House of Commons - Environment, Transport and Regional Affairs

Select Committee on Environment, Transport and Regional Affairs Eighteenth Report

AIR SERVICE AGREEMENTS BETWEEN THE UNITED KINGDOM AND THE UNITED STATES

Reasons for Renegotiating Bermuda II

33. Despite the apparent success of the aviation market between the United Kingdom and the United States since the agreement was signed, Bermuda II is widely regarded as unsatisfactory. The Department of the Environment, Transport and the Regions said that both the United Kingdom and the United States "accepted ... that this agreement is not ideal".[111] The CAA told us that "the presence of government-imposed restrictions on air services such as those in the existing Bermuda II agreement inevitably imposes a cost on users and on the UK economy".[112] British Midland told us that the "current situation is untenable and ... it is imperative for both Governments to negotiate a new more liberal air services regime".[113] Federal Express described Bermuda II as "one of the most restrictive aviation agreements between two otherwise-liberal trading partners",[114] and UPS agreed that the agreement is "highly restrictive".[115] Both contended that "the liberalisation of air cargo rights [will create] new direct and indirect employment opportunities, improved services for consumers, improved services and, therefore, enhanced competitiveness for UK-based exporters, [and act as a] catalyst for regional investment".[116] Virgin Atlantic told us that "Bermuda II is a restrictive agreement, one that should be replaced as soon as possible".[117] British Airways cautioned, however, that "Bermuda II has served the UK public interest well", although the airline supported "the United Kingdom Government's attempts to liberalise the UK-US bilateral".[118]

34. We heard some evidence which was lukewarm about the need for change: the Aviation Forum, an alliance of trades unions representing those working within the aviation industry, told us that Bermuda II "has helped United Kingdom carriers, greatly benefited consumers, and has worked to the advantage of the British economy".[119] However, the rest of our witnesses were united in their demand for amendment of the air service agreement between the United Kingdom and the United States. Their proposed solutions to the problems of Bermuda II form two opposing views.

THE UNITED STATES'S VERSION OF 'OPEN SKIES'

The US Government and US airlines perspective

35. We were given evidence from the US perspective by Federal Express, UPS, Continental Airlines and Delta Airlines. In addition we were briefed informally by State Department officials. We did not, unfortunately, receive evidence from American Airlines and United Airlines, the two US carriers which most benefit from the existing arrangements. Nevertheless, we believe that we have a clear view of the objectives of US carriers and the US Government in the current bilateral negotiations.

36. Since 1992, the United States has pursued a policy of seeking to conclude liberal bilateral air service agreements which are described as 'Open Skies' agreements. By 1 June 2000, forty-six nations had signed such agreements with the United States,[120] including ten members of the European Union.[121] The five European Union members states yet to sign full 'Open Skies' agreements are France, Greece, Ireland, Spain and the United Kingdom, although France and the US have put in place a relatively liberal regime.[122] Under 'Open Skies' agreements third, fourth and fifth freedom rights for airlines of each signatory are entirely liberalised, so that they can fly any route they wish between and beyond the two countries.[123] There are no restrictions on capacity on routes, nor on access to airports: Delta Airlines told us that the purpose of 'Open Skies' was "to get Government out of the aviation marketplace ... to allow the marketplace to function [through] open routes, open designations, open pricing, open code-sharing".[124] Such agreements have generally been accompanied by undertakings by the United States that alliances between US carriers and those of the other signatory to the agreement will not be judged to be uncompetitive under US anti-trust laws.[125]

37. The consequence of coupling more liberal air service agreements with the grant of anti-trust immunity for co-operation between airlines has been to promote the growth of global airline alliances. Delta Airlines told us that the US Government's strategy had given rise to "a new global airline regime - one based on vast, competing networks created by the formation of multinational alliances. The development has created more flights to more cities with more price and service options for consumers".[126] Hence the 'Open Skies' agreement with the Netherlands prompted a growing relationship between KLM and Northwest, that with Germany has encouraged United Airlines and Lufthansa to come together in the Star Alliance, and the liberalised regime put in place between France and the US has seen a burgeoning relationship between Delta Airlines and Air France through SkyTeam.

38. The objective of putting in place an 'Open Skies' agreement between the United Kingdom and the United States was supported by those US airlines from which we heard. Passenger airlines said that they were concerned about the impact of Bermuda II on competition, and thus on the range of services and fares offered between the United Kingdom and the US. Delta Airlines told us that it was "a strong proponent of the US Open Skies policy ... our two countries remain burdened with an air services agreement that regulates the number of carriers in the market, the number of flights they operate and the prices they charge. We believe the impact of this situation has been detrimental to both US and UK carriers and the customers we serve".[127] Continental Airlines argued that the failure of the United Kingdom to conclude an 'Open Skies' deal with the United States would lead to other European nations over-taking the United Kingdom: "other European Countries ... have reached 'Open Skies' agreements with the US that have eliminated entry restrictions. The competitive advantages of these 'Open Skies' gateways will continue to grow as the options made possible by free competition in 'Open Skies' countries eclipse the historic dominance of London Heathrow as a connecting point for Europe-US traffic".[128]

39. Although the overall aim of our witnesses from the United States was the implementation of an 'Open Skies' agreement, certain aspects of such a deal were highlighted by individual witnesses. Continental Airlines and Delta Airlines stressed three matters. Their principal objective was to liberalise access for US carriers to Heathrow. Both airlines claimed that as a result of restrictions on access to Heathrow under Bermuda II fares on routes to the United States from Heathrow have become inflated, and the quality of service, as well as the choice of routes available, has not been as wide as it might be. Delta Airlines said that "the lack of capacity and competition, especially at Heathrow, has forced passengers (especially business class passengers) in the UK to pay a premium for trans-Atlantic flights when compared to similar trans-Atlantic gateways on the European continent".[129] Continental told us that "London Heathrow is dominated by British Airways and its alliance partners ... As a result, these airlines have been highly successful in restricting the level of competition between London Heathrow and the US, particularly for high-yield business passengers, and limiting the availability of lower fares and more carrier options for these UK passengers".[130] Liberalising access to Heathrow, Continental claimed, would lead to new services,[131] and would lead to "a more competitive market-place; that would impact on service standards and fares".[132] Delta took a similar view.[133]

40. In the past, including as recently as during discussions over the proposed close alliance between British Airways and American Airlines last year, the US Government has sought to ensure that new US entrant airlines at Heathrow would be able to obtain specific slots to fly in and out of the airport at commercially attractive times. That demand has now been modified in favour of seeking liberalised access to the airport, and then permitting airlines to obtain slots through their own devices, such as by negotiation with alliance partners and others.[134] Delta and Continental supported such a "self-help plan, where carriers from both sides would use the normal channels for accessing slots":[135] Delta, for example, thought that it might be able to obtain slots vacated by its alliance partner, Air France.[136] Nevertheless, they sought further reassurance, since if they could not access slots, liberalised access to Heathrow was "just a piece of paper. It is just open skies without open ground".[137] Continental argued that the rules governing the slot allocation process should be made clear.[138] It also said that "slots without airport facilities at congested airports such as London Heathrow would be meaningless. New US airlines operating at London Heathrow will require terminal space, ticket counters, back offices, baggage facilities, service offices, transfer desks, airport lounges, piers, office space and storage areas in prime locations".[139] Delta appeared to go further still, pointing out that the oneworld alliance dominated Heathrow,[140] and that "Government has a role ... to ensure that competition takes place, and one of the ways of doing that is to allocate slots so competition can be maintained".[141]

41. The second matter of importance to Delta Airlines and Continental Airlines was to obtain liberalised access to services from Gatwick. Continental told us that "although new entry at London Heathrow is of primary importance, carriers such as Continental that have long served London Gatwick must also be permitted to continue their existing services at London Gatwick and add frequencies in the future to meet demand".[142] Delta cited a specific example to support the point: for the past two years it had tried to add an additional flight on its Gatwick to Atlanta and Gatwick to Cincinnati routes, and that such a development has been rejected by the United Kingdom Government. It argued that such decisions should be made on commercial, not regulatory, grounds.[143]

42. The third priority of the two passenger airlines was price deregulation.[144] Both supported a 'double disapproval' regime, under which the price of a ticket on a particular route could only be controlled if both Governments disapproved of an airline's proposed fare.[145] Such a regime forms part of the US version of 'Open Skies', and thus already applies on routes between the United States and Germany, the Netherlands, Switzerland and so on.[146] Continental Airlines told us that such a pricing regime "takes the shackles off both the US and UK carriers to meet market demand and offer the prices in the market-place that the market will bear".[147]

The liberalisation of 'cargo fifths'

43. US freight carriers were also concerned about the restrictive nature of Bermuda II. For example, UPS told us that the agreement "does not give us the flexibility we need to meet customer demand ... Therefore, UPS strongly supports all efforts to reach a UK-US 'Open Skies' agreement".[148] Their priority was the liberalisation of fifth freedom rights, which would assist the development of their 'hub and spoke' networks across Europe,[149] and would "result in more business opportunities for all parties involved, including the smaller UK cargo carriers".[150] UPS and Federal Express argued that restrictions on fifth freedoms under Bermuda II adversely affected the costs and competitiveness of exporters and other companies in the United Kingdom.[151] For example, research carried out on behalf of Federal Express had found that the distribution costs of United Kingdom companies to global markets could be reduced by £276 million through improved air services.[152] Currently only 20 per cent of British imports and exports are carried by air, compared with 40 per cent worldwide, and much of this country's "air eligible trade does not go out of the United Kingdom; it is moved by lorry over to the Continent and goes out of Schiphol or Paris".[153]

44. The companies also claimed that the lack of fifth freedom rights from the United Kingdom had inhibited the development by air freight carriers of their networks, and thus influenced US cargo airlines in their decisions about where to base their min European operations. Federal Express observed that "none of the major integrators has chosen to locate their European hub in this country":[154] UPS has its hub in Cologne, whilst Federal Express is based in Paris. UPS pointed out that "development of a UPS air hub in the UK would dramatically enhance worldwide delivery options for local and national businesses and create excellent employment opportunities in the region".[155] Federal Express told us that 49 per cent of the European distribution centres for the US Fortune 500 companies were based around Schiphol airport, because the Netherlands had agreed liberal fifth freedom rights with the United States.[156] It also said that it currently employed 3,500 people in the United Kingdom, and "a liberalisation of the air services treaty would lead to a significant increase over that":[157] a decision to make a British airport, such as East Midlands, its second hub "would require the establishment of an open aviation regime between the US and the UK".[158]

45. There is some support for separating the issue of 'cargo fifths' from the negotiations over air services between the United Kingdom and the US, perhaps as part of a preliminary deal in advance of a full agreement between the two countries. Indeed, in 1994 the Transport Committee concluded that in respect of air freight "there is a strong case for the UK negotiators to offer [a] separate liberalisation deal to the US side".[159] In its evidence to this inquiry, Federal Express said that its "primary objective is to see the phased introduction of 'Open Skies' between the UK and US, with air cargo included in the first phase".[160] It argued that the granting of fifth freedom rights to cargo operators was a relatively uncontentious matter which was now being delayed by disagreements over trans-Atlantic passenger services.[161] Indeed the Government has itself taken unilateral action: in response to a request from Federal Express for open fifth freedom rights from Prestwick and Stansted it offered, in late 1999, such rights to US cargo operators from Prestwick. The measure was intended to result in "significant economic benefits accruing to the region".[162] Federal Express was unhappy not to have been given equivalent rights from Stansted, however, and by early this year had withdrawn its new service from Prestwick.

Access to Heathrow for British airlines

46. The call of the US Government and US airlines for an 'Open Skies' agreement was echoed by British Midland. It argued that "the existing Bermuda II agreement is probably the most restrictive bilateral air agreement in the world and was originally designed ... [to protect] the then flag carrier, British Airways. It severely restricts choice and competition from trans-Atlantic services from Heathrow [and] actually forces the price of the product up".[163] Indeed the airline told us that "it is now a well-documented fact that business travellers between London and the United States are being charged some of the highest business class fares in Europe. Because of the restrictions imposed by Bermuda II, passengers can only choose between two UK carriers (British Airways and Virgin Atlantic) and two US carriers (American Airlines and United Airlines) for flights between the world's most important international airport, London Heathrow, and the United States. Furthermore, passengers have a choice of only 11 non-stop US destinations from Heathrow compared to, for example, 16 destinations from Amsterdam".[164]

47. British Midland argued that to redress the situation a new liberalised agreement was required. The new agreement should, it said, allow new airlines to enter the aviation market between the United Kingdom and the United States, especially at Heathrow, without restrictions on frequency or on points served. It should also allow airlines to set whatever fares they chose, subject to relevant competition laws.[165] In short, the demands of British Midland closely mirror those of the US Government and US airlines: indeed British Midland told us that "we certainly believe that the 'Open Skies' model is acceptable",[166] although it said that it would prefer a 'phased' liberalisation of the aviation market, along the lines of the agreement between the United States and France.[167] However, unlike Delta and Continental, British Midland is not concerned about the availability of slots and facilities at Heathrow: it already operates domestic and short-haul services from the airport, and told us that if it were permitted to fly to the US from Heathrow it had "the slots available within our portfolio of slots to be able to accommodate the plans that we have".[168]

48. The establishment of a liberal air services agreement is of great importance to British Midland. The airline has already ordered four Airbus A330-200 aircraft, which are suitable for long-haul travel, and has taken options on a further eight.[169] Its first such aircraft will be delivered in April 2001, and, if a more liberal regime is in place by then, it intends to begin services from Heathrow to a number of US cities in the Summer of 2001.[170] It also intends to operate services to Washington and Chicago from Manchester, but made clear that it did not believe that services from Manchester would be economically viable "unless we serve both Heathrow and Manchester because we have our hub and infrastructure in Heathrow".[171] British Midland would also seek to operate services under code-sharing arrangements with its Star Alliance partner, United Airlines.[172] The airline believed that the entry of new entrants, including itself, to the trans-Atlantic market would bring competition over fares and services, and would ultimately "stimulate the market (as has been the case in Europe) and lead to more traffic".[173] British Midland also believed that code-sharing with United Airlines would enable more effective competition against the dominant airlines in the market, namely British Airways and American Airlines.[174]

THE UNITED KINGDOM'S VERSION OF 'OPEN SKIES'

Criticism of the US version of 'Open Skies'

49. Criticism of the arguments of those who sought an 'Open Skies' agreement between the United Kingdom and the US came in two forms. First, there was some dispute over whether or not the competitiveness of the trans-Atlantic market has suffered under Bermuda II, and claims that in fact the market offered an unparalleled choice of airlines, frequency of flights, and range of routes and fares. For example, Virgin Atlantic noted that "there are actually seven, not four, airlines permitted to serve the US from Heathrow",[175] since Air India, Air New Zealand and Kuwait Airways do so under fifth freedom rights, although their impact may not be enormously significant, since they account for only 1.3 per cent of all air traffic between the two countries.[176] British Airways pointed out that there is a greater frequency of flights between the United Kingdom and the US: the company said that "there are [approximately] 30 flights a day between here and New York, and the most there are for any other major city in Europe is eleven and that is Paris".[177] Moreover, as we have already pointed out, there will be 111 daily flights in each direction between the United Kingdom and the US this Summer, compared with 42 from France and 48 from Germany.[178]

50. It is true that the range of routes served from Heathrow compares poorly with the range served from other European airports. For example, only eleven destinations are served from Heathrow, compared with sixteen from Schiphol. However, as British Airways said, "Heathrow, of course, is not the only place. If you take London as a whole, we actually operate to more destinations in the United States from Gatwick than we do from Heathrow".[179] Indeed, taking London as a whole there are twenty-seven destinations in the US which can be reached non-stop from the two airports.

51. Finally, both Virgin Atlantic and British Airways argued that it was misleading to point out that fares from Heathrow are high when compared to those from other European destinations: Virgin said that "published business class fares may appear relatively high, but very few passengers actually pay them. Discounting is particularly prevalent in the UK market, almost certainly more so than in most other European countries".[180] The airline argued that "promotional fares to the US from London, including Heathrow, are among the lowest in Europe ... the same is true for fully-flexible Economy fares".[181] Similarly British Airways told us that "both unrestricted economy fares and promotional fares were significantly cheaper than elsewhere", and that "many of British Airway's corporate customers also benefit from discount arrangements which significantly reduce the cost of business travel".[182] British Airways also said that fares were currently distorted by movements in the price of sterling. Moreover, both airlines agreed that the quality of the products they offered on the trans-Atlantic routes "tends to be superior to that offered by most other carriers".[183]

52. The second criticism of 'Open Skies' was that, as Virgin Atlantic put it, "the US version of Open Skies is in fact itself protectionist, designed essentially to serve the interests of US airlines against their foreign competitors".[184] The CAA agreed, and told us that "the US Government's policy of 'Open Skies' falls substantially short of full liberalisation and is designed permanently to benefit its own industry over that of the UK and other major aviation nations".[185] The Government also told us that the US version of 'Open Skies' "falls short of full liberalisation".[186] The root of such criticism lies in the fact that the US Government does not intend under 'Open Skies' to take any major steps to open up its domestic market.

53. The US domestic aviation market is enormous, accounting for 36 per cent of all scheduled air services undertaken worldwide.[187] It is dominated by ten 'major' passenger airlines,[188] three of which have turnover in excess of that of British Airways.[189] Major US airlines operate according to a 'hub and spoke' system, each having a number of major airports into which they feed a range of domestic services. From the hubs passengers can be flown on to international destinations. It is the sheer size of the US domestic market, together with the unmatched ability of US airlines to feed passengers into hubs, and then onto trans-Atlantic flights, that has long been regarded as putting European airlines at a disadvantage: indeed it was fear of dominance by US carriers which led to the negotiation of Bermuda II.[190]

54. Two solutions present themselves to the problem of the advantageous access to the US domestic market enjoyed by US airlines, which would meet British Airway's aim "to improve access to the US hinterland, where a third of the total market lies".[191] The first would be to permit foreign airlines to operate their own feeder services, or spokes, to gateway airports in the United States, by granting them eighth freedom, or cabotage, rights.[192] That has been one of the UK Government's "big, historic demands",[193] and was strongly made by both the British Cargo Airlines Association,[194] and by Virgin Atlantic. Indeed Virgin wished to go further, and establish an airline in the United States which would be able to feed passengers onto its trans-Atlantic routes.[195] Both cabotage and the establishment of a foreign-owned domestic airline are, however, prohibited by US law, and there seems to be no immediate prospect of the legal position being changed: the Chairman of Federal Express informed us that "the US has said that as a matter of policy that it will not deal with cabotage",[196] and Delta Airlines told us that cabotage raised "concerns on the part of our labour unions ... we have to work very closely with our unions".[197] The second solution would be to allow a United Kingdom carrier to purchase a controlling interest in a domestic US carrier, and to align the services of that carrier to feed its international services.[198] However, US law limits foreign investment in airlines to 25 per cent.[199] Thus neither solution to the problem can be adopted.

55. Our witnesses generally agreed that the US market should not be compared with that of the United Kingdom, but rather with that of Europe: the Government, for example, told us that "matching like for like, the UK's equivalent of the US's domestic market is the combined European Economic Area".[200] In part this is because the size, population and economic activity of Europe as a whole are similar to those of the United States.[201] It also reflects the structure of the European aviation market: in January 1993, the Third Package of European Council Regulations were adopted which, following the implementation of the First Package in 1987, and the Second Package in 1990, liberalised air services in Europe,[202] replacing previous bilateral agreements with a single aviation market. The Third Package introduced the concept of a European, rather than a national airline, allowed European airlines access to all international routes within Europe and, from April 1997, most domestic routes, and allowed airlines freely to set their own fares.[203] Hence, as a number of our witnesses told us, United Kingdom airlines' "domestic market is essentially the European Union as a single market".[204]

56. Therefore the concern of a number of our witnesses was that by signing 'Open Skies' agreements with a number of European Union states, which liberalises fifth freedom rights, US airlines would be able to operate flights within Europe, whilst foreign airlines would be excluded from the United States. The Government suggested that this unfairly favoured US airlines.[205] Virgin Atlantic agreed, pointing out that "US airlines are able to fly between Member States, for example from Copenhagen to Vienna, or Frankfurt to Lisbon, but European carriers are prevented from serving Chicago from New York or Atlanta from Boston",[206] and the CAA told us that "if such 'Open Skies' agreements were to be in strict accord with the US model, US airlines would .. be given the ability to develop networks within Europe using widespread intra-European Union fifth freedom rights. But there would be no guarantee, or even probability, of equivalent access to the US market for European Union carriers".[207] In short, the CAA argued, "'beyond' fifth freedom rights are likely to be of significantly greater value to US airlines than to UK airlines",[208] since only 6 per cent of passengers on trans-Atlantic flights from London connected to or from domestic services, whereas in the United States 20 per cent of passengers connected to or from such a service.[209] Moreover European Union rules permit foreign investors to take a stake of up to 49 per cent in a European airline, compared with the 25 per cent limit in the United States.[210] Virgin told us that there are also additional restrictions in the United States on board and senior management appointments which do not apply in Europe.[211]

57. Another matter not addressed under the US version of 'Open Skies' is the Fly America or America First policy. The policy was instituted after the Gulf War, to ensure that the US Government had adequate access to both passenger and freight air transport in the event of a national emergency. Under the policy when travelling on business US Government employees or their contractors must buy a ticket to fly on US airlines which have agreed to supply aircraft when needed, although in fact passengers may be carried on foreign airlines under code-share arrangements.[212] There are also restrictions on mail and other US Government cargoes. The Government contrasted Fly America with the policy in the United Kingdom, "where value for money is the principal criterion for public servants travelling by air",[213] and the British Cargo Airlines Alliance pointed out that UK Government contracts are put out to competitive tender, for which US carriers may bid.[214] The Alliance said that Fly America was a "protectionist policy",[215] and Virgin Atlantic described the policy as "one of the most glaring examples of US protectionism".[216] The British Cargo Airlines Alliance claimed that it had generated $600 million of passenger revenue for US airlines in 1995, and had resulted in freight contracts to the value of $334 million being awarded in 1997.[217] However, Federal Express, which benefits from the policy told us that it supported the "elimination" of Fly America,[218] as did UPS.[219] By contrast Delta Airlines and Continental Airlines both said that they regarded it as a matter of national security, and therefore they had not sought its abolition.[220]

58. The US version of 'Open Skies' also does not address the current inequalities in wet-leasing[221] arrangements between the United Kingdom and the United States. Currently US airlines are prevented from wet-leasing aircraft from foreign carriers for use in the US domestic market, whereas the European Union allows it in defined circumstances, such as to provide additional capacity at times of peak demand, or to provide capacity in new, experimental routes where the operator is uncertain about the strength of demand.[222] The Government pointed out to us that "wet-leasing into the United Kingdom domestic market is not merely a legal possibility: it is an opportunity beneficially exploited by US carriers":[223] Atlas Air, for example, currently wet-leases a freighter aircraft to British Airways for use at Stansted airport.[224] By contrast, although the US Government has indicated that it will accept the use of wet-leased aircraft for international flights to points in the United States, it will not for domestic flights, since that would be regarded as cabotage: thus, as the Government told us, a US airline would not wet-lease a British aircraft under such conditions, since its use would not be fully flexible.[225] Therefore, as the British Cargo Airlines Alliance said, "the worldwide wet-leasing market is heavily skewed in favour of US airlines. Any air services agreement between Britain and the US must rectify this protectionist position on wet-leasing":[226] the current restrictions, we were told adversely affected not only cargo airlines, but also charter airlines such as Air 2000 and Virgin Sun.[227]

59. Hence the US version of 'Open Skies' was not, in the opinion of a number of our witnesses, an agreement which would sufficiently liberalise the aviation market between the United Kingdom and the United States. In short, the CAA told us, "signing a US-style 'Open Skies' agreement would involve the removal of the bilateral restrictions on access by US carriers to Heathrow without securing the removal of a host of other bilateral restrictions, including those on ownership and control or cabotage services. Such a deal would deliver all of the US's bilateral objectives while leaving fundamental UK needs unmet. Without the ability to use Heathrow access as negotiating leverage, it is difficult to see how the US would be persuaded to make future concessions".[228]

Another version of 'Open Skies'

60. Many of our witnesses sought a much more liberal air services regime than that proposed by the United States. The United Kingdom Government told us that "we should seek to agree with the US a new and liberal air services agreement ... The UK's concept of open skies .. would give carriers on either side equitable access to each other's domestic markets, maximising choice for consumers. It would also do away with other impediments to free competition".[229] The ideal agreement would be to liberalise access to Heathrow and other airports and to do away with restrictions on ownership, cabotage and wet-leasing, as well as Fly America. This aim was supported by the CAA,[230] British Airways,[231] Virgin Atlantic,[232] Air 2000,[233] and the British Cargo Airlines Alliance.[234]

61. It was, however, widely accepted that full liberalisation could not be achieved in the short-term. As the Government pointed out, "US domestic law, however inimical it may be to the concept of full liberalisation, could not be repealed quickly, even if the US Government were minded to put forward appropriate legislative proposals. So it may be necessary to look for other mechanisms by which UK carriers can gain beneficial access to the US domestic market in return for beneficial US access to the European Economic Area via the UK".[235] Moreover, those rules governing the ownership and control of airlines, the allocation of slots at airports and many competition issues are decided by the European Union, not by the United Kingdom. Hence, in the longer term, as the CAA told us, it may be that "the only practicable means of achieving a full liberalisation of the North Atlantic aviation market is through European Union-United States negotiations",[236] a matter which is clearly contentious and which is not likely to lead to a new agreement imminently.

62. Instead, in the short- to medium-term, an interim deal might be reached through bilateral negotiations. The Government told us that it would reach an interim 'Open Skies' deal provided that "it became clear that the competition conditions were not so stringent as to preclude UK carriers from securing effective access to the US domestic market through alliances",[237] or in other words if alliances which allow British airlines access to the US domestic market are granted anti-trust immunity by the US Government and are agreed by the European Union.[238] As a result, in the round of negotiations between 13 and 15 June it had said that it would "be prepared to defer the two big, historic demands for cabotage and lifting the investment and control restrictions in the US, provided that our own carriers can get effective access to the US hinterland".[239] The two Governments have apparently begun to negotiate a tentative agreement under which liberalisation of access to Heathrow will take place in phases[240] at the same time as British carriers obtain access to the US domestic market through alliances 'immunised' from the restrictions of US anti-trust legislation, as well as those of the European Union and United Kingdom competition authorities. This was described as a "wholly pragmatic approach".[241]

63. The Government's stance was supported by British Airways. It told us that other states of the European Union had been able "to conclude 'Open Skies for Immunity deals' with the US. UK policy should ensure British carriers get the same chance".[242] The airline said that "the key component is that ability to access the internal market [of the US], so a minimum outcome from our point of view is the ability to code-share with American Airlines, to access that market and we would also hope ... to get immunity from the anti-trust laws, so we can collaborate properly with American Airlines".[243] The Chairman of British Airways, Lord Marshall, summed up the position of the airline, telling us that "our ultimate objective is to see our Government achieve a version of 'Open Skies' which will provide us with the immunised agreement".[244]

64. Other witnesses were wary of the Government's approach, fearing that it might give away access to Heathrow, the "jewel in the European crown",[245] without obtaining adequate concessions from the United States in return. The CAA warned that "if the UK is to achieve full liberalisation, it must consider the impact of any interim deal on the prospects of securing the longer term objective. Increased access to Heathrow for US airlines constitutes the major source of negotiating leverage for the UK. In the CAA's view the UK should make significant concessions in this regard only as part of an agreement which would deliver full liberalisation".[246] The British Cargo Airlines Alliance urged the Government to "continue to play a constructive but forceful negotiating hand in air service negotiations. Open skies must mean true reciprocity. The Government must not throw away any rights ... It would be wholly wrong for cargo airline interests to be sacrificed simply to buy support for the UK's passenger airlines in their attempts to secure alliances with US carriers".[247]

65. Strongest opposition to the Government's proposal to move towards an 'Open Skies' agreement in exchange for the grant of anti-trust immunity for alliances between United Kingdom carriers and US airlines was expressed by Virgin Atlantic. It said that " access to Heathrow ... is the jewel in the UK's negotiating crown, something that the US is willing to pay a high price to obtain. It should not be wasted. In particular, so-called 'mini-deals' involving additional Heathrow access for US airlines risk weakening the UK's position".[248] Virgin argued that "the US model for 'Open Skies' would not satisfy the UK's principles. Indeed, it would damage UK interests. Clearly, if the UK were to give the Americans everything they want, particularly open access to Heathrow, the UK would be conceding any chance of persuading the US to amend its protectionist and discriminatory aviation policies".[249] The airline noted that there were no applications for anti-trust immunity for alliances between British and US airlines "currently on the table",[250] although the Government told us that both British Airways and British Midland have submitted applications to enter into code-share agreements.[251] It also noted that alliances required approval from competition authorities in the United Kingdom and Europe, as well as in the United States.[252] Finally, Virgin Atlantic repeated its desire to set up a domestic airlines in the United States, which would not be possible if the Government's current strategy is followed.[253]

The charter market

66. The charter market has faced particular difficulties as negotiations over Bermuda II have continued. Air 2000 told us that it "benefited from the generally relaxed provisions for the operation of non-scheduled flights to and from the US".[254] It operates some services to and beyond the United States under rights which fall outside the terms of Bermuda II, which are known as 'extra bilateral approvals'.[255] These are granted on a seasonal basis, although they have been granted regularly since 1986. However, when negotiations between the United Kingdom and the United States over air services have stalled, as they did in 1996 and again at the beginning of 2000, Air 2000 told us that the US Government had delayed the issue of extra bilateral permits.[256] The airline told us that this represented a 'Sword of Damocles' hanging over its head, and that "the uncertainty [it] engenders does not enable us to move forward and plan our flight programmes with confidence".[257]

67. Charter airlines, like cargo carriers, are discriminated against by the fact that US rules on wet-leasing aircraft are not balanced with those in the United Kingdom. Air 2000 pointed out that if a "US carrier wants to lease an aircraft to increase its Winter capacity, [it will need] to wet-lease because of a shortage of pilots. However, the US lease regulations prohibit US carriers from wet-leasing foreign aircraft ... the reverse, however, does not apply, insofar as any US carrier wishing to wet- or dry-lease to a UK carrier would be able to, and do so with minimal regulatory impediment".[258] Both Air 2000 and Airtours called for the rules, and thus the opportunities for airlines, to be made equal.[259]

Regional airports

68. Regional airports also have specific concerns about the outcome of the negotiations over air service agreement between the United Kingdom and the United States. At first glance it might appear that regional airports would seem attractive to airlines in the current situation in which access to Heathrow is restricted and access to regional airports has been liberalised for a number of years.[260] Indeed, as British Airways put it, "in view of the fact that US carriers have enjoyed open access to the UK regions since 1995, the absence of an 'Open Skies' deal is unlikely to have restricted growth of passenger services in this area significantly".[261] Manchester Airport disagreed. It said that "the current system of restricted rights under bilateral agreements tends to reinforce existing patterns of air services, causing airlines to concentrate services at points where scarce rights exist to the detriment of other markets. Only in a truly liberalised environment can air services develop in an optimum way to meet passenger demand".[262]

69. We were given a number of reasons why the current air services agreement might act against regional airports. First, because the market between the United Kingdom and the US as a whole is constrained, it is claimed that it is difficult for airports such as Manchester to demonstrate that there is a market for services to and from the regions.[263] Second, it is argued that "US airlines are often reluctant to initiate new services to regional points lest this be taken as a weakening of their interest in serving Heathrow and/or increasing their services to Gatwick".[264] Third, the unwillingness of British Midland to initiate services between Manchester and the US prior to being given access to trans-Atlantic flights from Heathrow is a measure of the difficulties faced by regional airports: British Midland told us that services from Manchester would not be economically viable without operating services from Heathrow.[265]

70. Conversely there is also concern that opening access to Heathrow might act against regional airports since airlines might be persuaded to turn over routes from Heathrow to such airports in order to find slots for new trans-Atlantic services. British Airways argued that restrictions on trans-Atlantic flights from Heathrow under Bermuda II had limited demand for slots for long-haul services, and helped Heathrow to maintain a mix of services to the regions and to Europe. The airline is concerned that liberalising access to Heathrow would put short-haul services under threat.[266] However, British Midland assured us that if it was permitted to operate to the US from Heathrow it had sufficient flexibility in the portfolio of slots it already held not to need to reduce regional services,[267] and BAA implied that certain airlines might currently be operating unprofitable services in order to retain slots which they or their alliance partners might use for long-haul services in the future.[268] Moreover, we were also told by the Government that it intended to seek amendments to the European Union regulation which governs slot allocations to ensure that services to regional airports would in future be specifically protected.[269]

WHAT SHOULD BE REMEMBERED IN THE CURRENT NEGOTIATIONS

71. In negotiating a new air services agreement with the United States, the Government must assess whether its priority is to benefit British airlines, British consumers or the wider economy of the United Kingdom. In our opinion, the Government's priority should be to benefit the economy as a whole, rather than individual airlines. It is likely that a more liberal agreement will lead to new passenger and all-cargo services to the United States both from Heathrow and from regional airports, increasing consumer choice, bringing lower fares through enhanced competition, and bringing economic benefits through the employment of ground and other staff, and through lowering costs for exporters using air freight. Equally a more liberal agreement will bring challenges for British Airways and Virgin Atlantic, but they have proved able to thrive in competitive conditions in the past, and seem well-equipped to do so in the future.

72. Like most of our witnesses, we believe that the ideal air service agreement between the United Kingdom and the United States would be fully liberal, doing away with restrictions on airline ownership and cabotage, and with other discriminatory policies such as Fly America. In the long term, that should be the Government's aim in the aviation market between the two countries. However, we recognise that the ideal will not be achieved in the current round of negotiations, in part because the United States will not amend the necessary legislation, and in part because the United Kingdom is not itself free to negotiate matters such as the ownership rules. The Government's objective should be achieve the best deal possible in the circumstances. The United States has proved to be intransigent about its domestic legislation relating to cabotage, airline ownership and Fly America. The current proposal to accept a more liberal air services agreement in return for permitting alliances between airlines in order to allow United Kingdom airlines to gain access to the US domestic market may lead to a deal in the short term, but such a deal should include a clear timetable for the lifting of US restrictions on cabotage and airline ownership, and of the Fly America policy.

73. The deal currently proposed is very similar to those reached between the United States and other European countries such as Germany and the Netherlands. The United Kingdom, however, is in a different position to other European nations, in that we have two trans-Atlantic carriers already, and another domestic airline has said that it is willing and able to enter the market. We recommend that the Government ensure that any deal offer equal opportunities to Virgin Atlantic and British Midland as well as to British Airways. Unlike British Airways and British Midland, Virgin Atlantic is not part of an alliance at present, and opposes the current proposal that access to the US market should be achieved through the agreement of 'immunised deals' between airlines. However, although it is unfortunate that Virgin will either be excluded by the proposed agreement or forced into an alliance because of it, we cannot oppose the proposal, which appears to be the only practical basis on which an agreement might be reached, on those grounds.

74. We are, however, unclear about the status of a deal to liberalise access to Heathrow in the event that either the US, British or European competition authorities reject proposals for an alliance between British and US airlines. We agree that any deal reached between the two countries should be, as is intended, phased in as competition authorities on both sides of the Atlantic grant airlines the ability to reach alliance agreements with one another. We further recommend that the Government ensure that liberal rights of access to Heathrow are rescinded if alliance agreements cannot be reached within a reasonably short timescale, and thus United Kingdom airlines prove unable to access the US domestic market.

75. A number of matters are not directly addressed by the current proposal. The first is that the rules which govern wet-leasing are clearly imbalanced between the two countries: US aircraft wet-leased by British carriers can operate between points in the United Kingdom, but British aircraft wet-leased by US carriers cannot do the same in the United States. We note that this is apparently because the US Government would regard the operation of a domestic route by a wet-leased foreign aircraft as cabotage, and we note the concerns expressed by British Airways about the matter.[270] We do not accept the view that this would be a form of cabotage, and we believe that the unacceptable discrimination against British cargo airlines and charter carriers in particular which results from the imbalance of wet-leasing regulations should be ended. The current situation also harms the United States, since carriers are not able to lease in aircraft at times of peak demand, and competition in the wet-leasing market is not as sharp as it might be. Moreover, the US Government's offer to permit wet-leased aircraft to operate services to and from points in the United States exposes the fact that their objection to wet-leasing is political rather than principled. We recommend that as part of any deal made now in advance of the removal of restrictions on cabotage and airline ownership the United Kingdom should ensure that the regulations governing wet-leasing into the United States be brought into line with those in this country. To do so will not allow British carriers to access the US market directly, but it will at least allow them to benefit from the size and strength of the market.

76. Although the conclusion of an 'Open Skies' agreement is likely to liberalise fifth freedom rights for all airlines, including all-cargo carriers, it has been proposed that 'cargo fifths' should become unrestricted even if a wider deal cannot be reached. We were told that the current restrictions on 'cargo fifths' prevented freight airlines operating the services they wished to from the United Kingdom, and thus had caused them to establish the hubs of their networks in other European countries. As a result, not only were British exporters paying additional costs not even faced by some European competitors, the direct and indirect employment associated with the establishment of a network hub had not come to the United Kingdom. However, we were also told that simply to grant US freight airlines unlimited fifth freedom rights would harm domestic all-cargo carriers, particularly if no reciprocal rights were offered in the US market. Liberalising fifth freedom rights for all-cargo services will undoubtedly bring benefits to the United Kingdom in the shape of increased employment and lower costs for exporters. Such a measure should therefore be considered as a possible basis for a preliminary deal in advance of a wider air services agreement between the two countries. However, we are concerned that domestic all-cargo carriers will not benefit from the grant of fifth freedom rights beyond the United States in the same way that US carriers will from operating to points beyond the United Kingdom. We therefore recommend that the Government should offer to liberalise 'cargo fifths' in return for an agreement that the United States will enable British all-cargo and charter carries to benefit from the US market through wet-leasing.

77. The charter airlines suffer from the fact that a number of their operations are carried out under permits granted only for six months, and which have been the subject of delay at times of tension between the two Governments. As a result they are unable to plan their routes and their investment strategies in the longer-term. We regard the current situation as intolerable. We recommend that the Government seek to improve the position of charter airlines either as part of the air services agreement between the two countries, or as part of a preliminary deal in advance of a full agreement, so that their permits to operate services to and beyond the United States are agreed either for a lengthy period or permanently, allowing them to plan future services and investments.

78. Under Bermuda II there are already far more air services between the United Kingdom and the United States than between any other European nation and the US, almost 40 per cent of passengers to the US fly from or via the United Kingdom, and from London, if not from Heathrow, it is possible to fly to more points in the United States than from any other European city. Moreover, British airlines have been extremely successful under Bermuda II, not only out-performing their US rivals on most routes to the United States, but also attracting more passengers from 'behind' London than US carriers attract from 'behind' gateway airports in the United States. This leads us to two conclusions. First, the Government should be alive to the fact that some of those who have been successful under the current regime may try to ensure that Bermuda II is retained, perhaps by seeking in exchange for a more liberal regime concessions that the United States refuses to give, or that the United Kingdom cannot offer. Second, given the strong position the United Kingdom currently enjoys, the Government should be extremely careful to ensure that a new agreement will bring substantial benefits to the United Kingdom's airlines and consumers, and to the economy as a whole, and that, if access to Heathrow for US carriers is liberalised, significant reciprocal benefits in the shape of access to the US domestic market for both passenger and all-cargo British carriers such as full wet-leasing rights are obtained.

The question of Singapore Airlines

79. We heard evidence about another matter which relates to the progress of the bilateral air service negotiations between the United Kingdom and the United States. Singapore Airlines has for a number of years operated passenger and all-cargo services to the United Kingdom.[271] It also operates flights from Singapore to New York via Amsterdam and Frankfurt under fifth freedom rights. However, although Singapore is a signatory to an 'Open Skies' agreement with the United States, and therefore enjoys authority from the US to operate trans-Atlantic services from the United Kingdom, it has not been given such rights by the United Kingdom.[272] Negotiations to obtain such rights have continued for a number of years. Currently the Government has said that the airline's case for flights under fifth freedom rights will be considered once the bilateral negotiations with the United States have been concluded:[273] this, Singapore Airlines told us, "effectively constitutes a permanent block on Singapore International Airline's application".[274]

80. It is striking that British airlines enjoy fifth freedom rights to fly from Singapore into Australasia, as well as code-sharing rights and the right to establish a 'hub' in Singapore: a British airline may base aircraft there and operate services within the region.[275] These rights do not only exist in principle: British Airways, we were told, already operates 17 scheduled services a week to Australia via Singapore.[276] Moreover, a number of other airlines of third countries operate services via the United Kingdom to the US under fifth freedom rights.[277] Finally, Singapore Airlines told us that additional services on routes between Heathrow and the US would increase consumer choice, enhance competition, [278] and bring economic benefits to the United Kingdom.[279] It is unfortunate that the granting of fifth freedom rights to Singapore Airlines to operate services from the United Kingdom to the United States continues to be delayed by the fact that the bilateral air service negotiations have not yet been concluded. We therefore recommend that the Government consider granting such rights to the airline in advance of the conclusion of its talks with the United States.