After more than four years of turbulent negotiations, Washington and Brussels have managed to achieve a historic pact on ‘open skies.’ The agreement will deregulate air traffic on both sides of the Atlantic, a market that represents about 60% of international travel. Starting in March 2008, U.S. and European airlines will be able to travel more freely to any location on the two continents. The only limitation will be the availability of flying rights to various airports.


The agreement is good news for the more than 25 million passengers who will enjoy new transatlantic flights at lower prices, according to EU estimates. Any deregulation effort, explains Serguei Netessine, a professor of operations and information at Wharton, will “inevitably lead to more competition and hence lower fares.” This will be especially true for the U.K.’s Heathrow Airport which currently accounts for 40% of transatlantic flight from Europe but is only served by four airlines (United Airlines, American Airlines, BA and Virgin Atlantic). Continental Airlines has already filed with regulators to offer service to Heathrow which, according to some estimates, can provide the airline with additional revenues on the order of $200 million. 


Beyond that, according to Antonio López de Ávila, director of the Instituto de Impresa’s executive master’s program for the tourism sector, “Just as we have watched low-cost carriers establish themselves in secondary airports, this greater accessibility will generate significant medium-term economic development around those airports that manage to capture the attention of companies from the other continent.”


Many U.S. states, as well as Europe, he adds, “have remained isolated to some extent from the other continent. New economic, social and cultural relationships — in services, tourism and various products exchanged by the two regions — will now open up and grow.” The European Union calculates that the agreement will lead to the creation of 80,000 new jobs, and economic benefits worth 12 billion euros.


A Limited Agreement


On the other hand, the agreement also opens up the possibility of new mergers and acquisitions that can lead to greater consolidation in the world of global aviation. In that respect, from a negative point of view, López de Ávila says, “You have to mention that the agreement maintains a limit of 25% on the voting rights that any European company can acquire in a U.S. airline, although they can buy more than 50% of the [U.S. company’s] total shares. This factor, along with a commitment to apply antitrust immunity for agreements made between airlines, leaves European carriers at a disadvantage compared with the Americans.”


The agreement does not make any changes in the important limitations that govern the ownership and control of airlines. This is one of the reasons why, despite the fact the pact has been unanimously ratified by the 27 members of the EU, some people remain unsatisfied. British authorities have demanded that the U.S. commit to taking a second step toward deregulation in 2010. In addition, they have managed to delay the implementation of the agreement by five months. It was originally expected to go into effect in October 2007. That’s because it’s predictable that British air carriers will suffer the most damage from ‘open skies,’ since they have more transatlantic flights. In the case of Heathrow, explains Netessine, “British Airways is the biggest loser.” He warns that other airlines that currently operate from this airport could also experience some turbulence.


As some experts note, Europeans generally feel that they are giving away more in this agreement than they are getting from the Americans. For example, by virtue of the new open skies, all European companies will be able to fly from any place in the EU to any destination in the EU, and not only from their own country of origin. Nevertheless, once they are in that foreign country, they will not be able to carry passengers from one city to another. In contrast, U.S.-based airlines will be able to fly to other places in Europe after arriving in one European city. Nevertheless, EU authorities approve of the progress made, and they anticipate that they will be able to overcome the limitations of the agreement when they engage in a second phase of negotiations in the future.


Congressional Protectionism in the U.S.


López de Ávila calls the pact a major step forward in aviation history even though some experts believe that the agreement falls short. The traditional reticence of the U.S. to allow foreign companies to control strategic sectors of the U.S. economy “means that the agreement might wind up having less significance on the corporate level.” From Netessine’s viewpoint, however, people should not have expected more from the negotiations. “I think it is somewhat unreasonable to expect that U.S. would completely open its lucrative market in a single deal. What has happened is a serious step towards a more competitive transatlantic market. We can only hope that, in the future, they will reach a better deal that facilitates competition further and leads to lower fares.”


However, more skeptical observers have told the European media that the protectionist trend in the U.S. Congress will prevent more substantial advances in the future round of negotiations. López de Ávila is one of the optimists. “Parity must be the golden rule for this type of agreement. As a result, I am convinced that the Congress of the U.S. will understand the great benefits that the pact will provide for both parties, and that Congress will then approve [a second stage of] greater deregulation in 2010. On the other hand, showing foresight, the government of the U.K introduced a clause that stipulates that if, by 2010, the EU has not eliminated   rules that prevent European companies from totally controlling U.S. airlines, any EU member-state will be able to automatically suspend parts of the agreement merely by serving notice to the [European] Commission. If there is no parity, there is no agreement,” he concludes.


On the other side of the Atlantic, Netessine is moderately optimistic. “Further liberalization down the road seems like the logical next step. However, it remains to be seen how many benefits of liberalizations will be appropriated by U.S. airlines versus European airlines.” 


The Outlook for Transatlantic Aviation


The agreement puts an end to a period of legal uncertainty that lasted five years. It could mark the beginning of a new era. Among other changes, the new alliance between the U.S. and the EU will create the concept of an EU airline. It will do away with the old system of national flag carriers. It will also end bilateral treaties between members of the European bloc.


Within this new framework, experts note that the agreement will permit mergers of European airlines without putting their U.S. routes at risk. That already happened in 2000, when the efforts of British Airways to launch a takeover for KLM of Holland were thwarted. It’s no wonder that when word about the open skies pact got out, rumors heated up that Iberia was going to be acquired. 


“In Europe, we had already been watching the merger of some great companies –LM with Air France; Lufthansa with Swiss. Only British Airways and Iberia have remained, at least for the moment, outside this game,” explains López de Ávila. Now it appears that it is Iberia’s turn. With its market capitalization of 3.5 billion euros, Iberia is smaller than Esther of the other merger candidates — British Airways or Lufthansa.


“The most valuable thing about Iberia is its specialization in the Latin America market because Iberia would decisively complement either the British company [BA] or the German carrier [Lufthansa],” says López de Ávila. Nevertheless, he won’t venture a guess about which candidate will work out better for Iberia. “British Airways appears to be a better fit for Iberia, and BA owns 10% of Iberia’s shares. There are other factors to take into account, such as approval from the [European] Commission for such a merger, or how the two organizations would be integrated [into one]. We shouldn’t forget that there are people behind any company.”


However, Iberia’s dizzying climb on the stock exchange, supported by seven consecutive months of rising prices and the company’s positive operational and financial results, “proves the excellence of its financial management,” explains López de Ávila. This has made Iberia “the center of attention, not only from other large aviation companies, but also from other players such as Texas Pacific Group, a risk capital fund that already owns some of Qantas airlines.”


Texas Pacific Group (TPG) is considering whether to launch a public offering for Iberia worth four billion euros. This would force British Airways to come up with a rival offer. “It seems that Iberia won’t be the one that leads the consolidation in European aviation, but whoever makes the highest bid for its shares,” comments López de Ávila.


“This pattern could be repeated with other companies,” he adds. “Companies need to merge in order to get larger, have greater bargaining power, reduce their costs and have a presence in the largest share-issuing markets. As a result, we will witness various sorts of alliances, mergers and acquisitions in coming years. However, it will always be the marketplace that ultimately determines their success or failure.”


It is too early to tell if these mergers will have a transatlantic character, notes Netessine. “As things stand now, foreign airlines cannot own more than a 25% share in any U.S. airline. It is possible that we could see some transatlantic mergers but I think it will take a few years to find out.”