the strike didn t bring any solution as low cost companies threat is still pending, as LCC being more aggressive than ever on ticket fares, and winning more and more popularity in the eyes of the public. Considering this, it is very likely that the company will be in a turbulent time for a long period. Above and beyond Air France-KLM case (all the major European airlines companies faced major social conflicts during the last four years) there are lessons that deserve to be learned. The main concern is the lack of ability of traditional airlines companies to anticipate the emergence of low cost companies and to adapt with the new market rule, which is basically to acknowledge that price is the most important matter to passengers. Enjoy the reading! For Professional Investors Only

2 Relevant sustainable issues in the SRI analysis of the Air freight, Airlines & Logistics sector Our main CSR (Corporate Social Responsibility) topics for the Air freight, Airlines & Logistics sector are summed-up in the following chart. We have chosen to base our SRI analysis on 5 ESG-relevant issues (the blue bars in the below chart represent the highest scores), on which company performance are assessed and rated. These are: greenhouse gases, safety, quality, social dialogue and work conditions. Air freight, Airlines & Logistics ESG issues Source: Generali Investments Europe S.p.A. SGR October 2014 For professional investors Only

3 Relevant sustainable issues in the SRI analysis of the Air freight, Airlines & Logistics sector For each company in our SRI universe we evaluated the impacts (main topics) of both extra-financial risks and exposure to business opportunities (concrete impact/materiality). Relevant Issue Main topics Materiality Greenhouse Gases Quality Safety Working Conditions Social Dialogue Climate change Carbon regulation Energy efficiency On-board comfort and services Punctuality Accidents Terrorist attacks Reducing harsh working conditions due to distance Massive restructuring in recent years High level of flexibility - The sector s carbon emissions account for 2% of global CO2 emissions, but traffic is increasing by 6% a year and efficiency gains (1.5% annually) are not enough to offset such increases. - Fuel prices (currently 30-45% of operating costs), growing traffic and sector integration in the EU ETS (European Union Emission Trading Scheme) will force companies to find efficient solutions for their activities. The sector is committed to halve the carbon intensity of flights by 2020, and NOx (Nitrogen Oxide) by 80%. - Customer satisfaction is key to maintain competitiveness. Poor quality products and services can damage a company s reputation and competitive advantage. - Because of airline fares, passenger expectations are high in terms of comfort, punctuality and the management of unpredictable situations. - Air transport for freight and passengers remains the safest means of transport. It is safer than road, rail and maritime transport was the best year ever from the point of view of safety. However, there are many threats (weather, human factors, terrorism) and the consequences can be very damaging for a company s brand image. - Airline employees used to enjoy a wide range of benefits to compensate for professional inconveniences (distance, mobility), but increasing competition has forced companies to reduce benefits. - Work in logistics is regarded as particularly tough as it consists essentially of handling tasks. - With the beginning of the sector s privatization and the arrival of low cost companies, the sector has been impacted by the need to be competitive. The economic crisis has forced many large companies to carry out massive restructuring operations. Increasing competition and pressure to reduce costs have prompted companies to tap cheaper skilled labour. Source: Generali Investments Europe S.p.A. SGR October 2014

4 Major Corporate Social Responsibility topics and key issues in the Air freight, Airlines & Logistics sector Key issues: We consider that some of the five relevant issues we defined in our methodology deserve specific attention, because of their particularly strong impact on reputation and operations, which could ultimately have a serious financial impact. We have, therefore, focused specifically on the following issues: financial transparency, water management and labour disputes. Green mobility, what are the perspectives? Air transport is among the sectors that have seen their CO2 emissions increase rapidly. Although air transport is a totally legitimate solution for long-haul transportation due to the absence of other solutions, the situation may be perceived as different in the case of short and medium-haul flights, because of an excessive environmental footprint (due not only to carbon, but also to carcinogenic small particles emissions and noise pollution) compared with other means of transport. Therefore, airline companies are coming under strong pressure from customers and regulators to make air transport more sustainable. In this context, the International Air Transport Association (IATA), which regulates around 95% of worldwide air transport, is committed to ensuring that, by 2050, air traffic growth is carbon neutral. Airline companies will have to balance their growth with fuel efficiency and a carbon mitigation programme. The challenge is huge, because the current traffic growth rate (6% per year) exceeds fuel efficiency gains (depending on companies, but usually at an annual rate of 1.5-2%). Increases in oil prices, which now represent 35% of overheads, are regarded as an important fuel efficiency lever. With such costs, profitability is improved via fuel efficiency. Therefore, the current trend appears to be unsustainable, both environmentally (emissions exceed IATA commitments) and financially (fuel cost and carbon tax are a serious threat to corporate profits).

5 Major Corporate Social Responsibility topics and key issues in the Air freight, Airlines & Logistics sector Despite the fact that no technological leap is expected, some fuel efficiency possibilities have been identified: Aircraft manufacturers have integrated the environmental constraint in their projects. The most advanced aircraft can reduce fuel consumption by 20% (new power train, electrification, alleviating, aerodynamic improvements), but according to manufacturers it is not possible to go further without a technological leap. Airline companies can improve their carbon footprint while maximizing the load rate or modernizing their fleet. Aircraft ground movements: according to a recent report of Oddo Securities ( Aero & Space: Ready For An ESG Take-Off, 12/2012), 5% of fuel could be saved by avoiding wasted parking time, reducing distance between parking and the runway, and using electric taxi systems. Air Control: according to the European Commission, improving air traffic management with the Single Sky Regulation project could generate intra-european flight fuel savings of up to 10%, reduce flight times and lead to EUR 2-3 billion of cost reductions. Biofuels: unless the problem of availability and social acceptability is solved, biofuels cannot be regarded as a potential solution for green air mobility. Despite increasing carbon emissions in absolute terms, as can be seen from the following chart airline companies have made some efforts to improve their carbon footprint, if we take into account carbon emissions per passenger per kilometre. Carbon emissions per passenger per km g CO2/passenger/km Air France - KLM Lufthansa Source: Companies Annual Reports 2013 Oil and carbon costs Nowadays oil accounts for 35% of airline costs. The cost structure of airlines is very sensitive to the continuous risk of volatile and rising oil prices. In addition, under a new regulatory framework (at least inside the European space) each metric ton of carbon emitted is due to be taxed. Although the exact procedure and details of the carbon tax are likely to be reshaped, it is now certain that companies will have to pay twice for fuel: once when purchasing it and once when it is burned. Therefore, fuel efficiency is above all a matter of profitability.

6 Major Corporate Social Responsibility topics and key issues in the Air freight, Airlines & Logistics sector High-speed rail transport threat High-speed rail transport tends to be favoured by public infrastructure policies in response to environmental issues. It remains clear that high-speed rail cannot compete with airlines on the medium-haul market. But, for distances of less than 1,000 km or those covered in less than 3 hours by high-speed rail, rail transport can strongly compete with air transport. By way of example, in less than 20 years the Eurostar captured the Paris- London and Brussels-London market (with a share of about 70% in 2012). Low-cost companies (LCC) are providing fierce competition Over the last fifteen years, LCC have succeeded in competing with historical network carriers. LCC now account for more than 25% of air traffic and their growth rates in 2012 and 2013 show that this trend is ongoing. The low-cost offering has opened up significant opportunities for passengers who can now enjoy cheaper fares and have access to many new air routes. According to a Cheuvreux study, prices decreased by 20% since LCC arrived on the market. LCC growth raises the issue of labour costs in the air transport market and therefore forces network carriers, which have traditionally a very protective social framework, to follow LCC social standards. Labour disputes (see alert section) Staff expenses represent between 12% (LCCs) and 30-33% (network carriers) of airline revenues. Recent cost-cutting programmes (implemented to tackle the crisis, but also to deal with the structural decline of short/medium-haul prices) have focused strongly on staff expenses. The following chart shows the labour costs gap between LCC and network carriers Source: Companies Sustainability Reports (2013) Network carriers operating short & medium-haul flights cannot ignore the fact that what matters the most for today s customers is no longer the quality but the price. Therefore, the arrival of LCC can be seen as very positive for customers, but as a threat from a social point of view.

7 Major Corporate Social Responsibility topics and key issues in the Air freight, Airlines & Logistics sector Ground operating costs Airlines are faced with growing costs imposed by monopolistic/oligopolistic suppliers such as airport operators and manufacturers. For example, Lufthansa faced a 12.5% increase in Frankfurt in , and British Airways had to contend with a 23.5% increase in Some relevant environmental indicators and figures Source: Companies Sustainability Reports (2013)

8 SRI leaders in the Air freight, Airlines & Logistics sector Air France-KLM Best practices in ESG risk management Labour conflicts: for a long time, reducing labour costs was not a priority. The focus on social peace between unions and the company led to significant overcapacity that needed to be reduced urgently with the arrival of LCC on Air France-KLM s main markets. Therefore, it had become essential to replace the former social framework with a more competitive one. The Transform 2015 plan has been particularly for Air France employees. Despite Air France s deep strike culture, no strikes had been deplored since Compared with other airline companies, the social dialogue at Air France can be described as calm and constructive. The management and, above all, Alexandre de Juniac, CEO, have managed to win the trust and approval of the unions within the framework of an ongoing dialogue. Despite restructuring and productivity enhancement programmes launched by the company, the benefits granted by Air France - FLM are still very favourable compared with those of peers, and the company does not have any attractiveness problems. Environmental footprint: Air France-KLM has one of the youngest aircraft fleet and this has a positive impact on the company s environmental footprint. Air France s target for 2013 was to reduce consumption per passenger per 100 km below 93 gco2, and 91.6 g of CO2 for KLM. The target has been achieved for both companies, with respectively 92 grams of CO2/passenger/100 km for Air France and 88.8 for KLM. It is to be noted that this represents a 3% energy efficiency improvement for both Air France and KLM. Four key areas in fuel saving measures can be distinguished: Aircraft: reducing on-board weight, the fuel consumption of engines and auxiliary power units, drag, etc. A 1 kg reduction in on-board weight on all Air France aircraft would result in an annual reduction of 76 tons of CO2 emissions. Airspace: flight path optimization, reducing aircraft waiting times, optimizing altitude, etc. Route optimization, accurate planning, weight savings and taxiing with one or two engines switched off resulted in 2012 in a fuel saving of 9 million litres for KLM. Offsetting emissions: Air France and KLM provide their customers with CO2 emission calculators, available on both of their websites, and the option to offset these emissions. The Group offers certified sustainable carbon reduction credits that guarantee high-level offsetting.

9 SRI leaders in the Air freight, Airlines & Logistics sector Air France-KLM Best practices in the creation of opportunities New customer-oriented commercial strategy: Customer satisfaction has been clearly identified as a major area of improvement by the management. The new management has re-iterated on several occasions its ambition to make Air France one of the most highly rated companies and to reverse its previously poor reputation in the areas mentioned below. Air France used to have a bad reputation in the following areas, but has made improving them a priority: On-board services Punctuality Last minute strikes Source: Air France - KLM Sustainability Report 2013

10 Focus on an SRI Alert Analysis of the recent strike at Air France-KLM: between corporatism and defending the social model Facts Since 15 September 2014, the majority of Air France-KLM pilots have been on strike. In September, Air France had its worst strike since 1998, with a daily cost of m according to the company, but probably with a much higher overall real cost. In addition to the financial prejudice suffered by the company, this crisis is a reminder of the fragility of the social situation at Air France and underscores just how difficult it will be for the management to roll out the unavoidable reforms. Context Air France s corporate culture is characterized by powerful and determined unions, ready to fight proposed changes to the company s obsolete social framework which has not really changed since the company s privatization in 1999, because of the focus on maintaining social peace. As a consequence, this lack of reform has led to a growing competitiveness gap between the company and its rivals, which has resulted in a progressive loss of market share on small and medium-haul flights and a deterioration in the company s financial structure. Fearing social conflicts, Air France had failed to tackle seriously the threat of low cost companies, considering that passengers would continue to pay higher rates in exchange for higher quality services. This strategic mistake had resulted in the Group becoming structurally loss-making. With a passenger load factor of less than 80%, operating costs (mainly due to labour costs) 10-15% higher than those of its peers, and a downturn affecting most airline companies, Air France s situation was not sustainable. 2011, a turning point in the history of Air France Given the critical situation of the company in 2011, the management decided to implement radical changes. After an in-depth audit of the company s workforce and social framework, and with the arrival of a new CEO, the management introduced the Transform 2012 plan (completed by the upcoming Transform 2015 plan).

11 Focus on an SRI Alert Analysis of the recent strike at Air France-KLM: between corporatism and defending the social model Transform 2015 plan The goal of the Transform 2015 plan was to achieve greater efficiency, via a redundancy plan, a two-year salary freeze and longer working hours. After negotiations, with numerous twists and turns, the majority of employees and unions accepted the Transform 2015 plan. The Plan has been carried out in a responsible way since the company did not face any strike actions despite the significant efforts required for the employees. The social aspects of the Transform 2015 plan are as follow: Cancelling and renegotiating all collective agreements, begun in April Increasing the number of working hours and optimising crew rotation. Reducing the number of cabin crew on flights. The loss of days not worked (RTT, no time off instead of public holidays), for example 10 days for ground staff, without any wage compensation. Freeze on general pay increases and promotions. Streamlining working hour compensation and benefits. In exchange, the company made the following commitments: Introduce a voluntary redundancy scheme, except for pilots. Targeted incentives to encourage a shift to part-time work. Work time sharing measures for cabin crew. Limit the pay gap between Air France and Transavia* pilots to 20%. Bonuses for pilots volunteering for a temporary transfer to Transavia. * Transavia is a lowcost company of the Air France-KLM Group

12 Focus on an SRI Alert Analysis of the recent strike at Air France-KLM: between corporatism and defending the social model Why the toughest strike of the last 15 years? Prior to the September 2014 strike, Air France was the only airline company implementing a cost-cutting plan that had managed to avoid strikes, thanks to a healthy social dialogue. Avoiding any strike action while implementing a tough cost-cutting programme had been an important victory for Air France, showing that the company was able to implement reforms slowly and confirming the relevance of Transform 2015, which had helped to improve the company s commercial and financial situation. The target To reduce the cost difference between Air France and Transavia is the target in order to be able to compete with low-cost companies on short and medium-haul flights. After having put Air France s situation on a healthier footing, the priority for the management was to stop the financial haemorrhage while focusing on Air France s most important weakness, namely the medium-haul flight segment, where the company had been running a deficit for many years, and which needed urgent remedial action. What exactly is Transavia? Initially Transavia was the low-cost arm of KLM. Due to Transavia s success the same brand was created for the French market following the Air France and KLM merger. Because 1/ Transavia France s costs were between 10% and 20% lower than those of Air France and 2/ Transavia France was very profitable, with very rapid growth (annual growth around 10%), the company s management wanted to implement the same concept at its Paris-Charles de Gaulle (CDG) hub, in order to create its own low-cost company for Europe, with departures from Paris-CDG. This would mean that some air routes operated by Air France would simply be transferred to Transavia Europe. Consequences In reaction to this programme, Air France pilots, the category of workers with the most to lose in the proposal, announced their intention to stop the development of Transavia Europe. Despite the fact that pilots felt betrayed after that the company had undertaken not to ask them for any more sacrifices after the Transform 2015 plan in exchange for the adoption of the plan, this strike underscores the high level of corporatism of pilots, who are often regarded as privileged workers. As such, it has been the company s longest labour dispute since 1998, whereas risks of labour conflicts at AF- KLM had been contained in recent years.

13 Focus on an SRI Alert Analysis of the recent strike at Air France-KLM: between corporatism and defending the social model However, over the last week, the management has put forward a certain number of proposals which echoed trade-union demands: three Transavia entities, with distinct operations (Transavia Europe will not fly to airports covered by Transavia France and Transavia Holland), the announcement of a specific Transavia France contract (still not on the Air France model, but whereby Air France pilots have new benefits: Air France copilots who volunteer to fly for Transavia will have co-existing contracts and will benefit from a second bonus which could amount to a maximum of 30,000). These concessions do not seem to be sufficient to satisfy the strikers, who want to go further in the renegotiation of their status and working conditions with the management. At this very crucial moment for Air France, prolonging the strike seems unreasonable given the important issues Air France will have to face and appears to show that the pilot s unions are more concerned about their personal situation than the company s one. On the other hand, the management may have underestimated the reluctance and fear of change of its pilots, and failed to explain clearly to its workforce exactly what is at stake. Indeed, budget flights are now a reality. Figures show that the market share of low-cost airlines is still growing, including for business trips. Neither the management nor unions can ignore and avoid the reality, namely that it is necessary to adapt and become more cost-efficient in order to survive in a very competitive market, since at least on this market - price is all that counts for customers. From the beginning of the crisis and until now, Air France has been very persuasive about reforming the company and updating its social framework. Unfortunately, the company missed the opportunity to do so. Consequences Following 14 days of strike and under pressure from the Air France management, the government and other company employees, the major pilots union (SNPL: Syndicat National des Pilotes de Ligne*) finally capitulated. The union is ending the strike without having reached any new agreement (something the management also regrets). As a result of taking on the unions directly and holding a steady course, the Chairman and CEO of Air France-KLM, Alexandre de Juniac emerged stronger from this strike. The consequences of this strike are very substantial: the dispute affected 840,000 to 980,000 passengers (estimated data from the company s management), cost between 210 mil and 280 mil and caused the share price to fall by 10%. *National airline pilots union Source: Media, brokers, Annual report company

14 Law & Legal aspects Carbon regulation The European Trading System (known as the EU ETS) has been in place since 2012 and applies to all flights within and passing through the European Economic Area. In practical terms, since 2012, this system has required companies to pay for the carbon they emit. This measure does not apply to carbon emissions for flights to and from non-european countries, which will not fall within the framework of EU ETS until However, because of pressure from IATA and many other countries (Russia, India, China and the US mostly, threatening an Airbus boycott in the event of the full implementation of the EU ETS), for the time being there is a question mark over the full implementation of the system. However, for companies operating within the European Area, the carbon tax is already a reality. The ability to pass CO2 costs onto customers is therefore a key issue for them. Airlines with an exposure to long-haul premium traffic will have an advantage versus short-haul airlines. Therefore, low-cost companies, operating mostly on intra-european short and medium-haul flights will be the most affected by this regulation. According to airline companies and analysts a full materialisation of CO2 costs would have an impact on the fuel costs; companies will pay from +11% to +20% more. Other pollutants regulation (NOx) Studies show that NOx emissions also contribute to the global warming footprint of airlines (eq. to ~40% of the CO2 effect) and have very harmful effects on human health. The EU 2020 target is to reduce NOx emissions by 80% from 2000 levels. However, there is a trade-off with CO2 emissions, as fuel-efficient engines tend to emit more NOx. The NOx effect is more local/regional and may thus apply to airports or certain routes. Noise pollution: The International Civil Aviation Organization (ICAO) Noise Standards monitor noise pollution during flight operations. The EU 2020 target is to reduce perceived noise pollution by 50% from 2000 levels. Air traffic management The effective implementation of a single European air space (currently within the framework of Single European Sky II) would help to improve the management of aviation safety and the environmental impact of air flights (e.g. potential kerosene savings of 12% by optimising routes). The implementation of this project will require the transfer of air traffic management to a European agency, and a harmonization of air traffic managers, who will lose certain benefits with this reform. Air traffic managers have announced that they will do all they can to stop the reform.

15 Law & Legal aspects Air passenger rights Airlines are facing tighter regulations on customer protection (imposing, for example, the payment of financial compensation in the case of flight delays or cancellations), price transparency and security rules for consumers. Labour rights The LCC model has been weakened by several Court decisions. Over the last two years, fines imposed on low-cost companies for undeclared workers increased. Some courts accused low-cost companies of breaching labour laws by employing some staff on Irish or British contracts in order to avoid the social and tax charges in respect of employees on local contracts. In France, the Aix-en- Provence criminal court fined Ryanair 200,000, ruling that the airline had effectively violated French labour law at its base in Marseille. The airline will also have to pay 9m in damages to the civil plaintiffs: 4.5 m in unpaid social security charges, 3 mil to retirement funds and 450,000 to the French public employment office. Low-cost airlines attempted to escape this legal framework by invoking the Treaty of Rome and its provisions regarding the free movement of services. They have all been found guilty of failing to comply with national labour laws. In such cases, the amount of the fines imposed is anecdotal. What matters for LCC is that they will have to stop outsourcing the labour contracts of their employees, which is one of the cornerstones of their competitiveness. Source: Brokers reports, Press Disclaimer: This newsletter is provided for information purposes only and does not constitute investment advice or a recommendation to make or liquidate an investment or to effect any other type of transaction. It does not constitute an offer or solicitation to make or liquidate an investment. This document reflects the opinions of Generali Investments Europe S.p.A. SGR (GIE) and it is based upon a GIE s specific methodology for the evaluation of corporate social responsibility. The content of this document is based upon sources of information believed to be reliable. GIE does not warrant the accuracy or exhaustiveness of this document, and disclaims all liability for losses that could arise from using the information herein. Any reproduction of this document, in whole or in part, is prohibited without GIE s prior consent in writing. For Professional Investors Only