UK: HOW STATE AID BOOSTS THE FLAGGING AIRLINES.

UK: HOW STATE AID BOOSTS THE FLAGGING AIRLINES. - The Uneven Playing Field - Part 2. Since January, EC carriers have had the right to fly anywhere in the Community. Yet this new measure to improve competitiveness in the open market is being distorted, as

by Stephanie Cooke.
Last Updated: 31 Aug 2010

The Uneven Playing Field - Part 2. Since January, EC carriers have had the right to fly anywhere in the Community. Yet this new measure to improve competitiveness in the open market is being distorted, as governments aid their own flag carriers. Britain is the only country which does not subsidise its leading airlines.

For almost a decade the European Commission has encouraged the airline industry along the path to an open, competitive market. On paper, at least, it has succeeded. Since 1 January 1993 all EC air carriers have had the right to fly anywhere within the Community following the EC's 'open skies' legislation. Yet clouds still linger. The British airline industry believes that the biggest obstacle to a successful open market is state aids. According to the Air Transport Users Committee (AUC), the Civil Aviation Authority's independent watchdog, these are a threat to the success of the single market. 'State aids constitute the greatest danger to a competitive and sustainable air transport market, for they distort competition between existing carriers and discourage new-comers from entering the market,' it warned in a memorandum to the European Commission last September.

Its concern is well founded. Over the past two years the the EC approved funding from governments to Air France, the Belgian airline Sabena and the Spanish carrier Iberia, amounting to a total of around £2 billion. British airlines, on the other hand, have received no government funding. Indeed, British Airways is the only flag carrier within the EC that does not receive direct financial backing from the state.

David Holmes, British Airways' director of government and industry affairs, says, 'Our worry is that if these three cases are taken as a precedent, they will open the way for state subsidies for almost every carrier in Europe.' British Midland chairman, Sir Michael Bishop, agrees: 'Fair competition cannot exist in Europe's airlines whilst direct state subsidies and indirect government actions continue to distort the market, allowing national airlines to escape the commercial pressures faced in the real world.' Furthermore, Virgin Atlantic's managing director, Syd Pennington, takes the view that 'state aids perpetuate inefficiency. They do not allow fair and free competition to develop.' Over the past two years, French taxpayers have contributed a direct cash injection of FF2 billion (£201 million) to supporting Air France. The company has also received a total of FF3.8 billion (£411 million) from two loans from the state-owned Banque Nationale de Paris. The first of these was a direct loan; the second involved a consortium of 21 banks. Spanish taxpayers paid out Ptas 120 billion (£667 million) in aid to Iberia. And the Belgian government gave a total of BF38.2 billion (£675 million) in cash aid, debt transfer and bridging finance to its persistently troubled airline, Sabena.

Karel van Miert, head of the EC's competition directorate, nevertheless attempted to reassure the British airline industry in his written reply to the AUC memorandum: 'The whole application of state aid control to the air transport sector shall necessarily become more stringent with the adoption by the Council of the third package of liberalisation measures which mainly come into force on 1 January 1993.' This new stringency, however, is still far from evident in the industry. Caught in a worldwide slump, Europe's state-owned airlines appear unable to survive without aid. Moreover, due to their long history of inefficient management, Brussels still seems ready to lend an overly sympathetic ear to funding proposals. Heinz Hilbrecht, the head of the air transport directorate DG7 which reviews proposals, says, 'Some member states still carry the burdens of the past and so you have to give them more time to start afresh.' Industry sources say that the Portuguese airline TAP already has an application under review; Olympic Airways is expected to be next in the queue, and there are fears that Aer Lingus will follow suit.

The EC has clearly stipulated that in order for government help to be legal it must first pass the private sector test, meaning that private financing of the same magnitude must be feasible. But, in its third survey of state aids published in September last year, the Commission wrote that the state-owned Greek Olympic Airways' extensive use of state guarantees for its borrowings - its mounting losses stood at Dr111.17 billion (£347 million) in 1989 - could be 'aimed at continuing the operations of a company which is not viable if normal commercial considerations are applied'. Yet there is the possibility that the EC will nonetheless allow the airline to continue to receive government aid.

'There is immense concern that state aids are apparently being nodded through,' says an official at the Department of Transport. Many critics of these hand-outs argue that they are giving state-owned carriers a leg up in the new open market, where expansion is crucial to survival. Air France swallowed up two smaller French airlines, UTA and Air Inter, before the airline submitted its first proposal for a government cash injection in 1991. Since then it has taken a large minority interest (35.6%) in recapitalised Sabena, and an effective controlling stake in the state-owned Czech airline CSA, thus vastly expanding its route structure in Europe, Africa, the Middle East, Far East and North America. The CSA stake was financed by an Air France consortium including French state-owned banks and the European Bank for Reconstruction and Development (EBRD), which is headed by Jacques Attali, the twin brother of Air France chairman Bernard Attali.

Although the EBRD has strongly rejected suggestions of collusion, Air France's rivals say that it is difficult, given the circumstances, to see what else the bank could have had in mind. 'One of the objectives of the EBRD is to encourage privatisation and, of course, the acquisition of a state airline by another state airline has a lot to do with privatisation,' says one rival, sardonically.

For Air France the logic was immutable. First, CSA provide a gateway to eastern Europe and Russia. Second, the UK Air Transport Users Committee claims, it provides a convenient dumping ground for excess Boeing aircraft orders held by both Air France and Belgian Sabena. Iberia was expressly forbidden by the EC to use its state aid to acquire interests in other European airlines, but that did not preclude overseas expansion outside Europe. The Spanish airline now has stakes in the three major South American airlines: Aerolineas Argentinas, Viasa, and Lan Chile.

The AUC argues that without state assistance some of these expansions would not have been possible. 'Allowing flag carriers to expand in this way, despite a lack of internally generated funds, means that they are likely to dominate air transport in the European region for the foreseeable future; whilst unless there is a substantial and unexpected increase in demand, there is likely to be considerable excess capacity for many years.' Flag carriers have historically received the full political and financial support of their governments because of their potency as symbols of national pride. The move toward market liberalisation has done little to change that. On the contrary, it appears to have reinforced governments' commitment to defending their airlines interests in the new European order.

In the last industry downturn, in 1984, the EC declared that 'despite recent difficulties, the Community's air transport sector should normally be capable of coping with market forces'. It further stated that it would 'prevent the granting of state aids resulting in the transfer of the difficulties of the enterprise of one member state to those of other member states', and that 'the Commission can only authorise aids where there is a compensatory justification in terms of the common interest'. In theory, these rulings still apply, in reality things are very different.

A crucial explanation for the ambivalent attitude of the Commission to reviewing airline state aid proposals is the fact that decisions on these lie with Brussels' transport directorate (DG7), in the same way that coal and agriculture subsidy cases have remained with their respective directorates, because of their historic links with government, and politically sensitive natures. State aid cases for all other industries are automatically handled by the competition directorate (DG4). It has only a consultative role in airline cases. This means that the decisions on applications for airline state aid are strongly influenced by political and social concerns, while aspects relating to market forces often take a back seat. Significantly, while DG4 opposed the recent aid cases involving Air France, Sabena and Iberia, its decisions were overruled by DG7.

With regard to these decisions, DG7's Hilbrecht says, 'From a starting point we in DG7 were perhaps more inclined to see that the airlines had special problems, especially in a recession, whereas DG4 has responsibility for competition and so feels it has to look at the proposal from the competition point of view.'

In what some free marketeers regard as a cruel twist of political fate, DG7's previous director, Karel van Miert, was put in charge of the competition directorate in January. His predecessor, Sir Leon Brittan, voted strongly against all three of the aid cases.

Without government assistance, it is difficult to see how any of the recent recipients of state aid would have obtained the capital they needed. Outside their protected enclaves, a worldwide credit crunch is hitting the airline industry. Bankers are wary of lending, and the effective cost of borrowing for airlines is high. 'The current air finance markets will not meet the total funding requirements of the next decade or 20 years,' Klaus Schlede, Lufthansa's executive board member for finance, claims.

Yet, although higher operating costs and fewer passengers were eroding Air France's bottom line - its accumulated losses amounted to FF4.5 billion (£570 million) at the end of last year - the Commission claimed that the capital injection and loans were commercially justified, and therefore could not be counted as state aid.

'A capital increase is not aid if one can assume that a private investor in a comparable situation would take a similar decision. Short-term as well as long-term aspects have to be taken into account. The Commission's conclusion on the present case is specific to the situation of the company concerned. Air France is generally efficient and has good prospects for further development,' the Commission said.

As far as Hilbrecht is concerned there was no doubt that the loans to Air France met the conditions stipulated for government funding (based on the market investor principle). 'The big question was whether the capital increase should be considered aid. We evaluated Air France very carefully. It appeared quite a well run company, with efficiency indicators better than others in the EC and a programme of staff reductions and other cost-cutting measures. We thought it could be accepted as commercial.'

But assumptions that the airline would be out of the red by the end of last year proved optimistic. The airline lost an estimated FF3.2 billion (£405 million) in 1992, and further heavy losses are expected this year. Hilbrecht says: 'We are a bit surprised that in 1992 it had big losses which neither we nor Air France foresaw.'

Its rivals, however, did. Despite plans for some 1,200 lay-offs this year following 3,000 over the last two years, and other cost-cutting measures they believe the airline has a long way to go before it will be on a sound 42e footing. 'Air France could not be privatised in its present state,' says BA's David Holmes. 'What they need is the kind of transformation which BA had 10 years ago.' An official in DG4 also argues that the capital was not advanced on a commercial basis. 'The money they invested was much more than the return (on capital) would have justified, so they were, in our opinion, handing out aid.' Another anomaly in the agreed funding was the bank charges. The interest charged on the first direct loan from BNP (amounting to FF1.25 billion) was 6.5%, well below the industry average of 8.8%. The second FF2.58 billion loan by the 21-bank consortium, though higher at 10.9%, was viewed as generous given the airline's poor financial health and the industry's general slump. A rival concluded that BNP was arm-twisted by the government.

The Sabena and Iberia hand-outs were officially declared state aids. With regard to Sabena, the Commission justified approval for aid on the grounds that restructuring was obviously urgently needed within the company. As for Iberia, it ruled that the airline was suffering a temporary downturn and also needed help to restructure.

The staff in DG4 argued against aid to both airlines on the grounds that the restructuring plans 'over-estimated the market potential and underestimated the effects of competition in the single market', a source said. But the Commission argued that Iberia had made a substantial turnaround in the mid-'80s and that the capital increase was tied to stringent commitments from the Spanish government, including assurances that it would only be used for a restructuring programme - not to expand into Europe.

While Sabena's situation was considered 'alarming' with losses of BF42.2 billion (£700 million) in 1991, arguments for state aid 'could be considered as an example of the Commission's policy to give airlines supporting past financial burdens a chance for a fresh start within the framework of a reorganisation programme aimed at regaining commercial viability,' claims the Commission.

The Iberia case, however, sparked off complaints from the Federation of Air Transport User Representatives in the Community (FATUREC), an association of user groups within the EC. In a letter to Karel van Miert, FATUREC chairman Charles Flocard said that the carrier had been a 'consistent lossmaker' with losses of up to Ptas25 billion (£138 million) in the first half of 1992 alone. He claims that the recapitalisation made a mockery of the market investor principle, 'since it is inconceivable that any private investor would consider virtually doubling the capital of an airline which is unable to operate efficiently even in a market in which it is highly protected' and that 'the capital increases would be employed to ease the debt burden of Iberia's on-going fleet expansion'. Finally, he said, 'Government action to protect Iberia from the results of its inefficiencies would deter new entrants from seeking to serve the Spanish market under the freedoms which are now being made available by the Council of Ministers.' Karel van Miert defended the decision insisting that it was 'fully compatible with the Court of Justice's case law and the Commission's policy of evaluating capital injections in accordance with the so-called market economy investor principle'. In Iberia's case, he added, the money cannot be used to buy other EC airlines and that 'the Commission insisted on the condition that this aid be the final one'.

Some industry officials believe that the process of reviewing state aid cases is simply too political to rely on fair judgment. BA's Holmes says, 'We believe that whenever there is a capital injection by a government to an airline there should be an independent review by an independent bank which asks the question: Is this loan commercial? Could a private bank be prepared to advance money on these terms to a private sector airline?' Then, he says, a full report should be published on the proposals.

EC officials, however, still claim that state aid review procedures will be tightened in the near future. 'It was easier to approve Sabena's aid two years ago than it will be a year from now,' Hilbrecht maintains. But many industry officials are sceptical. They point out that Iberia's restructuring proposal, the reason for its aid, is valid only up to 1996. 'That means they can come back in 1997,' says an official.

Air France is in an even better position to return for more funding. 'That was the stupidity,' says an DG4 official. 'Had we said it was aid, we could now say, "no more aid". Now Air France can say, "Iberia got aid. Now we want aid." It upsets the whole treatment of such cases.' Will the airline actually apply for more? 'Certainly,' predicts the official. 'How else will Air France get out of its difficulty?'

For the moment, British Airways can console itself with the fact that it is the only airline among Europe's major carriers that is making a profit. 'The saving grace is that, because of subsidies, they don't focus on the right things,' says a BA official of its immediate Continental rivals. He believes, however, that they will 'turn themselves around'. They have to, warns John Parr, the director-general of the AUC. If they do not, the taxpayer-financed deals will continue to make the industry's markets less efficient by encouraging overcapacity and driving fares down to unsustainable levels. 'Although users may benefit in the short term, new entrants will be discouraged; and the benefits that would come from real competition, based on efficient, low-cost operations rather than a fight for business at whatever cost, will never materialise.'

Winston Churchill once said: 'Civil aviation must fly by itself - the Government cannot possibly hold it up in the air.' Continental Europe's airlines have flown on the back of their governments for more than half a century. Most would now agree that the health of the industry depends on them learning to fly solo.

- In the May issue Stephanie Cooke reports on steel subsidies state aid in the steel industry.

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