November 17, 2016

The Strategic View—Aviation UK

This content first appeared as the UK section of the first edition of The Strategic View—Aviation, published by Global Legal Group.

—By Philip Perrotta and Alan D. Meneghetti

Alan D. Meneghetti and Philip Perrotta reflect on the impact on the UK aviation industry of the country’s recent vote to leave the European Union, and examine the upcoming decision on increasing airport capacity in the nation’s capital

1. Currently, what are the main issues (strategic and political) affecting those in the aviation sector in your jurisdiction?

Following the result of the recent referendum in the UK and the consequent decision to leave the European Union, despite some initial uncertainty it now seems certain that the UK will invoke Article 50 of the Treaty on the Functioning of the European Union (TFEU).  It is as yet unclear what this will mean for the UK’s body of law.  The International Air Transport Association (IATA) issued a report shortly after the result of the referendum was announced, in which it stated that “[p]reliminary estimates suggest that the number of UK air passengers could be 3–5% lower by 2020, driven by the expected downturn in economic activity and the fall in the Pound Sterling exchange rate.  The near-term impact on the UK air freight market is less certain, but freight will be affected by lower international trade in the longer term”.

In relation to aviation legislation and regulation, the position is decidedly unclear, as any exit from the EU will mean that the UK faces major challenges in accessing the European Single Aviation Market and balancing the conformity which this entails with the freedom to set its own aviation regulations.  Working on the basis that Article 50 TFEU is invoked, there will of course be no immediate impact on the country’s legislative position, as it will remain a member of the EU until the exit negotiations have been completed (Article 50 TFEU envisages a two-year period).  In addition to that, the UK will need to agree a new trading relationship with the EU – an issue which is, in itself, the subject of a considerable amount of debate.  To a large extent, the resulting agreement will also affect the impact of a ‘Brexit’ on any EU aviation legislation that continues to apply in the UK.

Currently, in aviation terms, the UK benefits strongly as part of the EU, where a long-standing and successful liberal aviation market has been created.  As a consequence, if the UK does ultimately leave the EU, a major objective of the negotiations could be that any exit agreement ensures: i) full and open traffic rights between the EU and the UK as currently allowed under EU Regulation 1008/2008; ii) that UK-registered carriers continue to retain the rights allowed for in EU Regulation 1008/2008; and iii) the continued application of European Aviation Safety Agency (EASA) rules and regulations to the UK operators and companies based in the UK, to create a common European regulatory framework.

Furthermore, the UK participates in numerous technical programmes to facilitate the movement of both passengers and cargo, and ongoing UK involvement and participation in these programmes will also have an impact on UK competitiveness.  As a result, a key consideration in understanding the regulatory implications of Brexit is the extent to which the UK is willing or able to secure continued access to the Single Aviation Market.

It is important to bear in mind that market access considerations go beyond UK–EU routes.  The UK's routes to the rest of the world will also be affected as, since 2002, EU Member States have been required to apply the provisions of the Single Market to bilateral air service agreements with third states.  Of particular importance here is the Community Carrier clause, which requires third countries to apply the same treatment to all airlines registered in the EU as to those airlines registered in the country signing the bilateral agreement.  At the same time, the EU has given effect to the external dimension of the Single Aviation Market by negotiating comprehensive agreements with third countries as a single trading bloc, the most high-profile of these being the EU–US Open Skies agreement (2008).  Depending on the terms of exit, these agreements would potentially cease to apply to the UK, possibly requiring the UK to negotiate a whole series of separate bilateral agreements.

Another development is that the atmosphere of uncertainty created by all of the above is already having a definite impact on inward investment into the UK’s aviation sector across the board, with a number of significant pending transactions – ranging from aircraft and airline investment to leasing platform launches, through to public offering programmes – either being placed on hold or having their related discussions terminated altogether.  Whether in the form of debt- or equity-sourced funding, it is a truism that money dislikes uncertainty (as opposed to known risk which it is able to assess and price accordingly); even some apparent short-term benefit currently being enjoyed by UK suppliers of aviation goods and services to the global market, as a result of the Sterling plummeting to a record low valuation, seems unlikely to offset the flight of financial institutions and investors from the sector in the UK, and a likely negative trend in the financial markets generally regarding investments, prices and jobs in UK aviation.

The other major issue currently animating the UK aviation industry is Her Majesty’s Government’s (HMG) decision regarding where to place a third runway.  A commission chaired by Sir Howard Davies (The Davies Commission) was appointed to look into this and delivered its final report in July 2015, recommending that a third runway be built at London Heathrow; however, the final decision rests with HMG, although this has been delayed given the activity around the referendum in the UK.  A decision is expected imminently and, whilst there was hope that this would be given before the summer parliamentary recess in August, the issues around Brexit arising after the referendum in June seem to have delayed this.  Of course, even a long-awaited decision like this will represent just the first major step in the project, while in the meantime the continuing capacity issues and associated strain on infrastructure at all London airports, most particularly London Heathrow, increase daily.  In many senses, this is part of the perfect storm of challenges facing the UK aviation sector, where the insufficient infrastructure and inability to produce a coherent improvement plan has combined with an ever-evolving security situation in the UK in reaction to world events leading to recurring transport problems.  This is only likely to persuade more of those investors and markets referred to above, already sceptical about the UK and London as a continuing financial centre, that they should consider other investment strategies and locate to other markets.

2. Where has your jurisdiction seen the most growth in the aviation sector over the past 12–18 months? And, if any, where do you anticipate growth coming from during the next 12 months?

The aviation sector has seen an increased number of flights and enhanced load factors as the global recession has tapered; however, given the situation outlined in question 1 above, it is likely that much of this growth may well be curtailed, at least insofar as outbound UK traffic is concerned (as a result of the currency depreciation), although this may be countered by an increase in inbound UK traffic as visitors from other countries take advantage of a weaker Sterling.

Once HMG makes its decision regarding a new runway, there will be development and growth at the selected airport as this runway is built and becomes operational, although this will of course be over a period longer than the next 12–18 months.

Until the recent Brexit decision, it is fair to say that investment volumes in UK aviation generally had demonstrated a number of growth patterns over a longer period of time.  Changes in the corporation tax regime for UK limited companies, introduced by the incumbent Conservative government as part of a previous budget, had persuaded a number of aviation businesses to consider the jurisdiction as an attractive location.  One tangible result was an increasing number of overseas businesses considering the UK as a base for its holding company or headquarter operations, including some developing aircraft lessors looking for alternatives to an already crowded market in Dublin.  This has been stopped in its tracks by the overall uncertainty detailed above.

3. Does the GDS distribution model continue unchallenged as the most popular model for flight distribution?

Yes, this remains the case, although there has certainly been some evidence of a mounting push-back from the airlines, perhaps globally and, in particular, in the United States, more than in the UK.  That said, there is certainly a move by the airlines to wrest back some control over the distribution of their seats.  Most notably, this has been seen with the Lufthansa Group and its application of a Direct Channel Fee on tickets sold through GDSs, as opposed to directly via the Lufthansa Group.

4. In your jurisdiction, does airport capacity require boosting and, if so (and even if not), what plans and/or processes are in place to address this (or increase or re-organise airport capacity, as the case may be)?

Yes, this has been well recognised in the UK.  The Davies Commission’s analysis shows that expanded airport capacity is crucial for the UK’s long-term prosperity.  Extensive re-distribution of airport capacity to the regions was discounted at a relatively early stage, and while each of the three schemes eventually shortlisted was considered a credible option for expansion, the Commission unanimously concluded that the proposal for a new north-west runway at Heathrow Airport, combined with a significant package of measures to address its environmental and community impacts, presented the strongest case and offered the best strategic and economic benefits, as it would entail around 40 new destinations from the airport and is anticipated to provide more than 70,000 new jobs by 2050.

The Commission’s recommendation is a fundamentally different proposition from previous proposals to expand at London Heathrow.  It proposes a full-length runway, which is situated further west than the current runways, and it is accompanied by strong measures to limit the impacts on those living nearby, including:

  • a ban on all scheduled night flights in the period from 11.30pm to 6.00am;
  • no fourth runway: the Commission proposes that HMG should make a firm commitment in Parliament not to expand the airport further;
  • a legally binding ‘noise envelope’ putting firm limits on the level of noise created by the airport;
  • a new aviation noise levy to fund an expanded programme of mitigation, including noise insulation for homes, schools and other community facilities;
  • a legal commitment on air quality that new capacity will only be released when it is clear that compliance with EU limits will not be delayed (this obligation may of course be lessened or rendered inapplicable upon the UK’s exit from the EU);
  • a Community Engagement Board, under an independent chair, with a say in spending on mitigation and compensation and in the airport’s operations;
  • an independent aviation noise authority, with a statutory right to be consulted on flight paths and other operating procedures at all UK airports; and
  • provision of training opportunities and apprenticeships for local people, so that nearby communities benefit from the jobs and economic opportunities created by the expansion of the airport.

As referred to in paragraph 1, HMG is expected to make a decision on the Commission’s report imminently, although no date has been given for this.  For the reasons explained previously, that decision cannot come quickly enough.

5. Does the national "flag carrier” carry the most passengers into and out of the national airports and: (a) if so, what competition exists and how significant is it?; and (b) if not, what are your thoughts on the reasons for this, and why do competing airlines have higher load factors?

Yes, currently British Airways, the UK’s ‘flag carrier’, is still the dominant player in the UK aviation market, although a full range of competition exists from a vast range of providers, from local UK airlines (such as flybe), to other national carriers (American, United, Air France-KLM), to low-cost carriers (Ryanair).

The competition, as one would expect in a ‘mature’ aviation market like the UK, varies dependent upon the route, with Ryanair and easyJet playing significant roles on short-haul and European routes as well as intra-UK routes, often being the dominant carriers on city-to-city pairs.

British Airways strives to retain its leading position in terms of passenger carry by combining its strength at London Heathrow with a leading role in the ‘One World’ alliance of global airlines.  However, major competition is encroaching in the shape of the Gulf carriers, notably Emirates and Etihad, acquiring slots at London Heathrow using their own alliance networks and aggressively marketing their connectivity and wider range of destinations, through Dubai and Abu Dhabi respectively.

6. What trends, in terms of regulatory intervention and involvement, has your jurisdiction observed over the past 12–18 months in relation to airline acquisitions and alliances?  Do you anticipate a change in the regulatory environment of your jurisdiction during the coming 12 months, and if so, how?

There has been relatively little intervention and involvement as regards airline acquisitions and alliances specifically.  Linked to the evolving security situation globally, there is more scrutiny on the identity, background, bona fides and source of funds of potential new overseas owners; however, most regulation – as before – continues to have an anti-trust/competition element to it, whether under UK laws and regulations or at EU level, and a focus on potential abuse of dominant positions.

7. What trends are being observed in relation to new technologies – such as UAVs/drones – and what impact are these technologies having on the aviation regulatory environment?

In the UK, there is very little legislation specifically addressing drones, which is possibly surprising in view of the increasing regularity with which drone utilisation and operation features in the UK press, and rarely positively.  The Civil Aviation Authority (CAA) has issued an Air Navigation Order with provisions which address small unmanned aircraft (and addresses, for example, the height at which a drone may be flown and its proximity to people and structures), and has also published guidance on how to conduct oneself when piloting a drone.  A Permission issued by the CAA is required before anyone may conduct aerial work with a drone.

In addition, there is other legislation which impacts on drone use, such as (and perhaps most notably) the UK Data Protection Act 1998, particularly in relation to the collection, processing and storage of personal data (which includes images).

8. Legal issues in the “lease-to-part out” market.  A major market development is the interest of investors purchasing mid–end life aircraft on lease for the purposes of making returns on a leasetail and component margin model.  What challenges are inherent in this segment of the aviation finance market, and what techniques and disciplines are required to manage the risks involved?

This development in aircraft trading and leasing is at once predictable but also particularly risky for investors, who are driving the phenomenon while having relatively little experience of the aviation markets, whether in the UK or globally.  The idea of purchasing aircraft with a highly depreciated value on lease to an airline which, at lease expiry, is relieved to avoid the normally onerous redelivery conditions is sensible, and the projected returns very attractive if the ‘right’ aircraft type is chosen with a substantive part-out value, often in excess of the aircraft as a ‘whole’ at that point of its life-cycle.  However, a thorough understanding of jurisdictional asset risk (consider, for a second, repossession of an aircraft you own from an enthusiastic airline and its entrepreneur owner in a country which doesn’t legally recognise your ownership rights, which despite what the creators and implementers of the Convention on International Interests In Mobile Equipment 2001 (the “Cape Town Convention”) continue to promote, is not solved in its entirety by developments in new international systems of rights recognition) and a keen eye for technical detail and the relevant aircraft component aftermarket is essential, as well as a good lease manager to track payments and anticipate financial constraints so that pre-emptive steps as a lessor can be implemented in good time.

9. Manufacturer support in the new cycle of new OEM products, e.g. MRJ, E2, C-series, etc.  In an increasingly sophisticated and competitive environment, in what way is the type of OEM financial and product support for this new era of aircraft more complex and far-reaching than in previous cycles?

The number of new competing aircraft types has created something of a buyer’s market; however, it has also coincided with some growth slowdowns in some of the economies long thought to be the sustainers of the next phase of volume-based aircraft orders.  Consequently, the demand for original equipment manufacturer (OEM) support has once again become highlighted in the context of available financing and competitive terms for airline and leasing company purchasers.  The range of finance and product support for the new aircraft coming to the market is developing to be more efficient, more sophisticated, and ultimately designed to persuade asset investors, as well as airlines, that the aircraft are attractive to purchase and essential to operate.  It is a generalisation, but manufacturer support historically has focused predominantly on customer finance support and the requirement to underwrite the financial value of the aircraft as an asset, typically by giving instruments such as deficiency guarantees and asset value guarantees.  Manufacturers invariably take views as to their role and the amount of support to be given, and what is clear is that increasingly both new entrants and existing OEMs have as their focus indirect support for asset values through a range of operating and performance underwriting, which is inherently more useful to the operators of the products themselves.  This sees a range of OEM support being provided as part of an aircraft acquisition programme, which ranges from guarantees of despatch reliability and engine fire burn, through to (interestingly in conjunction with other programme or industrial partners) comprehensive fixed pricing for aircraft and engine maintenance (also encompassing spares support) based on assumed operational criteria for the aircraft.  The most well-known example of this is the ‘Total Care’ programme pioneered by Rolls Royce for its engines, and others are following.

10. The advent of cheaper oil and the knock-on effects.  What are the consequences that arise as a result of the unexpected purchasing power of a number of third/fourth-tier airlines? What will challenge lessors and suppliers in particular as they are faced with speculative judgments on an airline's longer-term financial viability?

Firstly, it needs to be remembered that ‘cheaper oil’ is a market phenomenon and there is every possibility that prices will re-balance again (albeit possibly not as high as previously) as demand increases (including from a clutch of those third/fourth-tier airlines referred to) and those macro-economic factors responsible for the drop in prices become less significant.  In the meantime, the encouragement that cheaper fuel gives to would-be operators will undoubtedly result in some start-up operations using typically older equipment at the lower ends of the market, usually with the acquiescence of increasingly desperate speculative aircraft owners unable to liquidate their asset investments (as mentioned under question 8 above).  This will test a prospective lessor’s lease protocols and transaction modelling, in particular their ability to see through optimistic business plans and engineered balance sheet and profit/loss predictions to evaluate the likelihood of a carrier still being in existence in the coming months, never mind its ability and inclination to perform its contractual lease obligations to the owner.  Another, again likely short-term, effect of the oil/fuel price situation is a fresh look from prospective customers at the new aircraft products, such as the B787 ‘Dreamliner’ and Airbus A350, which positively accentuate their cheaper operating costs through reduced fuel burn, which was also the main rationale for aircraft products such as the Airbus A320 family’s new engine options (NEOs) and Boeing 737 MAX.

11. Iran and the market return.  What remain as barriers, including sanctions-related issues to navigate, where Iran and aerospace and aircraft transactions are concerned?  What sort of jurisdiction is Iran from a risk perspective, and what techniques from a supply perspective are likely to be needed so that Iran's potential and promise for OEMs, lessors, suppliers and service providers is realised and does not become the latest example of a disappointing gold rush?

In January 2016, the US government and the EU (which still includes the UK at this stage of post-referendum proceedings) removed a limited number of sanctions against Iran in accordance with the Joint Comprehensive Plan of Action (JCPOA).  General Licence J was then issued in July 2016 by the US government, which essentially allowed previously-restricted equipment including aircraft to operate into Iran, subject to certain conditions.  Airlines in Iran can benefit from a relaxation of the rules but a residual regulatory regime still requires compliance.  At this stage, regulated activities for the aviation sector in Iran include: sale, supply, transfer or export of passenger aircraft; information-sharing and technical assistance in aircraft maintenance and assembly; transfer of funds; establishing a joint venture; and opening a branch in Iran.  As regards US-origin aircraft (that is, typically those which include 10% or greater US-origin content by value), a licence from the US Office of Foreign Assets Control (OFAC) is required.  As regards non-US origin aircraft, no licence from OFAC, or indeed anywhere else, is required and the regime has been significantly liberated, although prior authorisations may be required depending on the nature of the proposed activity and there is a general exclusion of the US banking system in order to facilitate the transaction.  Even with the specific approval issued by the US government in September 2016 of Iran Air’s purchase of new Boeing and Airbus aircraft, it is probably still too early to evaluate the risks involved in aviation transactions with Iran, but in terms of its capability to join the international aviation market, its technical and commercial expertise is of the highest standard, and if it continues to comply with the conditions of JCPOA and trust continues to build, it could yet develop into the next big market for global aviation products and services across the board, with all the consequences that this would entail, albeit not at the pace some observers would have us believe.

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