United States Government Accountability Office GAO Report to Congressional Committees June 2006 AIRLINE DEREGULATION Reregulating the Airline Industry Would Likely Reverse Consumer Benefits and Not Save Airline Pensions GAO-06-630 June2006 AIRLINE DEREGULATION H AccountabilityIntegrityReliability ighlights Reregulating the Airline Industry Would Likely Reverse Consumer Benefits and Highlights of GAO-06-630, a report to congressional committees Not Save Airline Pensions Why GAO Did This Study What GAO Found The Airline Deregulation Act of The airline industry has undergone significant change since the late 1970s. 1978 phased out the government’s Industry capacity and passenger traffic have tripled. At the same time, the control over fares and service and industry’s profitability has become more cyclical, and the financial health of allowed market forces to determine large legacy airlines has become more precarious. Legacy airlines emerged the price and level of domestic from a regulated environment with relatively high structural costs, driven in airline service in the United States. part by labor costs, including defined benefit pension plan costs. Over the The intent was to increase last few years, facing intense cost pressures from growing low-cost airlines competition and thereby lead to like Southwest, both United and US Airways entered bankruptcy, voided lower fares and improved service. In 2005, GAO reported on the labor contracts, and terminated their pension plans costing the Pension tenuous finances of some airlines Benefit Guaranty Corporation, the federal government insurer of defined that have led to bankruptcy and benefit plans, $10 billion and beneficiaries more than $5 billion. In 2005, two pension terminations, in particular other legacy airlines entered bankruptcy leaving their pension plans in among those airlines that predated doubt. Only two airlines still have active defined benefit pension plans. deregulation (referred to as legacy airlines). The House Report Airfares have fallen in real terms over time while service—as measured by accompanying the 2006 industry connectivity and competitiveness—has improved slightly. Overall, Department of Transportation the median fare has declined almost 40 percent since 1980 as measured in (DOT) Appropriation Act 2005 dollars (see fig. below). However, fares in shorter-distance and less- expressed concern about airline traveled markets have not fallen as much as fares in long-distance and pension defaults and charged GAO with analyzing the impact of heavily trafficked markets. Since 1980, markets have generally become reregulating the airline industry on more competitive; with the average number of competitors increasing from reducing potential pension defaults 2.2 per market in 1980 to 3.5 in 2005. by airlines. GAO subsequently agreed to address the pension issue Median Fare, 1980-2005 within a broad assessment of the airline industry since deregulation. Specifically, GAO is reporting on, among other things, (1) broad airline industry changes since deregulation, (2) fare and service changes since deregulation, and (3) whether there is evidence that reregulation of entry and fares would benefit consumers or the airline industry, or save airline pensions. DOT agreed with the conclusions in this report. GAO is making no recommendations in this report. The evidence suggests that reregulation of airline entry and fares would likely reverse much of the benefits that consumers have gained and would not save airline pensions. The change in fares and service since deregulation provides evidence that the vast majority of consumers have benefited, www.gao.gov/cgi-bin/getrpt?GAO-06-630. though not all to the same degree. Although a number of airlines have failed To view the full product, including the scope and some have terminated their pension plans, those changes resulted from and methodology, click on the link above. the entry of more efficient competitors, poor business decisions, and For more information, contact JayEtta Z. inadequate pension funding rules. GAO has previously recommended that Hecker at (202) 512-2834 or [email protected]. broad pension reform is needed. United States Government Accountability Office Contents Letter 1 Results in Brief 3 Background 6 Airline Deregulation Was Originally Intended to Encourage Competition, Thereby Lowering Fares and Improving Service 8 The Airline Industry Has Undergone Significant Change since Deregulation 9 Real Fares Have Declined and Service Has Expanded since 1980 18 Evidence Suggests That Reregulation of Airline Entry and Rates Would Reverse Consumer Benefits and Not Save Airline Pensions 36 Agency Comments 38 Appendix I Scope and Methodology 39 Appendix II GAO Contact and Staff Acknowledgments 44 Figures Figure 1: Western Airlines (1962) and Eastern Airlines (1948) Route Map 7 Figure 2: Air Travel Capacity and Consumption, ASM and RPM growth 1968–2005 11 Figure 3: U.S. Airline Operating Revenue, Expenses, and Profits, 1968–2005 12 Figure 4: Airline Salaries and Benefits per Employee, 1968–2004 14 Figure 5: Airline Employee Compensation as a Share of Total Operating Expenses, 1968–2005 15 Figure 6: Airline Industry Employment and Capacity (ASM) Per Employee, 1977–2005 16 Figure 7: Median Round-Trip Fare, 1980–2005 20 Figure 8: Round-Trip Median Fares, 1980–2005 21 Figure 9: Mean Fares by Market Size, 1980–2005 22 Figure 10: Dispersion of Yields within Routes (Coefficient of Variation), 1980–2005 23 Figure 11: Real Yield Trends, 1950–2004 26 Figure 12: Average Number of Effective Competitors, 1980–2005 27 Figure 13: Percentage of Markets by Number of Effective Competitors, 1980–2005 28 Page i GAO-06-630 Airline Deregulation Figure 14: Average Number of Effective Competitors by Distance Traveled, 1980–2005 29 Figure 15: Percentage of Airline City-Pair Markets with 80 Percent of Passengers, 1980–2005 30 Figure 16: Number of City-Pair Markets with at Least 130 Passengers per Quarter, 1980–2005 31 Figure 17: Percentage of Markets and the Minimum Number of Connections, 1980–2005 34 Figure 18: Flight Distance Ratio, 1980–2005 35 Abbreviations ASM available seat miles CAB Civil Aeronautics Board DOT Department of Transportation DPFI Domestic Passenger Fare Investigation EAS Essential Air Service EPP Employee Protection Program FAA Federal Aviation Administration FTE full-time equivalent PBGC Pension Benefit Guaranty Corporation RPM revenue passenger miles SIFL Standard Industry Fare Level This is a work of the U.S. government and is not subject to copyright protection in the United States. It may be reproduced and distributed in its entirety without further permission from GAO. However, because this work may contain copyrighted images or other material, permission from the copyright holder may be necessary if you wish to reproduce this material separately. Page ii GAO-06-630 Airline Deregulation United States Government Accountability Office Washington, DC 20548 June 9, 2006 The Honorable Jerry Lewis Chairman The Honorable David R. Obey Ranking Minority Member Committee on Appropriations United States House of Representatives The Honorable Thad Cochran Chairman The Honorable Robert C. Byrd Ranking Minority Member Committee on Appropriations United States Senate In 1978, Congress deregulated the airline industry. The Airline Deregulation Act of 1978 phased out the government’s control over fares and service and allowed market forces to determine the price and level of domestic airline service in the United States. We have previously reported that overall fares have declined and service has increased since deregulation, but that these benefits have not been evenly distributed throughout all markets. More recently, we reported on the tenuous finances of some airlines that have led to bankruptcy and pension terminations,1 in particular among those airlines whose operations predated deregulation, referred to as legacy airlines. Critics of deregulation, including some academics and some in Congress, have pointed to industry instability that has resulted in industry layoffs and pension terminations along with declining service and high fares for some communities as evidence of negative effects of deregulation. The House report accompanying the 2006 Department of Transportation (DOT) appropriations legislation expressed concern about airline pension defaults and charged us with analyzing the impact of reregulating the 1GAO, Commercial Aviation: Bankruptcy and Pension Problems Are Symptoms of Underlying Structural Issues, GAO-05-945 (Washington, D.C.: Sept. 30, 2005). Page 1 GAO-06-630 Airline Deregulation airline industry on reducing potential pension defaults by airlines.2 In subsequent discussion with House appropriations offices, following our in- depth report on airline pensions and bankruptcy, we agreed to more broadly assess the airline industry since deregulation. Specifically, we agreed to report on (1) the original rationale for deregulating the airline industry in 1978, (2) broad airline industry changes since deregulation, (3) fare and service changes since deregulation, and (4) whether there is evidence that reregulation of airline entry and rates would benefit consumers and the airline industry, or save airline pensions. To address these objectives, we relied on historical documents, our past studies, and our analysis of DOT passenger ticket data. To assess the original intent of Congress in passing the Airline Deregulation Act, we reviewed the act and accompanying legislative materials and various other documents and studies. To evaluate past changes in the airline industry, we reviewed our past studies, reviewed DOT studies, analyzed financial and operational data, and interviewed industry experts. To analyze fare and service changes since deregulation, we used the DOT’s Origin and Destination Survey, a database containing information on every tenth airline ticket sold. The survey includes the fare paid (including taxes) and itinerary, including flight segments. The survey does not provide information on frequency, type of aircraft, or operational performance. We excluded tickets with international, Hawaiian, or Alaskan destinations or origins so that we could examine changes within continental U.S. domestic markets. To simplify the analysis, we examined only tickets for flights during the second quarter of each year—generally considered neither the busiest nor the slowest quarter of the year. We limited our analysis of service measures to only those city-pairs with at least thirteen passengers in our sample (or about 130 actual flying passengers) in every quarter in order to ensure that the changes in service we observed in our sample reflected actual flow routes and were not due to sampling or data error. Even so, the vast majority of passengers were included in our analysis—for example, in 2005, excluding city-pair markets with less than 13 passengers per quarter excluded only one percent of passengers. In addition, for our analysis of competition in city pairs, to ensure the sampling confidence in each competitor airline, we limited our analysis to city pairs with at least 118 passengers in the sample (or about 1180 actual 2House Report 109-153 accompanying P.L. 109-115, Departments of Transportation, Treasury, and Housing and Urban Development, The Judiciary, District of Columbia, and Independent Agencies Appropriations Act, 2006. Page 2 GAO-06-630 Airline Deregulation flying passengers) per quarter. No minimum passenger levels were imposed for our analysis of fares. Because the survey does not identify the destination airport, to ensure city-pair accuracy, we eliminated nonsymmetrical roundtrip tickets. We reviewed our methods and results with DOT and academic experts from the Massachusetts Institute of Technology’s Global Airline Industry Program. To determine whether there is sufficient evidence to reregulate the airline industry, we considered our findings under the prior questions of this report, especially the changes in fares and service since deregulation. We also considered the findings of our earlier reports, especially those relating to small community air service and defined benefit pension terminations and regulation. We performed our work between September 2005 and May 2006 in accordance with generally accepted government auditing standards. Results in Brief Airline deregulation was premised on an expectation that an unregulated industry would attract new airlines and increase competition, thereby benefiting consumers with lower fares and improved service. The intent of Congress was to allow new and existing airlines to enter and serve any market they wanted (and provide service at whatever price they wanted) in order to boost competition, thereby lowering fares and expanding service. The framers of the act recognized that this approach could cause some airlines to fail and could lead to some communities losing some levels of service. As a result, the act created the Essential Air Service (EAS) program which subsidizes air service to small communities. The act also established the Employee Protection Program (EPP), which was ultimately repealed and never provided any assistance, but was intended to provide displaced airline employees with compensation and the right to be rehired by airlines before any other potential applicants. Even with deregulation, the federal government continues to play a role in air commerce in a variety of other ways—from the Federal Aviation Administration (FAA), which oversees air navigation, safety, and airport investment; to the Department of Homeland Security, which oversees passenger security; to DOT, which oversees international agreements and has a mandate to protect consumers from unfair and deceptive practices in air transportation and its sale. The airline industry has undergone significant change since the late 1970s. Passenger traffic and, with it, industry revenues, have expanded. However, expenses have grown just as fast and profits have become increasingly cyclical. Airlines that predated deregulation, called legacy airlines, emerged from regulation with significant structural costs, including labor Page 3 GAO-06-630 Airline Deregulation contracts that funded defined benefit pension plans. Legacy airlines dominated the industry during the 1980s and 1990s because of their size and a variety of business practices that made it difficult for new entrant airlines to compete. Industry employment, compensation, and efficiency have all grown since deregulation. However, with the major industry downturn that began in 2000, new entrant airlines—unburdened by many of the structural costs of legacy airlines—were better able to compete for passengers with low fares and have gained market share. By 2003, we found that low-cost airlines served 2,304 out of the top 5,000 city-pair domestic markets, representing a presence in markets available to almost 85 percent of all passengers. In response to sizeable financial losses after 2000, both United and US Airways entered bankruptcy and terminated their pension plans, costing the Pension Benefit Guaranty Corporation (PBGC) nearly $10 billion and beneficiaries more than $5 billion. In 2005, two other legacy airlines entered bankruptcy, leaving their pension plans in doubt. Only two airlines, American and Continental, still have active defined benefit pension plans in place. As predicted by the framers of deregulation, airline markets have become more competitive and fares have fallen since deregulation. For consumers, airfares have fallen in real terms since 1980 while service has generally improved. Overall, median fares have declined in real terms by nearly 40 percent since 1980. However, fares in shorter-distance and less-traveled city-pair markets (e.g., those between smaller cities) have not fallen as much as fares in longer-distance and heavily-trafficked markets. While the competition brought about by deregulation likely played a significant role in bringing down fares, the extent to which these changes are directly attributable to deregulation as opposed to other factors, such as advances in technology or economic factors, is difficult to isolate. Various studies have attributed substantial consumer benefits to deregulation, but estimating the size of this benefit requires making several assumptions about what fares would be if they were still regulated. Furthermore, our analysis of airline service indicates that more passengers are flying between more city-pair markets, but that, on average, passengers are making more connections to reach their destinations. Service improvements have not been as evident in smaller markets as in larger ones. Since 1980, city-pair markets have generally become more competitive even while passenger traffic became more concentrated. Longer-distance and more heavily traveled markets in particular have become more competitive, with the average number of competitors growing from 2.2 per market in 1980 to 3.5 in 2005. Some DOT indicators of other aspects of service quality, such as rates of on-time arrival or lost luggage, suggest that service quality may have eroded somewhat over the Page 4 GAO-06-630 Airline Deregulation past few years; however, we did not evaluate these measures or other indicators of service quality, such as flight frequency, type of aircraft used, or in-flight amenities. The evidence suggests that reregulation of airline entry and fares would likely reverse much of the benefits that consumers have gained and would not save airline pensions. Our analysis of fares and service since deregulation provides evidence that consumers have benefited from lower fares since the airlines were deregulated. Since deregulation, competition has generally increased, traffic has expanded, and fares have declined. The primary dislocations that have occurred since deregulation—loss of service to some communities and the decline of legacy airlines’ finances and pensions—are the result of competitive market forces. Therefore, attempting to resolve the dislocations that have occurred for some small communities or the loss of pension benefits for some airline workers by restraining these same forces could reverse some of the gains that have accrued. If Congress determines that service to small communities is inadequate, then direct subsidies—such as the Essential Air Service program provides—might be a more efficient solution than reregulating the industry and diminishing the benefits gained by a majority of consumers. The financial distress of some legacy airlines, while regrettable (especially for airline employees), was not unanticipated, and is evidence of a functioning market in which lower-cost airlines have emerged, generally benefiting consumers with lower fares. These financial problems also caused several legacy airlines to freeze or terminate their defined benefit pension plans, leaving only two airlines with active plans. The airlines’ pension problems are no different from the pension problems occurring throughout the economy and, as we previously reported,3 can be traced to broad economic factors, poor management decisions, and inadequate pension regulation. Therefore, broad pension reform that is comprehensive in scope and balanced in effect, such as we previously recommended, would more logically address problems with airline pensions than more sweeping airline industry regulation, which could undo the benefits that deregulation has achieved. DOT generally agreed with this report’s facts and conclusions, but did not provide written comments. DOT provided technical comments and suggestions that we incorporated as appropriate. 3GAO-05-945. Page 5 GAO-06-630 Airline Deregulation Background Industrywide regulation of the U.S. airline industry began in 1938 in response to congressional concern over safety, airlines’ financial health, and perceived inequities between airlines and other regulated forms of transportation. The Civil Aeronautics Act of 1938 (P.L. 706) applied to interstate operations of U.S. airlines and gave the Civil Aeronautics Authority, redesignated as the Civil Aeronautics Board (CAB) in 1940, authority to regulate which airlines operated on each route and what fares they could charge. Airlines could not add or abandon routes or change fares without CAB approval. CAB also limited the number of airlines in the industry. In 1938, the interstate U.S. airline industry consisted of 16 “trunk” airlines, but this number contracted to 10 by 1974, despite 79 applications from new airlines to initiate service. Competition was limited on a route to one airline unless the CAB determined that demand was sufficient to support an additional airline. Airfares were based on a complex cost-based formula used by the CAB, though the exact formulas and process varied over the life of the CAB. Generally, though, airlines during this time had little incentive to reduce costs, since each was assured a fixed rate of return. As a result, the competition that existed among airlines was largely based on the quality of service. Airlines operated largely a point-to-point system, more similar to railroads than the airline networks that we know today. For example, as shown in figure 1, the route-maps of Eastern Airlines (1948) and Western Airlines (1962) show a system vastly different from today’s hub-and-spoke networks. Page 6 GAO-06-630 Airline Deregulation