Archived — October 22, 1999 - Letter from Konrad von Finckenstein to the Honourable David Collenette

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Commissioner of Competition
Competition Bureau
Place du Portage I
50 Victoria Street
Hull, Québec  K1A OC9
Facsimile: 819-953-5013
Telephone: 819-997-3301

October 22, 1999

The Honourable David M. Collenette, P.C., M.P.
Minister of Transport
Transport Canada
Place de Ville, Tower C
Ottawa, Ontario
K1A 0N5

Dear Minister:

I am writing in response to your letter of August 30, 1999 (attached as Annex A) requesting my views on those aspects of a potential restructuring of the Canadian airline industry that relate to competition issues.

As you requested, I have assumed, first, that a dominant carrier will emerge from this process, second, that the current framework for Canadian ownership and control will not change, and, third, that foreign carriers will not be allowed to fly domestic routes. These terms of reference exclude an examination of the government's policies on foreign ownership and cabotage — that is, allowing foreign airlines to fly domestic routes. These policies are the largest regulatory barriers to entry into the airline industry, and the government may wish to reconsider them if a dominant carrier emerges.

The Competition Bureau ensures that all Canadians enjoy the benefits of a competitive marketplace — low prices, product choice and quality service. To that end, in cases of potential mergers, the Bureau conducts a comprehensive review to ensure that mergers do not lead to a substantial lessening of competition. However, given the use of section 47 of the Canada Transportation Act suspending parts of the Competition Act, your terms of reference, and the short deadline, this letter as requested will merely: a) identify the competition issues as the Bureau sees them and b) indicate any condition or government action that the Bureau feels might mitigate them.

It is the view of the Competition Bureau that very significant competition concerns will develop in most domestic airline passenger markets if a dominant carrier emerges from this process under the terms outlined in your August 30 letter. The most vulnerable consumers are likely to be business travellers in transcontinental, regional and local markets, and leisure passengers in local and regional markets. Competition concerns may also arise in the Canada–United States markets, known as transborder markets, and in other international markets.

Within the terms of reference for our advice, the Competition Bureau has examined as many areas as possible that may create more favourable conditions for new players to enter the market or expansion by existing competitors. None of the generic recommendations contained in this letter, alone or together, can guarantee that there will be new entry or effective competition. These recommendations are not a detailed list of terms and conditions for remedying any substantial lessening of competition that results from a particular merger proposal.

The Bureau has not looked at any current specific airline transaction, nor has it sought access to financial statements, contracts, internal business strategies or marketing plans. More specific recommendations would follow any future merger review under the Competition Act.

To provide this generic advice, the Bureau has interviewed many industry participants, including scheduled and charter air carriers, airport authorities, consumer groups, foreign regulators and academic observers. It has also drawn on the expertise of economic and legal experts in the sector, and looked at airline regulation abroad.

As well, the Bureau has relied heavily on the knowledge and experience of its own experts, who were involved in several major sector-related merger reviews. These include the review of the mergers of Air Canada and Canadian Airlines International Ltd.'s (Canadian) computer reservation systems (1987), Canadian and Wardair (1989), the proposed merger of Air Canada and Canadian (1992), the potential failure of Canadian (1993), and the alliances of American Airlines and Canadian (1994) and Air Canada and United Airlines (1996).

While the focus of this analysis is on the dominant carrier scenario, it is our view that many of the recommendations contained in this letter could be implemented in a non-dominant carrier environment to benefit Canadian consumers.

The first part of this letter summarizes the historical and current competition concerns that arise from a dominant carrier scenario, whether from the merger of Air Canada and Canadian or from the failure of Canadian.

The second part sets out a number of recommendations to mitigate those concerns. These are presented in four categories: possible terms of restructuring, possible changes in government policy, possible regulatory changes and possible legislative changes.

Part I
Historical and current competition concerns

Background

Competition in the airline industry was the subject of a thorough review before the Competition Tribunal in 1993. The Gemini II1 decision considered in detail the competitive effects on airline markets of the failure of Canadian. As the Tribunal noted, "The possible failure of Canadian is analogous, for purposes of competition analysis, to an Air Canada-Canadian merger."2

After four weeks of hearings, the Tribunal came to the following conclusion:

  • "After considering the initial reduction in competition that would follow Canadian's failure and the competition remaining and likely to arise, it is the Tribunal's conclusion that the end result of that failure would undoubtedly be a substantial lessening of competition in most if not all airline passenger markets on southern routes in Canada. Even in high-density markets where entry is most likely to occur, travellers are unlikely to enjoy competition with respect to matters that are important to them, including frequency of service, range of service and frequent flyer points. Moreover, even for travellers for whom price is of primary importance, it cannot be concluded that they will not be hurt by Canadian's exit from high-density markets. The two trunk carriers do compete with each other on price. Both trunk carriers also respond to the inroads of other carriers offering low-price options and each of their responses affects the other trunk carrier."3

The Tribunal based its conclusion on several factors: the overwhelming dominance of the remaining national carrier, the difficulty of successful entry, the lack of effective remaining competition and the prohibition of foreign competition in domestic markets.

As part of its competitive analysis, the Tribunal adopted the origin-destination city-pair as the relevant geographic market, since other destinations are not close enough to be alternatives for most travellers. In the Gemini II case, the product market was airline passenger service, which includes both time-sensitive (business) and non-time-sensitive (leisure) passengers.4

In 1990 (the most recent year for which data was available for the Tribunal hearings), Air Canada, Canadian and their affiliates, accounted for approximately 96 percent of all domestic passengers travelling on scheduled carriers, and approximately 92 percent of domestic passengers overall. By contrast, charter carriers accounted for less than four percent of all domestic passengers, although they carried up to 20 percent of passengers on some high-density transcontinental routes such as Toronto–Vancouver. The net result was that in the great majority of city-pair markets in 1993 the combined firm would have had a virtual monopoly.

The Tribunal found that charter carriers are important competitors because they offer low prices for leisure travel. However, as the Tribunal said, "Charter carriers only compete on price and their influence in this respect can be mitigated by a major airline like Air Canada through the judicious use of seat management."5

The Tribunal also noted that Air Canada and Canadian compete across the full range of product characteristics, including frequency of service, choice of seat classes, frequent flyer programs, distribution through computer reservation systems and price. The Tribunal concluded that, "...while the presence of charter carriers is important in some of the largest markets, their role is circumscribed and they cannot take up the competitive slack that would be created in the event Canadian failed."6

In terms of regional airlines, the uncontested evidence of Canadian was that its regional affiliates depend to a significant extent on the traffic they receive from and send to Canadian's trunk lines. Without this feeder traffic and the other services Canadian provides to its regional affiliates, all but one of them would have likely failed along with Canadian.

As described below, the Tribunal identified a number of barriers that make large-scale successful entry difficult, including feed traffic, frequent flyer programs and commission structures.

The need for feed traffic. Feed traffic at both ends of an origin-destination route is important to providing service over a network of scheduled flights. It adds to profitability and allows for more frequent service. For example, Wardair lacked feed traffic for its transcontinental routes from regional and international services since it did not own regional carriers (as Air Canada and Canadian did). In addition, there were no independent regional carriers operating in southern Canada with which Wardair could contract, nor did Wardair have rights to fly international scheduled service to a wide variety of international destinations (including Canada–U.S. transborder markets).

Frequent flyer points and other incentives. The Gemini II hearings identified several incentives. First, a widely accepted frequent flyer program is necessary to attract business travellers. Second, without a large volume of business, new entrants would have to pay higher commissions to agents than would a dominant carrier. In addition, it is industry practice to pay additional commissions (overrides) to loyal travel agents. These commission overrides can have an exclusionary effect when used by a dominant carrier.

While the Tribunal acknowledged that agreements and alliances among individual carriers may mitigate some of the barriers, it found — when the effect of all the barriers in combination is considered and given the absence of available carriers with whom individual airlines could form alliances — piecemeal entry by individual airlines would leave entrants at a significant disadvantage.

The Tribunal found reasonable prospects for entry of a scheduled carrier on Toronto–Ottawa–Montreal routes (eastern triangle) and Vancouver–Calgary–Edmonton routes (western triangle). It also found some room for expansion of charter carriers on transcontinental routes. However, the Tribunal noted that the disappearance of Canadian "would still leave most city-pairs that are now served by Canadian and its affiliates with monopoly service from Air Canada" The Tribunal continued, "...even in those markets where entry or expansion can be anticipated, there is no evidence that it would be of a degree or kind that could be considered a reasonable replacement for Canadian."7

The Tribunal also noted agreement among expert witnesses on the issue of cabotage. The experts said that if foreign airlines were allowed to serve the Canadian domestic market, competition on high-density domestic routes would not be a problem if Canadian failed. However, the Tribunal acknowledged that the Canadian government did not permit cabotage and there was no evidence to indicate that it would be allowed in the foreseeable future.

The current environment

Domestic markets

Prior to the Gemini II Tribunal hearings, Canada saw the failures of Wardair, City Express and Intair. Since 1993, the environment for successful new entrants into domestic scheduled airline service has continued to be difficult as evidenced by the failed entry by Nationair into the eastern triangle, Vistajet, and Greyhound on transcontinental routes.

One notable exception is the entry of WestJet Airlines Ltd. (WestJet) into western regional markets, including the western triangle. In addition, some charter carriers — particularly Canada 3000 — have expanded domestic service on transcontinental routes.

WestJet entered the market in 1996, adopting the low-cost, point-to-point single aircraft model pioneered by Southwest Airlines in the United States. Its business model involves stimulating demand for air service by offering very low prices — making its air service an affordable alternative to car, bus and train service — and targeting underserved western markets with jet air service.

WestJet keeps operating costs low by using one type of aircraft (B737-200) and using those aircraft often. WestJet also avoids many of the costs network carriers must incur, such as frequent flyer programs, meals and booking fees paid to computer reservation systems. As a result, WestJet accounted for approximately three percent of domestic passenger revenues in 1998. Since it only operates in western markets, WestJet has a correspondingly higher market share in those markets than this aggregate number would indicate.

However, WestJet has indicated publicly that it has no intention of expanding into eastern markets in the near future. Instead, the company favours gradual expansion.

Charter carriers accounted for approximately five percent of domestic passenger revenues in 1998. While charter carriers now offer more domestic routes than in 1993, their focus remains on the international leisure market.

In the domestic market, there is no longer any legal distinction between charter services and scheduled services as the same type of operating licence governs both. In this letter, we use the term charter to refer to a business model different from the scheduled service provided by a carrier that has a network of flights. Canada has four principal companies known as charter carriers in the domestic market: Air Transat, Canada 3000, Royal Airlines and SkyService. In international markets, there continues to be both a legal and economic distinction between charter and scheduled services.

Based on the information assembled in the time available, it appears that although there is reason to be somewhat more optimistic than in 1993, the overall conclusion of the Competition Tribunal appears as valid today as it was six years ago.

The Bureau's preliminary analysis shows that the combined market share of Air Canada and Canadian, together with their affiliates, is greater than 80 percent of all passengers in the top 200 city-pair markets. These city-pairs represent approximately 90 percent of total domestic passengers.

In 1998, the two carriers combined also accounted for more than 90 percent of the total domestic passenger revenues in the competitive universe that includes Air Canada, Canadian, the four charter carriers and WestJet.

Barriers to entry to large-scale scheduled service of the type offered by Canadian and Air Canada remain high. While charter carriers could expand further on transcontinental routes, they do not provide a suitable alternative for business travellers who want frequent year-round service with convenient connections to international and regional cities, access to an attractive frequent flyer program, and the ability to change reservations on short notice.

It is an open question whether the WestJet model in western Canada could be successfully replicated in the eastern triangle or in the shorter haul eastern regional markets. In section 1.6, we discuss the ability of breakaway regional affiliates to become effective competitors.

Our preliminary analysis suggests that there are many significant challenges. Charter services, WestJet and regional carriers are niche players that cannot replicate the services and competition supplied by full-scale network carriers such as Canadian and Air Canada.

In summary, we believe the failure of Canadian or a merger with Air Canada raises very serious competition concerns in domestic airline markets. The most vulnerable consumers are likely to be business travellers in transcontinental, regional and local markets, and leisure passengers in local and regional markets.

Canada Transportation Act, section 66

It is noteworthy that there is no effective regulatory protection against excessive pricing in the dominant carrier environment. Section 66 of the Canada Transportation Act gives the Canadian Transportation Agency the power to roll back unreasonable increases in full fares on monopoly routes. Since 90 percent of passengers use discount fares, this section fails to address the possibility that a dominant carrier could significantly increase prices by reducing the range of discount fares or the number of seats made available at these lower rates.

In addition to price, as a rule the track record of dominant firms in most industries in terms of the quality of service or the rate of innovation is questionable. The lack of any effective safeguards for consumers in this possible new environment underscores the need for comprehensive and urgent action to reintroduce competition into domestic markets. Any voluntary commitments by the dominant carrier are, in our view, a poor substitute for the rigour of a competitive marketplace.

Transborder and other international markets

In the Canadian airline industry, transborder refers to Canada–U.S. routes, and international refers to routes between Canada and other foreign countries. In addition to the domestic competition concerns outlined above, the emergence of a dominant carrier may also lead to competition concerns in both transborder and international markets. The specific concerns depend on which international alliance the dominant carrier joins. Moreover, it is important to note that the economic well-being of network carriers depends on their ability to gather traffic from as many points as possible. Accordingly, the strength of domestic network competitors will be enhanced if they can compete in international and transborder markets as well.

To put this in context, in 1997 the domestic, transborder and international markets accounted for 47.7, 18.5 and 33.8 percent, respectively, of total Canadian airline industry revenues. The transborder market is by far the largest international air services market for the Canadian airline industry, accounting for approximately 60 percent of all international passengers and 36 percent of combined transborder and international revenues.

Both Canadian and Air Canada have joined international alliances to benefit from access to larger international networks. Air Canada is a member of the Star Alliance, which includes United and Lufthansa. Canadian is part of the OneWorld alliance, which includes American Airlines and British Airways.

While data on passenger and revenue market shares is not publicly available for international markets, the Competition Bureau has calculated market share estimates based on the seat capacity of scheduled carriers. The Bureau estimates that Canadian carriers account for 52 percent of the scheduled capacity on routes to Europe and 55 percent of the capacity to Asia.

In two of the three markets where both Canadian scheduled carriers provide service — the U.K. and Japan — the combined market share of Canadian carriers, based on seat capacity, is 72 percent and 68 percent respectively. This data is inconsistent with the proposition that when more than one Canadian carrier is designated to serve a route, the total share for Canadian carriers is lower than for foreign carriers. In the third market, Hong Kong, the combined market share of Canadian scheduled carriers is 45 percent of seat capacity. This share is restricted by frequency limitations in the Canada–Hong Kong bilateral air services agreement.

If a dominant carrier emerges that would provide most of the international services out of Canada, competition concerns may arise in certain international and transborder markets. These concerns would be magnified when the dominant carrier joins an alliance whose partners fly the same international routes.

Part II
RECOMMENDATIONS

The objective of these recommendations is to mitigate competition concerns by reducing entry barriers, facilitating new entry and expansion by remaining competitors and restricting the ability of the dominant carrier to engage in anti‑competitive acts. Given the market power of the dominant carrier that will result from the restructuring process, it is vital that every opportunity be taken to promote and create competition. Most of these recommendations could also be implemented in a non-dominant carrier environment to the benefit of Canadian consumers.

The term new entrant throughout this letter refers to both new and existing Canadian air carriers other than Air Canada and Canadian.

The recommendations set out in this section are divided into four themes:

1. Possible terms of restructuring.

2. Possible changes in government policy.

3. Possible regulatory changes.

4. Possible legislative changes.

1. Possible terms of restructuring

This section outlines the terms and conditions that could be imposed on the dominant carrier emerging from either the failure of Canadian or the merger of Canadian and Air Canada. Many of the recommendations in this section impose obligations on the dominant carrier with reasonable terms and conditions. Where this term is used, it is assumed that an arbitration mechanism would be established to settle disputes over what constitutes a reasonable term or condition.

Legislation may be required to establish monitoring mechanisms for any behavioural conditions that might be imposed on the dominant carrier, such as those set out in the recommendation on travel agent commissions.

1.1 Airport access

While many of the recommendations about airports can be directed at actions taken by the dominant carrier, there are issues that also call for the government to implement policy guidelines or regulations. This section notes the need for such government initiatives and discusses them in sections 2.1 and 3.1 which cover possible policy and regulatory changes.

To mount competitive service, new entrant Canadian carriers must be able to obtain reasonable access to takeoff and landing slots, and to various airport facilities, such as gates, loading bridges and ticket counter space, and other airport infrastructure.

Domestic Airports

Slots

A slot is a scheduled time of arrival or departure available or allocated to a particular airline on a specific date at an airport. Toronto's Pearson Airport is the only Canadian airport that is currently at slot capacity. The following discussion, therefore, focuses on Pearson. However, the same principles could be applied to other airports, such as Vancouver or Dorval, if slot constraint issues emerge.

At Pearson, Air Canada, Canadian and their regional affiliates currently account for 75 percent of all slots held by all airlines, and for 92 percent of all slots held by Canadian carriers.8 The competition concern arises from the fact that Air Canada and Canadian also account for a substantial majority of the slots at congested peak times in the early morning and late afternoon/early evening. For example, during certain desired hours when slots are fully allocated, such as 8:00 to 9:00 a.m. or 5:00 to 6:00 p.m., Air Canada and Canadian often hold more than 75 percent of the available slots. This share is higher if these airlines' international partners are included. Further, as many of the remaining slots are held by incumbent U.S. and overseas carriers, the overall result is that other Canadian carriers hold few, if any, slots at peak times.

Various factors may affect the extent to which slot constraints will pose a problem at Pearson in the future. If Air Canada and Canadian merge, rationalization might free up slots. On the other hand, the dominant carrier might seek to block effective new entry by hoarding slots at peak times by moving in flights from off-peak times or offering increased frequency at peak times.

New slots will eventually become available as construction advances at the airport, including the building of new runways. Such new capacity is welcome from a competition perspective; however, based on current slot allocation procedures, a new entrant Canadian carrier would unlikely be able to obtain sufficient peak-time slots at Pearson to allow it to launch a competitive service (for example, frequent flights in the Montreal–Toronto–Ottawa commuter market).

The Bureau therefore recommends that the dominant carrier give up, on demand from other Canadian carriers, a sufficient number of slots at Pearson, and at any other Canadian airport should slot constraints emerge, at times reasonably close to the requested times, so that effective competition can be mounted in domestic markets. The Competition Bureau recommends that the slots should then be allocated according to regulations to be developed by Transport Canada (see section 3.1).

In addition, any slots currently attributed to a regional affiliate that might seek to establish itself as an airline independent from the dominant carrier should continue to be held by that affiliate, rather than by Air Canada or Canadian. The affiliate would also likely require additional slots.

Airport Facilities

New carriers might have difficulty obtaining access to airport infrastructure, such as gates, loading bridges, counter space and baggage facilities, because many of these facilities are under the effective control of Air Canada and Canadian.

Over the past several years, Transport Canada has transferred administration of most of the major airports in Canada to not-for-profit airport authorities, some of which are converting their facilities to allow for common use. These conversions may partly address the access issue and should be encouraged.

The Bureau recommends that the dominant carrier surrender to airport authorities, on reasonable terms and conditions, its rights, under subleases or licences, to those facilities that could be converted to common use, such as gates, loading bridges, ticket counters, baggage systems and flight information display systems. The federal government could provide incentives (for example, reduced rent) to encourage airport authorities to adopt this recommendation (see section 2.1).

The airport authorities have raised two additional points:

- In some cases, the airport authorities have agreements with carriers that include majority-in-interest clauses that allow carriers representing two thirds of passenger volume to delay proposed capital expansion plans, including plans for new gates and terminals. The dominant carrier should waive such rights so it could not unnecessarily delay the construction of new facilities.

- Cost sharing of airport services such as security clearance and de-icing follows the so-called Chicago Formula, in which the carriers, regardless of size, share equally the first 20 percent of the cost and split the remaining 80 percent according to passenger volume. This has the effect of raising the per passenger costs for these services among small carriers, an effect that increases when Canadian and its affiliates are removed from the equation. The Bureau recommends that all of these costs be charged on a per passenger basis.

Transborder Airports

As part of the 1995 Canada–U.S. bilateral air agreement, the government of Canada obtained free access to 24 new daily slots at Chicago's O'Hare and New York's LaGuardia. The government allocated 16 of those slots to Canadian and 8 to Air Canada, at no cost to these carriers. The Bureau recommends that a sufficient number of these slots be made available for reassignment to new entrant Canadian carriers (see section 2.1). It also recommends that, if necessary, the dominant carrier make gates and other airport facilities available to qualified Canadian air carriers seeking to operate transborder services to these airports. The intent of this recommendation is not to undermine the ability of the dominant carrier to provide frequent services, but to balance the advantages of service frequency with the benefits of competition.

International Airports

To allow for meaningful international entry, a new entrant Canadian carrier would need access to slots and other airport facilities at congested international airports. Therefore, the Bureau recommends that the dominant carrier be obliged to facilitate the transfer of available slots, gates and other facilities at airports such as London's Heathrow and Tokyo's Narita to accommodate a new entrant Canadian carrier. See section 2.1 for further recommendations.

Recommendations

Domestic Airports

The Competition Bureau recommends that:

- the dominant carrier give up, on demand from other Canadian carriers, a sufficient number of the slots acquired at Pearson as a result of the restructuring, and at any other Canadian airport should slot constraints emerge, at times reasonably close to the requested times, so that effective competition can be mounted in domestic markets.

- the dominant carrier surrender to airport authorities, on reasonable terms and conditions, its rights, under subleases or licences, to those facilities that could be converted to common use, such as gates, loading bridges, ticket counters, baggage systems and flight information display systems.

- the dominant carrier waive majority-in-interest rights so it could not unnecessarily delay the construction of new facilities.

- the dominant carrier make the necessary agreements to change the Chicago Formula for allocating airport services costs to a formula that is wholly based on per passenger usage.

Transborder Airports

The Competition Bureau recommends that:

a sufficient number of slots at Chicago's O'Hare and New York's LaGuardia be made available by the dominant carrier for reassignment to new entrant Canadian carriers (see section 2.1). If necessary, the dominant carrier should also make gates and other airport facilities available, on reasonable terms and conditions, to new entrant Canadian carriers seeking to operate at these airports.

International Airports

The Competition Bureau recommends that:

a sufficient number of slots at international airports such as London's Heathrow and Tokyo's Narita be made available by the dominant carrier for reassignment to new entrant Canadian carriers (see section 2.1). If necessary, the dominant carrier should also make gates and other airport facilities available, on reasonable terms and conditions, to new entrant Canadian carriers seeking to operate at these airports.

1.2 Frequent flyer programs

Frequent flyer programs are very important to attracting and retaining business travellers. Large network carriers can offer the most attractive programs because customers have more opportunities to earn points and redeem them toward desirable holiday destinations. New entrants targeting business customers have difficulty competing because they do not have a large network. They can try to offer much more generous terms to earn or redeem points, but still lack a sufficient choice of destinations. At one time Wardair offered to triple the value of their points compared to Air Canada and Canadian, but this marketing tactic failed.

New entrants could try to purchase frequent flyer points from an incumbent airline, which in this case would be the dominant carrier. However, even if the entrant could purchase points, its costs would likely be much higher than those of the dominant carrier.

One way to address this issue would be to allow new entrants to purchase points in the dominant carrier's plan at a cost equal to either the parent's cost or the internal transfer cost to affiliates, whichever is lower. New entrants would award such points on all domestic flights, and be allowed to award points on transborder and international routes that, after a competitive analysis, are found to be insufficiently competitive. Points awarded by new entrants would have the same rights and privileges as those awarded by the dominant carrier. The European Commission has imposed a similar remedy as a condition of approval of a number of alliances.

The disadvantage of this option is that it reinforces the dominant carrier's frequent flyer program and builds the brand image of the dominant carrier at the expense of the new entrant.

Under this proposal, the new entrant should be able to spread start-up costs over a number of years and have non-discriminatory access to customer data held in the points program. In addition, the dominant carrier would have to make clear volume and service commitments in order to maintain or expand the availability of frequent flyer seats to third-party plan members. New entrants would not be prohibited from having their own plans, nor restricted from participating in other airlines' plans.

Another option is to require that the dominant carrier sell the frequent flyer plans of either Air Canada or Canadian to a new entrant Canadian carrier on reasonable terms and conditions.

Recommendations

The Competition Bureau recommends that:

- new entrants be able to purchase points in the dominant carrier's plan at a cost equal to either the parent's cost or the internal transfer cost to an affiliate, whichever is lower:

  • - such points would be awarded by the new entrants on all their domestic flights.
  • - such points should also be awarded on transborder and international routes if a competitive analysis conducted at the time of restructuring reveals that there is insufficient competition on these routes.

- points awarded by new entrants have the same rights and privileges as those awarded by the dominant carrier.

1.3 Travel agent commission overrides

Travel agents are by far the most important distribution mechanism for air travel, accounting for more than 75 percent of ticket sales by scheduled airlines in Canada. Airlines pay travel agents base commissions on a fixed percentage of the ticket price up to a capped value. For domestic bookings, commissions are currently nine percent of the airfare, but are capped at $50 round trip or $30 one way.

Airlines make additional commission payments, called override commissions, when travel agents meet certain sales targets. For example, if a carrier's market share based on sales for a particular city is 55 percent, the airline would only pay the override if the travel agent books 55 percent or more of its total sales with that carrier.

On October 15 of this year, Air Canada announced that it would reduce commissions to five percent and change caps to $60 for a round-trip ticket as of December 31, 1999. As a result, commission overrides will become an even more important revenue stream for travel agents.

These override commissions provide strong incentives to agents to steer business to particular carriers. In the dominant carrier scenario, the market share targets could be set so high that these override commissions would have a powerful exclusionary effect.

Override Commissions: The European Experience

The European Commission has had experience, both in the recent British Airways abuse-of-dominance case and when setting conditions for the approval of alliances, in developing remedies to address the problems associated with override commissions. Its guiding principle is that travel agent compensation schemes should be based on sales volume and not be directly or indirectly tied to agent loyalty. The Commission also adopted the principle that commission levels should be based on distribution cost savings or the increased value of the service the travel agent provides to the carrier. In addition, in the British Airways case, the airline agreed to increase commissions only on a straight-line basis and to not tie them to previous sales.

While these conditions could be imposed on a dominant carrier in the domestic market, they would be less appropriate for international markets, in which foreign carriers may choose from a selection of commission programs. In calculating travel agent compensation, airlines should consider domestic and transborder/international sales separately so that no incentive is created to favour domestic bookings on the dominant carriers because of volume incentives in transborder/international markets. The dominant carrier should implement new agreements with travel agents that reflect the above conditions within six months of any restructuring.

Recommendations

The Competition Bureau recommends that:

- for the domestic market only, the dominant carrier link its travel agent remuneration system to sales volume alone, on a straight-line basis, and not tie it directly or indirectly to travel agent loyalty. Canada should examine the principles adopted by the European Commission for possible application in the Canadian market.

- the dominant carrier should negotiate new agreements with travel agents reflecting the above conditions within six months of any restructuring.

1.4 Surplus aircraft

While we have not had the opportunity to explore any specific proposals, it is likely that a dominant carrier would divest itself of its B737-200, DC-9 and DC-10 fleets. The B737-200 is especially important for the future of domestic competition since it is a good all-round aircraft favoured by independent operators such as WestJet and Royal Airlines.

Moreover, due to Stage II9 limitations, and Transport Canada's high safety standards, importing older aircraft into Canada can be time-consuming and expensive. To delay competitors' expansion, the dominant carrier could consider parking rather than selling surplus aircraft. To prevent this from taking place, the Bureau recommends that the dominant carrier offer to transfer all its surplus aircraft, either owned or leased, to any interested parties in the domestic market before selling them abroad or parking or mothballing them. This obligation should be in place for a reasonable period of time after restructuring and subject to reasonable terms and conditions.

Recommendation

The Competition Bureau recommends that:

- the dominant carrier offer to transfer, within a reasonable period following restructuring and on reasonable terms and conditions, all surplus aircraft, either owned or leased, to any interested parties in the domestic market before selling them abroad or parking them.

1.5 Interlining and code sharing

Interlining refers to agreements between two unrelated carriers to facilitate connecting service. These agreements involve the companies charging less for a combined ticket than for two tickets purchased separately. In addition, the carriers facilitate ticketing and baggage handling for the connecting service.

In the dominant carrier environment, new regional entrants must be able to negotiate interline agreements to access feed traffic from the dominant carrier. This would allow a regional airline, for example, to participate in a connecting service such as Sudbury–Toronto–Frankfurt. In this example, the dominant carrier would have no incentive to use a new regional carrier for such a route if it had its own regional network. Similarly, a new transcontinental entrant may need to have interline arrangements with regional carriers. The Bureau recommends that the dominant carrier be obliged to negotiate interline agreements on reasonable terms and conditions with all new entrants in the domestic market wanting such agreements.

In its simplest form, code sharing is the agreed use for marketing purposes of an airline's designator code by another airline in computer reservation systems and timetables and on tickets. Code sharing enables carriers to extend their marketing reach because code-shared flights are considered to be on-line flights. With code sharing, an interline connection will show up as an on-line flight in the computer reservation system, automatically giving it a higher display preference than competing interline flights — even when competing flights have a shorter elapsed time than the code-shared flight. Depending on the city-pair they choose, busy travel agents may display many screens of flight options, but seldom do. One early study10 indicated that agents make 80 percent of bookings from the first screen and 50 percent from the first line of the first screen. Clearly, display preference does matter.

Code sharing can take many forms and may be part of a broader marketing alliance in which two carriers make other changes to more closely align their schedules, gate access, service levels, baggage handling and frequent flyer programs.

Code sharing in its simplest form should become an obligation of the dominant carrier. This would be an extension of the interlining agreement between the new entrant and the dominant carrier. As the ticket issuer, the new entrant could attach its code to those flights for which it has interline agreements with the dominant carrier.

Recommendations

The Competition Bureau recommends that:

- the dominant carrier be required to negotiate interline agreements on commercially reasonable terms and conditions with all new entrants in the domestic market wanting such agreements.

- new entrants be able to place their codes on those flights for which they have an interlining agreement with the dominant carrier.

1.6 Regional carrier civestiture

Divestiture of some or all of the dominant carrier's regional affiliates may go some way toward introducing competition into domestic markets. We have not had the opportunity to examine this option in detail, and would need to carry out a full merger review before recommending it as a remedy.

In the event of regional carrier divestiture, a number of issues would have to addressed.

First, regional carriers do not compete with the parent carrier, but are organized to serve local and regional markets. Regionals are restricted in the aircraft they can fly, the routes they can serve, and the commercial airlines with which they can partner. These restrictions should be eliminated.

Second, the success of the regionals depends on the feed traffic they receive from and send to the mainline carrier. To sustain these divested carriers, some form of mandatory interlining and code-sharing agreements between the dominant carrier and the divested regional airline(s) would likely be necessary for the foreseeable future.

Third, regional carriers are financially and operationally dependent on parent carriers. Parent carriers typically control many of the operational and commercial arrangements and systems an independent airline needs, such as slots, gates, counter space, loading bridges, aircraft leases, internal reservation systems, travel agent distribution, ticket processing, revenue collection and accounting.

Fourth, regionals also benefit from the parent's volume purchasing of items such as fuel and spare parts, and from joint insurance. They also share the loyalty benefits of the parent carrier's frequent flyer program. Without transitional measures to ensure these services continue for some time, the parent carrier could put the regional carrier out of business overnight.

On the assumption that the divestiture of regional carriers is feasible and would result in viable competitors, the government would need to address all four of these points.

Recommendations

In the event that regional carrier divestiture is required, the Competition Bureau recommends that:

- a divested regional carrier be relieved by the dominant carrier of any restrictions on its ability to compete, including restrictions on aircraft, routes or airline partners.

- the dominant carrier be required to enter into interlining and code-sharing agreements on reasonable terms and conditions with any divested regional airline(s).

- the dominant carrier be required to transfer to the divested regional airline(s) slots, and, on reasonable terms and conditions, gates, counters and other facilities comparable to those it currently enjoys.

- the dominant carrier accord to any divested regional airline(s) the same level of financial and operational services it now provides for a reasonable transition period at prices no less favourable than those currently offered to regional airlines or to any continuing affiliated carriers, whichever is lower.

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