Embraer China Market Outlook

Embraer China Market Outlook 2012-2031

executive summary and global trends a look forward china market overview trends and analysis market forecast by the numbers methodology and definitions China Market Outlook 2012-2031

Join us as we build a bright future for the Chinese regional aviation market. Guan Dongyuan Senior Vice President, Embraer President, Embraer China 2

Embraer China Market Outlook (2012-2031) Foreword In 2011, world air transport was still feeling the effects of the global financial and European debt crises. The downturn led to softer demand which prompted Embraer to revise its forecast for new segment are forecast to surpass those of Europe. The expected future demand for 1,005 new jets in China represents 15% of global deliveries of jets in this capacity segment. aircraft. Over the next twenty years, air transport is expected to grow at an average annual rate of 5%. By 2031, 6,795 new jets in the 61 to 120-seat capacity segment will join airline fleets throughout the world. Leaders from central to local governments agree that the development of civil aviation can drive economic growth and that regional aviation is a natural way to build a strong nation and improve the living standard of its citizens. Around China, there are examples Civil aviation in China will be a bright spot in world air transport and see continued rapid growth with revenue passenger kilometers (RPK) increasing 7.2% year over year. Looking forward to the period of the twelfth five-year plan, China s economy will have strong momentum characterized by high stability and fast growth that, in the long run, will level out. Limits with the environment, resources of that development. Three years ago, the Inner Mongolia Airport Corporation started promoting greater accessibility to remote areas for the many regional airlines operating in that part of the country. This is but one example of how the Airport Corporation is making air travel more affordable to a new segment of consumers in remote parts of China who never travelled before by airplane. and other factors will contribute to gradual slowing although the rate for the world s second largest air transport market will still be higher than the world average. The next one or two decades will see the golden development of China s air transport industry. Its strategic position will become more prominent and regional aviation will play a more significant As of September 2012, Embraer received 156 firm orders from 12 customers in China and has delivered 125 aircraft. To better serve those customers, the company established Embraer China Aircraft Technical Services (ECA) to offer comprehensive before and after sales service. role in boosting economic development particularly with more regional airports coming online in central and western China. Since the official launch of the Essential Air Service program and the gradual implementation and improvement of subsidies and policies supporting regional aviation development, the sector is assured to have a promising future. With their low operating costs and high versatility, Embraer s advanced 61 to 120-seat jets effectively bridge the gap between traditional regional and mainline aircraft. They have enjoyed great Let s join hands and work together to create a bright future for China s regional aviation industry. popularity with airlines around the world that deploy them to replace ageing fleets, reduce excess capacity and develop new routes. The Asia-Pacific region, including China, will be the fastest growing market in the world where deliveries of jets in this capacity Guan Dongyuan Senior Vice President, Embraer President, Embraer China 3

4 On every continent, Embraer aircraft are linking cities, growing commerce and connecting people.

china market outlook 2012 2031 executive summary and global trends a look forward 5

Executive Summary Over the past 40 years, worldwide air transport activity has been characterized by strong growth rates led mainly by advanced economies, such as the United States and Western Europe, and to a certain degree by the Asian market in the last years. Some drivers like the globalization of business, technological development, the revolution in communications, tourism, deregulation in the United States, liberalization in Europe, the advent of the Low Cost business model, and lower fares have been the engines of growth. From 2012 to 2031, the center of gravity for aviation will move eastward, most notably to Asia and, to some extent, southward to Latin America. The main drivers that will impact the global air travel industry are: Strong pace of economic growth in emerging markets; Economic growth driven by middleweight cities; Surge of an urban middle class; High fuel prices and increased environmental concerns; Increased competition and search for business efficiency. Air Traffic Demand Forecast Embraer foresees a 5.0% year-over-year Revenue Passenger Kilometer (RPK) growth over the next 20 years, which will require 32,800 new aircraft deliveries representing a total market value of US$ 3.6 trillion. In a baseline scenario, in which global GDP is expected to grow by 3.1%, emerging economies will remain among the fastestgrowing in the world. Apart from Asia, the best-placed regions in economic terms are the Middle East, Latin America and, to a lesser extent, Africa. Midsized and small middleweight cities will drive almost 40% of the global economic growth. Population will become wealthier as a large urban middle class will outpace the number of poor people; more income will be available for discretionary expenditures, including travel. In this scenario, the Middle East, China and the Latin America will be the fastest-growing markets, with an average annual RPK growth rate of around 7.0%, followed by Asia Pacific with 5.8%, the Commonwealth of Independent States (CIS) with 5.6%, and Africa with 5.3% over the next 20 years. Developed economies will grow less due to their market maturity, North America with 3.2% and Europe with 4.1% by 2031. Market Drivers Likely Impact Economic growth in emerging markets Economic growth driven by middleweight cities Surge of an urban middle class High fuel prices & increased environmental concerns Increased competition and search for business efficiency - Power more dispersed with new countries/players - Faster pace of air traffic growth in emerging markets - Potential for emerging economies to expand air services through regional aviation - Development of second and third-tier airports - Potential for network diversification/integration - Opportunities for airlines to explore low to medium-density markets - Increased propensity to travel, availability of income for discretionary expenditures - Strong air transport demand growth in emerging markets - Emissions and noise restrictions getting tougher - Increased use of renewable energy sources - Removal of old and inefficient aircraft - Match aircraft capacity to market demand (right-sizing) - Aircraft with new engine technology (lower fuel consumption and emission) 6

Embraer forecasts that world air transport demand will increase roughly 2.7 times by 2031, reaching 13 trillion RPK. By 2031, Asia Pacific and China will be the largest market in the world, accounting for 34% of world RPKs. Europe and North America will follow at 21% of RPKs each. (Chart 1) Uncertainty lies ahead with regard to short-term recovery and long-term projection since there are some risks to an economic forecast. Embraer provides alternative scenarios to its baseline forecast, as the high unpredictability of the external operating environment represents a major risk to the forecast. The first alternative scenario is a downside scenario accounting for 30% of probability, characterized by an increasing solvency risk in the Eurozone and a resurgence of political tensions in the Middle East driving oil to a US$ 200 per barrel peak. This will create a demand shock slowing down the fragile economy. Sustained high oil prices would weigh on consumer behavior in many countries, impacting the demand for air transport. Advanced economies will face a recession similar to the 2008/09 economic crisis, and emerging markets will still lead global growth, although at a slower pace as they will feel the effects of a global slowdown due to reduction of exports to advanced economies. In this scenario, over the next 20 years, in which GDP is expected to grow 2.3% per year, global air transport demand is projected to grow 4.5% annually. Additionally, the upside scenario accounting for 10% of probability assumes a faster- than, expected debt reduction in the Eurozone and a gradual improvement in consumer spending and business investment in the United States. Emerging markets will benefit from a better economic outlook with stronger export demand and increasing internal consumption. A surge in final demand in China and other leading emerging markets would further contribute to strong economic development through higher GDP growth rates. This economic background will result in faster RPK growth rates driven by a more optimistic business environment. In this scenario, in which GDP is expected to grow 3.5% per year over the next 20 years, global air transport demand is projected to grow 5.9% annually. Although we forecast different scenarios, the results presented in the sections ahead are based on a baseline scenario. executive summary and global trends a look forward Chart 1 Projected Traffic and Economic Growth (2012-2031) Billions of RPK North America Europe Asia Pacific China Middle East Latin America CIS Africa 2011 Additional 2012-2031 Annual Growth Rate RPK 2012-2031 GDP 3.2% 2.6% 4.1% 1.9% 5.8% 3.4% 7.0% 5.5% 7.2% 3.9% 7.0% 4.3% 5.6% 3.4% 5.3% 4.4% 0 500 1,000 1,500 2,000 2,500 3,000 World 5.0% 3.1% Source: Global Insight; EIU; Embraer 7

30 to 120-Seat Jet Segment Embraer foresees world demand for 6,795 new jets in the 30 to 120-seat capacity segment over the next 20 years, representing a total market value of US$ 315 billion. From 2012 to 2021, 3,005 new aircraft will be delivered, and the remaining 3,790 units will enter the market between 2022 and 2031. The 91 to 120-seat segment will be the largest market, with 3,765 new deliveries in the next 20 years, representing 55% of the segment, followed by the 61 to 90-seat segment with 2,625 new deliveries, or 39%, and the 30 to 60-seat segment with 405 new units, or 6%. Market Segment (seats) 2012-21 2022-31 2012-31 30-60 0 405 405 61-90 1,325 1,300 2,625 91-120 1,680 2,085 3,765 30-120 3,005 3,790 6,795 The 30 to 60-seat capacity segment has been impacted by high fuel prices and a weak revenue environment, mainly in North America, where some 70% of 50-seat jets are in service. However, this category will continue to be essential to hub - and - spoke sustainability, as the aircraft have the capability to link many low to mediumdensity markets to major hubs and to develop regional aviation in emerging countries. Efficiency is paramount. Aircraft in the 61 to 120-seat segment, such as the E- Jets family, position carriers for sustained growth as the use of right-sized equipment allows airlines to maximize operational efficiency and profitability through better yields and competitive positioning. It is a very significant part of today s aviation network and has been providing much-needed flexibility to airlines by right-sizing (complementing or replacing) larger jets, replacing ageing aircraft in the same seat category, developing new markets, and expanding from smaller regional jets (natural growth). (Chart 2) Chart 2 E-Jets Network Around the World Right-sizing Natural Growth Direct Replacement New Markets 8 Source: OAG

Commercial Jet Delivery Forecast 30 to 120-Seat Segment, by Region (2012-2031) World Region New Deliveries Share Africa 210 3% Asia Pacific 505 7% China 1,005 15% Europe 1,460 21% Latin America 670 11% Middle East 305 4% North America 2,195 32% Russia/CIS 445 7% Total 6,795 Over the next 20 years, 47% of new deliveries (3,225 units) will be added to support market demand growth and 53% (3,570 units) to replace ageing equipment. The world fleet in service of 30 to 120-seat jets will increase from 4,150 aircraft in 2011 to 7,375 by 2031. Some 14% (580 jets) of the current fleet will still be in operation. (Chart 3) Turboprops High energy prices and environmental concerns tend to favor turboprop demand growth, mainly in short-haul markets and in routes where there is no direct competition with jets. For medium and long-haul missions, jets will still be preferred due to their higher productivity, overall operational efficiency and schedule compatibility with narrowbody jets. By 2031, 2,515 new turboprops (with a capacity of 30 seats or more) will be delivered, 46% to support market growth and another 54% to replace ageing aircraft. Around 83% of all turboprop demand will be in the capacity segment of 60 seats and greater. Market Segment (seats) 2012-21 2022-31 2012-31 30-60 210 230 440 60+ 875 1,200 2,075 30+ 1,085 1,430 2,515 In 2011 there were 2,070 turboprops in service with an average age of 15 years. By 2031, 35% of the current fleet will still be in service, and the total turboprop fleet will increase to 3,235 aircraft. (Chart 4) executive summary and global trends a look forward Chart 3 World Jet Fleet Evolution Number of Aircraft (30 to 120-Seat Segment) Chart 4 World Turboprop Fleet Evolution Number of Aircraft (30+ Seat Segment) 7,375 3,225 4,150 3,570 3,235 1,165 2,070 1,350 580 720 2011 2031 Retained Replacement 2011 2011 2031 Growth Source: Embraer 9

Narrow and Wide-Body Aircraft Over the next 20 years, airlines will require 23,490 new jets with more than 120 seats (70% of total new aircraft deliveries), 17,305 narrow-bodies and 6,185 wide-bodies. Market Segment (seats) 2012-21 2022-31 2012-31 Narrow-bodies (121-210) 7,855 9,450 17,305 Wide-bodies (210+) 2,855 3,330 6,185 120+ 10,710 12,780 23,490 Of total new deliveries, 54% will be added to support market growth and 46% to replace old aircraft. In this segment, the world fleet in service will increase from 13,395 aircraft in 2011 to 25,985 units in 2031. Some 19% of the current fleet in service will remain in operation. (Chart 5) Chart 5 World Narrow and Wide-Body Fleet Evolution Number of Aircraft (120+ Seat Segment) 25,985 12,590 13,395 10,900 Growth Replacement 2,495 Retained 2011 2031 Source: Embraer 10

World Projected New Deliveries Seat Capacity Segment 2012-2021 2022-2031 2012-2031 Share Turboprop 30-60 210 230 440 1% 60+ 875 1,200 2,075 6% Total Turboprops 1,085 1,430 2,515 7% Jet 30-60 0 405 405 1% 61-90 1,325 1,300 2,625 8% 91-120 1,680 2,085 3,765 12% Total 30-120 3,005 3,790 6,795 21% NB 121-210 7,855 9,450 17,305 53% WB 210+ 2,855 3,330 6,185 19% Total 120+ 10,710 12,780 23,490 72% Total Jets 13,715 16,570 30,285 93% Total 14,800 18,000 32,800 executive summary and global trends a look forward World Fleet in Service Seat Capacity Segment 2011 2031 Turboprop 30-60 1,275 800 60+ 795 2,435 Total Turboprops 2,070 3,235 30-60 1,620 625 61-90 1,095 2,730 91-120 1,435 4,020 Jet Total 30-120 4,150 7,375 NB 121-210 10,215 18,900 WB 210+ 3,180 7,085 Total 120+ 13,395 25,985 Total Jets 17,545 33,360 Total 19,615 36,595 11

Global Trends Economic Growth in Emerging Markets The balance of global economic power is shifting to the East and South, paving the way towards the development of a multi-polar world with a greater number of influential countries. While advanced economies have been contributing less to global economic growth than they did 20 years ago, countries commonly called emerging markets are becoming an increasingly significant part of the global economy and financial markets. The economic might of the fastest-growing economies has been matched by their growing geopolitical influence. (Chart 6) Economic Growth Driven by Middleweight Cities Global economic growth includes a demographic component: the process of urbanization. Half of the world s population now lives in cities, and it is expected that the urban population as a percentage of total population will reach 60% by 2030, favoring midsized and small middleweight cities defined as cities with a population between 150,000 and five million inhabitants. The predominant growth pattern in smaller cities is resulting in a more equal level of urbanization across all regions. Urbanization is key to the expansion of the airline industry. Future economic growth will take place mainly in midsized and small middleweight cities. According to the McKinsey Global Institute (Urban World: Mapping the Economic Power of Cities), such cities are poised to drive around 40% of global economic growth in the next 15 years. Megacities per capita GDP growth is slowing down, allowing the middleweight cities to catch up. As companies look for fast-growing cities that are likely to contribute most to global economic growth, there will be a need to develop regional aviation and generate new opportunities for airlines to explore low- and medium-density markets. Expanding global connectivity will be a priority to put economic growth on a solid, more sustainable foundation. Midsized and smaller cities will require better air services, including first-ever non-stop flights in key origin and destination markets and competitive options on hub sectors. The 30 to 120-seat jets are Chart 6 Share of World GDP 100% 80% 60% 40% 20% 0% 2000 2010 2020 2030 Advanced Economies Emerging Markets Others Source: Global Insight 12

better suited for both of those missions. The Surge of an Urban Middle Class As economic activity in emerging markets around the world has been growing significantly and will continue to increase over the next 20 years, the world population is experiencing an increasing equality through distribution of wealth as the GDP per capita grows at a faster pace in regions such as Asia, Eastern Europe and Latin America. (Chart 7) Apart from a substantial reduction in poverty, the world is also witnessing the creation of a large urban middle class. By 2030, emerging market cities will have more higher-end middle-income households than developed cities. According to the Organization for Economic Co-operation and Development (OECD), by 2022 the number of people in the middle class will outpace the number of poor people. The size of the global middle class will increase from 1.8 billion to 3.2 billion people by 2020 and to 4.9 billion by 2030, raising its demand globally from US$21 trillion in 2010 to US$56 trillion in goods by 2030. This surge in the global urban middle class is associated with significant wealth redistribution. Today, six out of ten countries with the biggest middle class consumption are in the developed world the United States, Japan, Germany, France, the United Kingdom and Italy. By 2030, this number will be reduced to four out of ten, while India, China, Indonesia, Russia, Mexico, and Brazil will rank in the top ten. executive summary and global trends a look forward Chart 7 GDP per Capita Percentage of Countries 2005 U.S. Dollars 2010 2030 1% 4% 19% 27% 46% 15% 65% 23% < 7,500 7,500-20,000 20,000-70,000 > 70,000 Source: Global Insight 13

Based on spending power, there are four income segments defined by annual household income in PPP terms: Struggling, Aspiring, Consuming and Global. Struggling are those whose annual income is lower than US$ 7,500. Aspiring and Consuming are the intermediate segments whose annual incomes range from US$ 7,500 to US$ 20,000 and from US$ 20,000 to 70,000, respectively. Global are those whose annual income is higher than US$ 70,000. While 64% of today s population belongs to the Struggling segment, it is expected that this portion will be reduced to 20%, bringing the majority of future households to the Aspiring segment, which will represent 60% of world population. The Consuming segment as a percentage of world population will increase from 4% to 19%. (Chart 8) As a growing portion of the population becomes wealthier, more income is available for discretionary expenditures, including travel. High Fuel Prices and Increasing Environmental Pressure Increasing demand for oil from emerging countries is one of the main drivers of oil price escalation. Although the effects of energy prices are incorporated in the 20-year economic and air transport projections, the price of oil is the major downside risk for aviation due to the influence of external events and speculation on the commodity market. In addition, stricter environmental regulations, such as the EU Emissions Trading Scheme, and new government rules tend to reduce noise and emissions, impacting the aviation sector. Oil prices will remain high compared to historical standards. As the major component of a typical airline s cost structure, jet fuel prices put pressure on operating costs. Fuel efficiency is the long-term alternative to reduce the impact of oil price volatility. As every industry looks for untapped opportunities to improve efficiency, the aviation sector has been continuously striving to improve metrics, especially lower fuel consumption, and meet environmental requirements. One solution to reduce jet fuel dependency and greenhouse gas emissions is a more intense use of alternative fuels, in particular carbon-neutral biofuels that must be economically feasible and industrially scalable. This will require an integrated approach among fuel suppliers, airframe, aircraft systems, and engine manufacturers. Chart 8 Percentage of World Population by Disposable Income PPP U.S. Dollars Consumer category Income segment $ PPP % of World Population 2007 2025 Global 100,000+ 70,000-100,000 0 0 0 1 Consuming 35,000-70,000 20,000-35,000 3 1 4 15 Aspiring 10,000-20,000 7,500-10,000 16 16 16 44 5,000-7,500 28 15 Struggling 2,000-5,000 1,000-2,000 33 2 0 5 <1,000 1 0 14 Source: 2011 McKinsey Global Institute Cityscope

Increased Competition and Search for Business Efficiency Apart from increased cost, the airline industry will continue to face a weak revenue environment. The search for efficiency is essential in order to temper cost increases as well as revenue reductions. To accomplish the next level of business efficiency, the industry will need to evolve in three major areas: airline operations, aircraft and infrastructure. Competitive positioning, such as cost leadership and differentiation, is an important factor when it comes to airline strategy. The low-fare, high-cost environment will force airlines to rethink their stuck-in-the-middle business strategy in order to provide low-cost services or unique operations widely valued by customers. Airlines will continue to search for efficiency by offering the best costbenefit ratio, through longer-term, highervalue relationships with air travelers. Another aspect, future aircraft engine technology, will balance fuel efficiency, emissions mitigation, and noise reduction. Engine design, geared or advanced turbofan, will enable higher bypass ratios and high-temperature systems for improved thermal efficiency, reduced emissions, and reduced fuel consumption. Moreover, the establishment of the advanced air traffic management (ATM) systems in the United States and Europe, guided by NextGen and SESAR programs, respectively, will enable improvements and consolidation of air traffic control in these regions, increase capacity and reduce system cost. For airports, congestion in major hubs will lead to the emergence of secondand third-tier airports. In order to maintain competitiveness, hub airports will need more integration with ground transportation. Small- and medium-sized airports will benefit from traffic increases, but they will need to improve their own connectivity in order to bring efficiency to the air transport system. executive summary and global trends a look forward 15

16 Embraer E-Jets are bringing affordable air travel to people who have never flown before.

china market outlook 2012 2031 china market overview trends and analysis 17

China Regional Market Trends and Analysis In the thirty years since China opened its economy to the global market, the country s total airline revenue passenger kilometers (RPKs) have grown over 17% annually, far higher than that of other transportation modes. China has become civil aviation s second largest air transport region with an increasingly prominent strategic contribution to the national economy and the traveling public. In 2011, it was clear that air transport in China had recovered quickly from the global financial crisis. In that year, airlines and airports posted profits of RMB 27.8 billion and RMB 4.3 billion respectively. Although slightly lower returns than those of the previous year, they were, nonetheless, still bright spots against their counterparts in the rest of the world. With fast growth of the domestic passenger air travel, regional aviation has also made great progress in China with its own characteristics and trends. Current Conditions and Characteristics Stable Increase for Regional Air Transport with Low Volume Stable Increase for Regional Air Transport with Low Volume With dozens of years development, particularly over the last decade, regional aviation has become an indispensable part of China s entire air transport system. The number of routes served by jets with fewer than 100 seats grew from 248 in 2003 to 387 in 2011, a 60% increase. (Chart 9). Regional jets now operate on more routes with greater frequency. The rate of regional airport development is similar. According to 2011 statistics for passenger throughput at civil airports nationwide from the Civil Aviation Administration of China (CAAC), regional airports in third-tier cities had higher YOY growth than those of second or first-tier airports (Chart 10), a very promising trend for regional aviation. The CAAC also cites 1,377 scheduled domestic routes operated by all airlines in 2011. The majority of those were categorized as medium and low-density Chart 9 Comparison of Regional Network in China 2003 2011 Source: OAG 18

routes. Measured by each way passenger volume (PDEW), 1,050 routes (nearly 76%) carried an average of fewer than 300 travelers, (Chart 11), suggesting a huge untapped market for regional aviation. Expansion of Regional Fleet with an Imbalanced Profile In mid-2012, there were 1,820 in-service aircraft in China s civil fleet including 140 regional aircraft with 120 or fewer seats, just under 8% of the total. Aircraft with up to 120 seats accounted for only 3.2% of all seat capacity in civil aviation and carried 2.9% of the total passenger volume. The regional fleet was comprised of 41 ERJ145s, 20 CRJ200/700s, 64 E190s and 11 Modern Ark 60s. Ten airlines currently operate regional aircraft. With the exception of Tianjin Airlines, the fleets of the regional airlines are too small to derive true economies of scale which explains their relatively high operating costs. Analyzing the profile of the civil fleet over the past decade, it is not difficult to see that airlines have always preferred trunk routes to regional routes and purchased aircraft accordingly. The disproportionate number of aircraft of large jets to regional aircraft has not been addressed over the past few years and changes to the trend have been marginal. The imbalance in the development of trunk and regional routes has been a long-standing problem. Analysis shows that 69% of flights carried fewer than 120 passengers (Chart 12), which could have been operated by more efficient regional aircraft with fewer seats. The lack of regional aircraft forces trunk airlines to serve medium and low volume routes with large aircraft. More than 75% of routes with fewer than 300 PDEWs were flown by aircraft with 120 or more seats. Bigger aircraft inevitably lead to over-capacity on some routes which adversely affect operating efficiency and prompts airlines to reduce frequency. In the current domestic market, only 10% of airlines offer two or more flights per day, which offers few options for the traveling public. Accessibility to remote areas to be improved Despite the enormous potential for regional aviation and its considerable progress in recent years, a more comprehensive regional network is still in china market overview trends and analysis Chart 10 Regional Airports have higher growth Traffic growth in 2011(%) 100 90 80 70 60 50 40 30 20 10 0 Big Airports Second-tier Airports Regional Airports 1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 Rank of Pax volume in 2011 Source: CAAC 19

development. The majority of flights are still point-to-point and non-hub which is a consequence of the current domestic airline fleet profile. It is encouraging to see that Xinjiang and Inner Mongolia have developed Urumqi and Hohhot into regional aviation hubs with a hub-andspoke route network connecting several regional airports. Poor accessibility has been another problem. According to CAAC statistics, 66% of the 185 civil airports with scheduled commercial flights reach fewer than 10 destinations (Chart 13). Poor accessibility is a result of few frequencies and even on some newly-opened routes there is insufficient capacity to match passenger volume. Improving accessibility will require airlines to open more new routes with aircraft with lower risk and operating costs, higher economic benefits and rational seat capacity. They will need to increase frequency in existing markets, too. Those initiatives will require more regional aircraft. China s Regional Aviation Market: Future Development Maintain High Economic Growth and Accelerate Infrastructure Construction Economic development is closely related to air transport. The long term growth forecast for China s economy will be a strong driver of regional aviation development. Both central and local governments agree that in order to be strong, invest in civil aviation. Local governments have noticeably increased their investments in air transport over the years which have led to the construction of new regional airports. That public infrastructure, particularly in the central and western cities, will become a focus of future airport development. To encourage even more development, the Chinese government will emphasize construction and operation of regional airports in the central and western regions in the twelfth five-year plan period. Over the next five years, RMB 425 billion will be used to build the civil aviation infrastructure, including the construction Chart 11 Number of Domestic Routes by Passenger Volume Daily Passengers Each Way >600 181 500-600 400-500 300-400 44 49 53 200-300 94 100-200 207 <100 749 0 100 200 300 400 500 600 700 800 20 Number of Routes Source: Civil Aviation Administration of China (CAAC)

of 56 new airports, relocation of 16 airports and reconstruction and expansion of 91 airports. The majority of those planned new facilities will be regional airports. By the end of the twelfth five-year plan period, the number of airports in service will have increased to about 230 which will bring access to air travel to within 100 kilometers of 89% of the Chinese population. Construction and operation of such a large number of new airports will undoubtedly bring greater visibility to regional aviation. More New Policies to Encourage Development of Regional Aviation Civil aviation plays a significant role in the development of the economy, in politics, society, military affairs, diplomacy and culture which has raised its profile among governments at all levels. The Several Opinions of the State Council on Promoting the Development of Civil Aviation issued in 2011 clearly defines civil aviation as a strategic industry and regards its development as a national strategy. The declaration has helped to stimulate further development. Regional aviation development is now also recognized by all levels of government. Recently, the CAAC issued the Interim Measures for Administration of Subsidies to Middle and Small Airports, the Interim Measures for Administration of Subsidies to Regional Aviation and the Interim Measures for Loans with Discounted Interest to Construction of Civil Aviation Infrastructures as well as other documents, together with the National Development and Reform Committee (NDRC) and the Ministry of Finance. These entities have stepped up support for regional aviation and vigorously promoted its development. Since the eleventh five-year plan was introduced, the central budget has allocated a total of RMB 90.04 billion to support development of civil aviation, an amount more than double the figure in the tenth five-year plan period. RMB64.11 billion of the allocation is to support construction of civil aviation airports and air traffic control and RMB 24.26 billion is used to subsidize middle and small airports, regional aviation, and interest on loans for construction of infrastructure. The Chinese government will also improve existing regional aviation subsidization china market overview trends and analysis Chart 12 China Domestic Market Profile Percentage of Daily Flights Percentage of Markets 10% 15% 69% of departures with up to 120 passengers on-board 32% 22% 15% 16% 15% 75% No Nonstop Service < 2 flights > 2 flights 5-45 46-90 91-120 121-135 135+ Pax per Departure Source: Embraer; OAG; Airport-IS 21

policies to encourage airlines to operate on regional routes. These revisions include an exemption on import duties and the value-added tax for spare parts of regional aircraft, and the exemption of airport construction fees allocated to regional flights. Implementation of these new policies will effectively reduce the cost of travel for passengers, stimulate consumer demand for regional flights, enhance sector profitability and encourage airlines to increase capacity on routes connecting mid and small-size cities. In order for people living in remote areas to benefit from air transport, the Chinese government will need to better understand the experience of the more mature airline industry of developed countries so that it can improve its local policies and guarantee basic services. The government will also need to provide more support to those small and medium-sized regional airports with low passenger volumes and encourage airlines in the form of funding and policies to increase capacity on regional sectors. All these measures will raise regional aviation in China to a higher level. Urbanization Driving Growth of the Regional Aviation Market In the 20th century, urbanization had become the most common social evolution phenomenon in the world. Since 1950, the world s population increased from 2.5 billion to 6 billion. Sixty percent of the population is in urban regions, particularly in developing countries. If the 20th century was defined by urbanization for developed countries, then developing countries will be recognized for their urbanization in the 21st century. China s own drive to urbanization accelerated in 1980 and continues today. (Chart 14) The Chinese Academy of Social Sciences (CASS) highlighted in its 2012 Urban Blue Book: China City Development Report No.5 that China s urban population reached 691 million in 2011 with an urbanization rate of 51.27% and a population urbanization rate of more than 50%. The trend indicated that China began to shift from a predominantly rural society to an urban one. Acceleration of urbanization not only brings huge changes in cities but also Chart 13 Connectivity in China connection<10 connection11-40 connection41-70 connection71-100 connection>101 22 Source:OAG

promotes closer social, economic and cultural contact and exchanges with others. In such a process, rural people flood to cities and become consumers of transportation. With the emergence of a greater number of midsize and small cities, China s regional cities will be at the forefront of rapid development. Changing life styles associated with that development also impacts methods of consumption. With more disposable income, people are more willing to travel and their spending on transport can increase in multiples. Statistically, the proportion of travel expense per capita as a percentage of disposable income increased from 7.9% in 2000 to 14.73% in 2010 ( Chart 14) Increasingly Fierce Market Competition Urging Airlines to Keep Improving Operating Efficiency Rapid development of Chinese aviation has led to increasingly fierce competition among airlines in the more developed eastern regions of the country where air transport markets are becoming saturated. Carriers are shifting their attention to remote areas and seeing the development of regional aviation as a new source of profit. There are few flights between many second and third-tier cities and there is even a lack of nonstop flights between some cities. In the future, Chinese airlines will need to serve these markets with more economical aircraft that have lower risk and fewer seats so that they may maximize both social and economic returns. High-speed rail means more competition and challenges for air transport but it also signals new opportunities for regional aviation. Firstly, high-speed rail mainly serves the densely populated and economically developed regions so its impact on trunk air routes is far greater than that on regional routes. As a result, regional aviation will still be the dominant mode to connect the vast western regions to the world. Secondly, because the distances between high-speed rail stations are long, regional airlines can provide convenient services between many second- and third-tier cities. This is also applicable in the developed areas in the east of the country. Finally, on some city pairs that are also served by high-speed rail, airlines will certainly face the problem of over-capacity as their passengers migrate to rail. In order to stay competitive and profitable, carriers will need aircraft with fewer china market overview trends and analysis Chart 14 Proportion of Travel Expense per Capita as a Percentage of Disposable Income 60 Proportion of urban porpulation(%) 50 40 30 20 10 0 7.90% 12.55% 14.73% 1949 1974 1984 1994 2004 2000 2005 2010 23

seats. Regional jets with their more appropriate seat capacity can become powerful competitive tools. The age of low fuel prices is long gone. Both aircraft manufacturers and airlines are relentless in their efforts to improve fuel efficiency. The impact of fuel prices on the operating cost of an advanced 100-seat jet is far lower than that on the operating cost of an existing widely-used 150-seat aircraft (Chart 15). Jets with fewer seats are an ideal choice for airlines to open new markets with lower risk, offer more frequent flights, and with more optimized fleets. As fuel prices keep rising, airlines in China are facing increasing pressure to adopt practices that protect the environment. Chinese airlines have been replacing a large number of ageing aircraft such as the MD82, BAe146 and B737-300 with new, more environmentally-friendly, fuelefficient types and improving the efficiency of flight operations to save energy and reduce emissions. In the future, airlines will pay more attention to right-sizing their fleets to better match capacity to market demand in order to increase seat occupancy and reduce over capacity. Regional jets will be instrumental in delivering true advantages in markets with low and medium passenger volumes. A Break with Tradition Creating New Ways for Regional Aviation Inner Mongolia is an important heavy industrial, commercial, tourism, agricultural and animal-rearing province in North China. Its transport system is underdeveloped in a region that spans 2,400 kilometers from east to west and 1,700 kilometers from north to south. There are a large number of airports separated by long distances that, by themselves, give regional airlines an advantage. There are 14 civil airports in the Inner Mongolia Autonomous Region, all of which are regional airports with the exception of Hohhot Airport(Chart 16). For years, several factors prevented the development of regional aviation in Inner Mongolia. First, airlines did not have the right capacity aircraft for regional routes. Second, airlines were not willing to start regional flights because of high operating costs. Third, airlines were reluctant to Chart 15 Impact of fuel prices on operating costs hange of operating cost per flight segment (RMB) 3,500 3,000 2,500 2,000 1,500 1,000 500 0 150-seat jet Advanced 100-seat jet 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 Fuel price change (RMB) 24 Source: Embraer

deploy their existing aircraft on regional city pairs that had a wide range of passenger volumes that made it difficult to develop markets and generate profits. Contrary to the reluctance of airlines to introduce more regional flights, local governments were eager to respond to the urgent demand for new service since new frequencies would attract local economic investment. To address the stalemate, the Inner Mongolia Airport Corporation broke with tradition and actively explored new ways to develop regional aviation. In February 2006, it established a virtual airline to operate several regional routes that not were not served by airlines. A virtual airline is different from a true airline in that it is not required to be registered or to buy aircraft that operate under a corporate structure. An entity of this kind can lease aircraft from other airlines, pay rentals through daily usage rates, and fly on any regional route within Inner Mongolia over a long period of time. A virtual airline is intended to cultivate the market as a market pioneer. Once is becomes profitable, the route is transferred to an airline. This process reduces the risk for airlines operating in regional environments and encourages carriers to participate in the development of more regional services. Since this initiative was introduced, many airlines have partnered with the Inner Mongolia Airport Cooperation. The concept of a virtual airline has stimulated the regional airline industry in Inner Mongolia by making air travel more accessible to consumers. After two years of operating a virtual airline, government subsidies to the Civil Aviation Administration of Inner Mongolia reached RMB 850 million. In that time, the government realized the tremendous importance of regional aviation and was recognized for contributing to the social welfare that air transport provides. Governments of various other cities in Inner Mongolia noticed the positive impact of regional aviation and offered their own financial incentives. Many domestic airlines began increasing capacity on regional routes within Inner Mongolia. Today, there are 15 domestic airlines serving routes in the region. The establishment of the virtual airline not only addressed Inner Mongolia s poor market forecast by the numbers 25

air service, it also brought significant economic returns to its airlines Moreover, it has satisfied consumer demand for more flights and promoted more economic activity. A virtual airline has one main advantage carriers do not need to find new business in the market. They need only to focus on flying their aircraft, maximizing daily utilization and performing routine maintenance. Before the virtual airline concept was introduced, airlines opened routes and then abandoned them. Today, regional routes have regular flight schedules with aircraft of sufficient capacity to meet market demand. Operational risk to airlines has been reduced and airports have seen improvements in cash flow. Where there was once monopoly service, there are now several carriers competing on the same route. In 2011, airports in Inner Mongolia enplaned 9.109 million passengers (a YOY increase of 21.3 %,) had cargo throughput of 46,000 tons (a YOY growth of 34.3%) and recorded 100,000 landings and takeoffs (a YOY increase of 22.8 %.) Today, some 164 air routes connect over 60 destinations. The virtual airline concept has made a remarkable difference in the region. In developing the virtual airline concept, 50-seat ERJ145s were favored by the Inner Mongolia Airport Corporation. Their low operating costs and smaller seat capacity gradually became the predominant type in the virtual airline. Over the years, Tianjin Airlines and China Eastern Airlines operated ERJ145s in Inner Mongolia with economic success. From the perspective of the Inner Mongolia Airport Corporation, there can be no B777 aircraft in the Inner Mongolia air transport market which, however, cannot work without ERJ145. Recently, the ERJ145s have been gradually withdrawn from some of the long-established, mature routes and redeployed on new ones.the mature routes are now flown with 100-seat E190s that offer more capacity and better economics. The Inner Mongolia Airport Corporation s innovative and successful development of regional aviation clearly shows that aircraft with fewer than 100 seats have great potential in China. The imbalance in trunk route and regional aviation has been one of the factors restricting development of civil aviation. The tough challenge has been successfully addressed by the CAAC Chart 16 Airports in Inner-Mongolia 26

of Inner Mongolia through incentives to local governments, leading departments of the industry, airlines and airports. In 2011, the RPKs on regional routes already exceeded those on trunk routes in Inner Mongolia, proof that the model can work elsewhere in the country. The Inner Mongolia Airport Corporation has expanded its development plan for regional flights through the introduction of regional express airlines that follow the principles of using small aircraft with high frequency and selling tickets at low prices to generate high passenger loads. Regional expresses offer consumers transport between regional and neighboring hub airports, strengthening the network scope of those regional airports. Preferential ticket pricing policies are enabling more people to benefit from air service. Aircraft passenger load factors are climbing which, in turn, is keeping operations viable. In 2010, the Inner Mongolia Airport Corporation launched the Hohhot- Xilinhot Regional Express. The objective was to establish frequent flights rather than immediate profitability. Even in the peak season when seats were in limited supply, fares were kept low to ensure more passengers would travel. Seven daily flights offered tremendous convenience and assured that Xilinhot was always accessible. Its location in a relatively remote area is now connected with several regional points including the hub airport in Hohhot where passengers can transfer to any destination in China and then to the world. The opening of regional expresses has brought new benefits to a large number of passengers. The flights have introduced affordable air travel to an entirely new segment of consumers, improved accessibility of cities served by regional airlines and strengthened regional airports. Today, regional airlines in the Inner Mongolia Airport Corporation are raising the profile of essential air services. Although the road ahead has many challenges, the outlook for regional aviation in Inner Mongolia looks bright as more people become aware of the benefits of air travel and the market grows. Success of the Inner Mongolia Airport Corporation undoubtedly provides valuable experience for the development of regional aviation in other areas of China. market forecast by the numbers 27

28 Right-sized aircraft are opening new markets and building the emerging economies of the world.

china market outlook 2012 2031 market forecast by the numbers 29

Regional Aircraft Market Forecast - China China s impressive growth over the past few decades has established it as largest economy in the world, only second to the USA. Although there are a number of challenges in developing regional aviation in China, Embraer remains optimistic with its forecast. In the future, the gradual implementation of the Essential Air Service program and the operation of more new airports together with the improvement of the country s regional route network will require Chinese airlines to introduce more regional aircraft. More flights in those markets will, in turn, promote natural development of the sector. China s economy is forecast to continue with a high rate of annual GDP growth rate no lower than 5.5% over the next twenty years. By 2031, China s airlines will have 4,705 aircraft which will represent 12.9% of the world fleet. growth and 12% to replace old aircraft in the current fleet (Chart 17). The 30 to 120-seat jet fleet will increase from the current 125 units to 1,005 by 2031 with its share of the total feet increased to 21%. Turboprops From 2012 to 2031, 170 new turboprops will be delivered to Chinese airlines: 6% to replace ageing and old aircraft and 94% to support market growth. The turboprop fleet in service is projected to increase from 20 to 180. 120+ Seat Jet Segment Embraer foresees a requirement of 3,375 new aircraft with more than 120 seats and of various types: 46% to replace ageing and old aircraft and 54% to support market growth. The 120+ seat jet fleet will grow from the current 1,685 to 3,520. Eight percent of the current fleet will still be in service by 2031 30 to 120-Seat Jet Segment Embraer forecasts a need for 1,005 new aircraft by Chinese airlines in the next two decades: 88% to support market Chart 17 China Regional Aircraft Fleet Evolution Number of Aircraft (30-120 Seat Segment) 1,005 880 125 125 Growth Replacement 2011 2031 30 Source: Embraer

Projected New Deliveries - China Seats 2012 ~ 2021 2022 ~ 2031 2012 ~ 2031 Turboprop 30~60 60 60 120 60+ 25 25 50 Total Turboprops 85 85 170 Jet 30~60 0 0 0 61~90 260 195 455 91~120 190 360 550 Total 30-120 450 555 1,005 NB 121-210 975 1,695 2,670 market forecast by the numbers WB 210+ 310 395 705 Total 120+ 1,285 2,090 3,375 Total Jets 1,735 2,465 4,380 Total 1,820 2,730 4,550 Projected China Fleet in Service Seat 2011 年 2031 年 Turboprop 30~60 20 130 60+ 0 50 Total Turboprops 20 180 30~60 65 0 61~90 5 455 91~120 55 550 Jet Total 30-120 125 1,005 NB 121-210 1,395 2,670 WB 210+ 290 850 Total 120+ 1,685 3,520 Total Jets 1,810 4,525 Total 1,830 4,705 31