testimony

 

Before the U.S. House of Representatives Judiciary Committee

Regarding Airline Alliances

May 19, 1998

Mr. Chairman and members of the committee, my name is Kevin Mitchell.  I am Chairman of the Business Travel Coalition (BTC), an advocacy group located in Lafayette Hill, PA.  BTC was formed in 1996 by a group of corporations to initiate a debate about the need for increased levels of airline industry competition.

BTC represents the interests of 20,000 independent business travelers, mid-size airports, and major corporations including Black & Decker, Chrysler, Ford, General Motors and Procter & Gamble as well as smaller companies such as American Inks and Coatings. 

During 1997, BTC conducted two Airline Competition Summits in Washington, D.C. to shed light on airline industry competition problems, and to examine solutions.  Some 500 business, community and government leaders from 37 states participated in the Summits, underscoring serious concerns about the status of airline industry competition.

Thank you for requesting the views of customers of the air transportation system. Today’s hearing regarding recently announced airline alliances is critically important and symbiotic with the overall debate regarding airline industry competition.

My testimony will include the following sections:

• Position Summary Regarding Proposed Alliances
• Competition Debate Background
• Concerns Regarding Competition Levels
• Concerns With Competitive Consequences of Proposed Alliances
• Recommended Remedies—Primary, Secondary

I.   Position Summary Re Alliances

BTC participants are impassioned champions of deregulated and open markets. We are not opposed to airline alliances per se.  But recently announced alliances—CO/NW—UL/DL—AA/US—will accelerate market concentration, reduce choices and increase costs for business travel.  This development comes at a time when experts concede the industry is already too concentrated. 

Importantly, the competitive analysis of the proposed alliances must be expanded beyond markets in which partners currently provide overlapping service, and include secondary competitive effects in other markets.

It is BTC’s analysis that these transactions should be blocked.  If regulators’ analyses turn out differently, then substantial remedies must be negotiated to address current competition problems as well as additional problems that will result from these alliances. 

II.   Competition Debate Background

In the year since BTC held its first Airline Competition Summit, a consensus has emerged that, at the 20th anniversary of airline industry deregulation, we have serious systemic competition problems.  Those concerned are unbiased individuals and organizations whose only interests in the debate are a stronger airline industry and consumer welfare.

Those who have publicly expressed concern include some of the most ardent free market defenders in Congress--from both political parties, leadership at the U.S. Departments of Justice and Transportation, transportation scholars and the Editorial Boards of major newspapers such as The New York Times.  Even Alfred Kahn, the “Father of Deregulation” has expressed dismay at the state of industry competition and the lack of stewardship shown by airlines entrusted with the public’s assets and the confidence of Congress through the Deregulation Act of 1978.

The airlines’ first response to BTC’s April, 1997 Airline Competition Summit was denial that there is a problem.  Shortly thereafter, airline CEOs began a campaign of labeling concerned government officials as mere “backdoor re-regulators.”  Soon the message shifted to the suggestion there is a “perception problem” wherein airlines had done a poor job of educating government and consumers about how they price their products.

More recently, airlines testified before Congress that the real problem was that DOT had done a shoddy job in the past two years of promoting the consumer benefits of deregulation—in other words, DOT had stopped being major airlines’ shill. 

And in one of the more offensive acts in this saga, an airline executive recently compared Congressman James Oberstar to Fred Smith’s professor who could not see the possibilities of a Federal Express.  To appreciate this miscue, consider that Representative Oberstar is probably the most knowledgeable Congressman on airline matters in the history of aviation.

The Washington, D.C. airline lobby had become accustomed to getting its way through tactics of strong-arming, stonewalling and shifting the debate with disingenuous spin.  But what changed this past year is that airlines’ best corporate customers, having had their concerns ignored, combined their voices with those of consumers, communities, airports and government officials.  A “divide and conquer” strategy was no longer an available alternative to major airlines.

Airlines’ miscalculations, and unproductive public responses, continue even as the airlines have lost the argument.  The Air Transport Association (ATA) apparently recently retained a public relations firm to conduct focus groups around the country.  The purpose was to craft a message that would be believable when airlines state they are not engaged in anticompetitive practices and that there are no competition problems.

The first target of what will surely be a well funded public relations attack is DOT’s proposed Enforcement Policy Regarding Unfair Exclusionary Conduct in the Air Transportation Industry.  Full page newspaper advertisements last week unveiled the ATA’s new message:  the DOT policy will result in higher fares and less service.  Apparently, major airlines have not yet grasped that it is ultimately counterproductive to insult the intelligence of so many people that have so much to say about the future of so many airlines. 

It is said the First Rule of the Hole Theory is, when your in one, stop digging.  And DOT Inspector General Kenneth Mead recently warned that if airlines don’t engage in a sincere problem solving process with government and other stakeholders, they risk ending up with an equivalent to the Surface Transportation Board to hear customer and competitor complaints, or something worse.

III.   Concerns Regarding Competition Levels  

Deregulation was to allow any airline—willing, fit and able—the opportunity to offer services at all U.S. airports.  Marketplace efficiencies were to be driven by consumers’ purchasing decisions.  And deregulation was to bring competition in the form of new airlines—the mere threat of market entry was to be sufficient to discipline prices—the “contestable markets” theory. 

Instead, today we have highly concentrated hubs, record-level business airfares and virtually no new entrant airline applications to DOT in the past two years.  And while GAO and DOT studies do show deregulation has lowered average fares, these benefits have been unevenly distributed.  For example, access to affordable business airfares for the upper Mid-West, Southeast and Northeast is actually worsening at a time benefits from deregulation should be expanding.   

BTC recently performed an analysis of average yields at three so-called “Fortress Hubs” to determine the premium consumers there pay.  These three Fortress Hubs—Cincinnati, Dallas/Fort Worth, Detroit—were compared with three other more competitive airports—Los Angeles, Seattle, Kansas City—that also offer excellent non-stop services, but affordable airfares as well.

BTC found that consumers pay exorbitant premiums at these Fortress Hubs.  Worse, because the data are averaged, the much higher prices business travelers pay are masked.  Lack of competition is the reason prices are high, not the robust economy, strong demand for air travel and superior levels of non-stop service that incumbent carriers insist are the reasons. 

Indeed, the analyses in the three charts below prove that a deregulated airline industry can produce intended consumer benefits where competition is allowed to flourish.

 

 

 What’s gone wrong?  There appear to be systemic problems.

1.  Mergers such as Northwest/Republic—TWA/Ozark—USAir/Piedmont—were allowed to proceed          during the 1980’s with little scrutiny regarding potential impact on future competition levels.

2.  Airline practices intimidate investors and limit competition.  Examples abound.

Responding to new entrants with exclusive corporate contracts, increased frequent flyer benefits and travel agency commission bonuses.

Dumping large amounts of cheap seats into a market to drive out a new entrant.

Blocking new entrants by refusing to sublease airport facilities such as gates and counter space.

3.  Federal regulations still exist that stifle competition such as the High Density Rule.  Implemented in 1986, this rule provided incumbent airlines at four major airports—DCA-JFK-LGA-ORD—coveted takeoff and landing time slots for free, which ultimately resulted in greatly diminished competition levels.

IV.   Concerns With Competitive Consequences of Proposed Alliances

According to Salomon Smith Barney, 66% of the 50 largest U.S. airports--which account for 80% of all enplaned passengers--are excessively concentrated.  The balance of the airports are considered concentrated. 

There is a national debate regarding existing competition levels that has yet to include sincere input from major airlines.  Therefore, without an industry “settlement” regarding the status of competition at the 20th year milestone, it is dangerous to allow the allocation of 80% of the domestic air transportation market among three alliances to proceed.

Regulatory analysis should encompass the direct and indirect impacts on competition to include the following considerations:

Overlapping Routes.  Airlines mislead when they argue that their alliances will only overlap on some small number or percentage of city-pair routes.  Many of the route overlaps are huge markets such as Detroit – New York.  For example, Continental and Northwest overlap in markets with a combined total of approximately 4 million annual passengers.

The near total consolidation of the domestic U.S. market into just a few superpower supplier blocks will reinforce the recent practice of major airlines avoiding competition by staying out of each other’s hubs

Hub-To-Hub Quid Pro Quo.  The Stealth weapon against competition and free markets will likely be the wink and a nod” organization of hub-to-hub routes, capacity and pricing.  For example, hypothetically, United could help alliance partner Delta in the Cincinnati - Salt Lake City market in exchange for Delta’s help in the Los Angeles - Chicago market.

Delta flies non-stop from Cincinnati to Salt Lake City while United flies from Cincinnati to Salt Lake City through Chicago.  United could reduce its low fare capacity to Salt Lake City to allow Delta to raise its prices further.

In return for this favor, Delta could reduce its low fare capacity from Los Angeles to Chicago through Salt Lake City.  This would allow United to increase its prices on its non-stop service from Los Angeles to Chicago.

The breadth and scope of this category of quid pro quo, needs to be understood on an alliance-by-alliance and industry-wide basis.

Domestic Airline Leverage Vis-à-vis Corporations.  The proposed transactions--NW/CO        - AA/US - UL/DL--will provide airlines with even greater leverage in negotiations with                  corporations.  In a hypothetical negotiation with Detroit-based “ABC Corp.”, Northwest                   Airlines would likely have unfair leverage over ABC Corp.  For example, it could require,       for existing discounts with Northwest Airlines to remain in effect, that ABC Corp. shift                its business elsewhere in the new alliance network to Continental.

 International Airline Leverage Vis-à-vis Corporations.  Hypothetically, after the United-Delta alliance is fully approved, Delta will be positioned to call on a corporation in Cincinnati and introduce the customer to their “new Star Alliance Global Suppliers.”  In other words, the customer will have its international suppliers dictated to them. 

Delta will be able to leverage its dominant position in the Cincinnati market to require corporations there to move market share to Star Alliance partners in other markets in order to maintain any type of discount with Delta.  A quid pro quo will likely apply here.

Consumer Confusion.  In a free market, consumers require complete and accurate information regarding real choices in order to drive marketplace efficiencies and innovation.  For example, 65 different airfares with varying rules between Cincinnati and Atlanta alone represents consumer confusion, not true consumer choice.  When you overlay this already complex structure with the current 400 domestic and international airline alliances, comprising 177 airlines--that on average last only 2-1/2 years--the consumer will continue to pay unnecessarily high prices.

Airline Leverage Vis-à-vis Travel Agencies.  In recent years travel agencies have had their commissions cut to a point where many are on the precipice of financial collapse.  Similarly, because new airline entry has virtually dried up, incumbent airlines have been able to dramatically increase their leverage over travel agencies at the negotiation table on a variety of issues.

As these alliance partners pull out of markets and reduce capacity in support of each other’s yield management goals, commission override programs will become more strategically targeted.  Financially beleaguered travel agencies will be easy targets for airlines seeking to transform them into “Exclusive Dealerships” where, for example, the agency only sells Star Alliance partners in markets where those partners provide service.

The long-term ramifications for competition are staggering and we are already seeing the beginnings of the end-game with British Airways’ test of an exclusivity-oriented commission override program in the Miami to London market.  Travel agency dealerships would likely have the following consequences:

The loss of unbiased advice for consumers who need to understand the competitive choices available in an increasingly complex and confusing fare structure environment. 

New entrant airlines will be effectively blocked from the primary distribution channel.

New Entrant Blocking.  The proposed alliances will make available vast new resources, including joint frequent flyer and frequency scheduling and travel agency and corporate marketing programs, to frustrate new entrant competition.

The Demise of Frequent Flyer Benefits.  DOT, and other industry participants, believe that the competitive forces unleashed by deregulation have produced the frequent flyer benefit.  Call it a discount, call it a perk--it’s a quantifiable benefit.

In recent years, airlines have dramatically expanded their ancillary frequent flyer programs with partners such as banks, florists and roofing companies wherein airlines sell frequent flyer points for two cents per mile.  Indeed, one major airline has a program for undertakers where he receives one free round-trip ticked for every 30 corpses shipped on the airline.

The upshots are an increasing number of consumers accruing frequent flyer points and ever more angry travelers unable to redeem points for tickets.  The problem of securing seats to popular destinations using frequent flyer points has become frustrating for consumers.

The proposed alliances will make it virtually impossible for the so-called “Road Warrior” to take his or her family on a vacation to a popular destination that perhaps he or she spent years working toward.  Airlines allocate approximately 8% of their seat inventory for frequent flyer redemptions.

If, for example, the Northwest – Continental merger is approved, 26 million Northwest frequent flyer members will have instant access to Continental’s limited seat inventory.  Consumers who are members of Continental’s frequent flyer program, like the millions of Americans who belong to all six airline alliance partners’ frequent flyer programs, will lose a highly cherished benefit.

V.   Recommended Remedies

As stated previously, there are sufficient compelling reasons to either block these proposed alliances or defer their examination until there is a “settlement” with the airline industry over a host of competition issues.  Barring these outcomes, the alliances should only be approved if an effective set of remedies is enplaced to correct for current marketplace distortions and anticipated competition problems resulting from the further reduction in competition.

PRIMARY REMEDIES

1.  Issue.  The proposed alliances may offer “seamless” service in some cases.  However, from a pricing standpoint, the customer will continue to be held hostage in individual city-pair markets as well as the hub-to-hub markets, as discussed earlier.  Moreover, these alliances will greatly strengthen airlines’ market and pricing power.

Major airlines like to use the telecommunications industry model as a rationale for networked alliances.  They argue that 30 years ago a phone call from Washington, D.C. to Cairo, Egypt would go through some five telephone companies, and the consumer would know it, often getting disconnected.  By contrast, today the service is “seamless” even though the consumer is not aware he may still be handed off from one telephone company to another.

However, the plausibility of the comparison ends there.  Recently, AT&T announced a new cellular phone pricing plan.  For 11 cents a minute customers can call anywhere in the country without roaming or long distance charges 24 hours a day, 365 days a year.  Competitors are expected to follow. 

This is pro-competitive because businesses can now avoid being held hostage in individual monopolistic phone markets where obscene roaming charges are extracted.  Unlike in the airline industry, businesses will be able to receive bids on their phone volume each year in a simple process that will support price competition.

Remedy.  The remedy is to require alliance airlines to offer a simplified, system-wide pricing structure.  The structure could be based on a cents-per-mile, anywhere in the system approach.  Alternatively, to account for the saw tooth effect of per-mile pricing, mileage blocks could be established.

This remedy would release businesses currently held hostage in monopoly markets and encourage price competition among the proposed three mega networks.  Businesses will be able to put their air travel volumes out to bid on an apples-to apples basis.

2.   Issue.  Even large businesses that spend millions of dollars in annual air transportation purchases have surprisingly little parity at the negotiating table with airlines.  Small businesses are particularly powerless.

For example, in 1994, IBM with $300 million dollars in annual air transportation purchases asked its airline suppliers to remove frequent flyer programs from their contracts.  Airline response was not no--it was hell no.  In what other industry would a buyer with $300 million dollars to spend not be able to negotiate what product features it wanted added, dropped or changed?

Similarly, in 1996, the Business Travel Contractors Corporation, a corporate buying group, offered airlines $1.5 billion in business opportunities in exchange for a simplified airfare structure and airfares guaranteed for the term of a contract.  Airlines were able to ignore $1.5 billion in new business opportunities!

Airlines currently have awesome market power and incredible leverage over their very largest customers who spend millions of dollars on air travel.  Allowing 80% of the country to be carved up among three superpower supplier blocks could make 1998 seem like the good old days when a $2000.00 coast-to-coast fare was apparently a bargain.

The real point here is that Congress and federal regulators should not be so concerned about the Fortune 100 who have joined the Business Travel Coalition out of frustration and concern.  Rather, the concern should be focused on the other 9 million U.S. businesses that have no chance of negotiating with airlines.

Congress should be particularly worried about a subset of U.S. businesses.  According to USA TODAY, "About 276,000 companies account for 70% of all job growth. That's just 3% of all U.S. companies. And of those companies, 97% have 100 or fewer people working for them when they start growing."  Businesses require access to affordable airfares to grow their businesses.  Our current robust economy is masking a deleterious impact on small businesses that we will all pay for sooner or later. 

Remedy.  As a condition for alliance approval, regulators should require airlines to negotiate business agreements with buying cooperatives comprised of small and mid-size businesses.  The cooperatives would be self-organized and independent from the government.  This may be the only conceivable solution for the millions of small businesses and independent business travelers.  This remedy is particularly appealing when combined with the preceding remedy regarding system-wide, simplified pricing.

3.   Issue.  As explained earlier, the proposed alliances will likely eliminate for some consumers the benefit of the frequent flyer programs.  The 26 million members of Northwest’s frequent flyer program will surely find Continental’s service levels and popular destinations to South America very appealing.  Continental’s frequent flyer members will likely lose much of their benefits as they will find it difficult, if not virtually impossible, to redeem their frequent flyer points for tickets to popular destinations at desirable times.

Remedy.  Regulators should require alliance airlines to offer frequent flyer members the option of cashing in their frequent flyer points for two cents a mile—exactly what airlines are selling them for--so they could at least use the funds to help defray the costs of a flight on any airline providing service to the desired destination.  Otherwise, the frequent flyer points become virtually worthless.

SECONDARY REMEDIES

1.    Issue.  Travel agency commission overrides can be targeted against new entrant competitors in a way that prevents consumers from knowing a lower priced product is available in the market.  For example, the Free Press reports, “And in a give-no-quarter move, a fax from Northwest to travel agents showed that the big airline was offering a whopping 20-percent commission to agents (who then typically got 10 percent) if they booked Northwest flights to the Pro Air destinations.”

The targeted use of override commissions can deprive a new entrant from reaching its breakeven load factor resulting in its exit from a market wherein the incumbent airline is free to raise prices.

Remedy.  DOT must issue guidelines regarding what constitutes unfair, exclusionary conduct with respect to use of override commissions.

2.    Issue. There are numerous anticompetitive practices such as commission bonuses targeted against new entrants.  However, the recently proposed Enforcement Policy Regarding Unfair Exclusionary Conduct in the Air Transportation Industry focuses on the most important competition problem:  an incumbent airline dumping massive numbers of cheap seats into a market to intentionally run a new entrant out.

The objective of this predation is to prevent a new entrant from reaching its 60% breakeven load factor by starving it of traffic through adding capacity.  If an incumbent carrier were to match a new entrant seat-for-seat, a typical response to entry by Southwest Airlines, the new entrant would do just fine because market size can triple in response to affordable fares.

However, when an incumbent that previously had 1,000 seats in a market at $75.00 responds to a new entrant by adding 50,000 seats at $75.00, it erodes its own revenues by millions of dollars.  This is a “red flag” sign of predation. 

The only rational explanations for losing such sums of money are if:  1) an incumbent’s purpose is to run a competitor from a market and then recoup loses through fare increases to previous or higher levels; and 2) if the predation serves to discourage future entry into markets dominated by the incumbent.

BTC believes the proposed DOT policy is an important step of the many required to remedy market power abuses.  BTC would like to see the policy strengthened in terms of punishment.

Remedy.  If an incumbent airline is found by an Administrative Law Judge to have engaged in predatory behavior, in addition to fines, it should be required to maintain the capacity and pricing used in response to the new entrant for 10 years.

3.    Issue.  Computer reservation systems (CRSs) owned by major airlines are not permitted to compete on price because of DOT rules.  Accordingly, the prices charged by CRSs are undisciplined and have increased recently at a rate of ten times the inflation rate for some airline customers.

Major airlines that own these CRS’s derive excessively profitable revenue streams that are used to cross-subsidize competition with low-fare airlines by dumping thousands of cheap seats into markets.  Likewise, the exorbitant prices charged by CRSs increase costs for smaller, low-fare airlines.  At the end of the day, the consumer is paying for a dysfunctional, costly distribution system in the price of the airline ticket.

Remedy.  Require major airlines to divest themselves of CRSs.  Furthermore, allow corporations and buying groups to introduce price competition by issuing Requests For Proposals to the newly independent CRSs.  Cross-subsidization will disappear, airlines’ costs will fall and the consumer will benefit from lower prices.

4.    Issue.  Major incumbent carriers at the four High Density airports were provided takeoff and landing slots for free as a result of the 1986 Buy-Sell Rule.  These slots are extremely valuable as evidenced by entries on airlines’ balance sheets.  The slots are a license to print money with the public’s assets, and moreover, used to cross-subsidize competition with low-fare airlines.  Likewise, new entrants cannot gain sufficient access to these strategically important airports because incumbent airlines are unwilling to sell or lease slots to them.

Remedy.  Require incumbent airlines at the High Density airports to pay a slot lease fee to the government in consideration of the value of these public assets.  Proceeds should be used to support capacity expansion initiatives for new entrant competition.

5.    Issue.  Frequent Flyer programs are a huge barrier to competition.  Many airlines respond to new entrant competition by doubling or tripling points to discourage consumers from supporting a new entrant.  New entrant carriers without a mega network are at a disadvantage when faced with this type of targeted anticompetitive response.  The problem will grow exponentially more serious as these proposed alliances combine their frequent flyer programs.

Remedy.  Require alliance partners to allow all airlines’ customers to redeem their frequent flyer points on alliance partners’ flights.  For example, customers of Southwest Airlines would be able to redeem points earned on Southwest Airlines for tickets on United Airlines.  This would reduce the anticompetitive impact of the combined alliance frequent flyer programs and be a major benefit to consumers.  An ARC-like clearinghouse could facilitate the reconciliation process among airlines.

Mr. Chairman, this concludes my testimony.  I appreciate the opportunity to present a customer perspective on competition issues and the proposed alliances.