It's a jungle up there

Regulators could blow the BA and KLM merger off course
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The Independent Online

It was in the immediate aftermath of the First World War that the companies that eventually became British Airways and KLM took off. Within a decade, Europe's first full-blown commercial airlines had been formed from what started out as hobbies set up by demobbed pilots eager to retake the skies. Since the Second World War, their flight paths have diverged at times, but deregulation and competition have lately blown BA and KLM back on similar courses. Hence the announcement last week that the British and Dutch national carriers were in merger talks designed to create Europe's largest airline.

It was in the immediate aftermath of the First World War that the companies that eventually became British Airways and KLM took off. Within a decade, Europe's first full-blown commercial airlines had been formed from what started out as hobbies set up by demobbed pilots eager to retake the skies. Since the Second World War, their flight paths have diverged at times, but deregulation and competition have lately blown BA and KLM back on similar courses. Hence the announcement last week that the British and Dutch national carriers were in merger talks designed to create Europe's largest airline.

The view from their respective cockpits has changed dramatically since those maiden flights of 1919. Once the airline industry got off the ground in the 1950s, it became dominated by national carriers like BA that enjoyed effective monopolies of flights to and from their own country. But the signal to fasten seatbelts came in 1978 when Jimmy Carter, then US President, liberalised the North American market to allow regional carriers to compete in their rivals' backyards. It took another 20 years, but finally in 1997 the European Commission came up with a similarly deregulated market.

So national airlines found their airspace invaded by competitors. Just as the thermal of government money that's kept state-run carriers like BA aloft has been removed with most European governments privatising their national airlines. So BA and KLM have decided their future lies together.

"The degree of consolidation is a reflection of the degree of competition," says Chris Tarry, transport analyst at Commerzbank. "As industries mature, companies tend to get together."

Another analyst adds: "The underlying factor is that the airline industry has never had any consolidation to speak of. If you are in the US, you're protected by Chapter 11. In Europe, people have been protected by state aid. So airlines have not reduced capacity, even when they are losing money."

BA has been trying for years to form alliances and mergers beyond its national borders, a previous attempt to link up with KLM itself having failed in 1992. It is no surprise that almost Rod Eddington's first act as chief executive of BA was to propose a merger with KLM. Indeed, they are certainly not the first to seek strength in numbers. Only last month, the world's largest carrier, America's United Airlines, announced plans to buy US Airways.

Until now, the method of consolidation favoured by airlines has been to form loose alliances that let members co- ordinate their timetables and to code-share, whereby carriers can offer tickets in the name of another airline in the same alliance. BA, for instance, set up OneWorld with American Airlines, but its hopes of extending this alliance have been frustrated by regulators. British Midland is a member of the Star Alliance that includes United Airlines, Germany's Lufthansa and Singapore Airlines. Virgin is a loose affiliate of Star as Singapore has a 49.5 per cent stake in Sir Richard Branson's carrier. .

But there is evidence that an alliance won't be enough to protect airlines from fierce competition, as the US example indicates. After Mr Carter's liberalisation kicked in, the market exploded with new entrants until there were as many as 30 carriers in the US. Now, after several either went bust or into the arms of larger rivals, there are just six main players.

"Alliances are like a halfway house," says Mr Tarry. "If you look at the revenue benefits, all they do is redistribute rather than create anything new." An-other analyst says: "Quite often, alliances are emotional things in which one side feels it isn't doing as well as another."

Analysts have calculated that Lufthansa, for example, could wipe more than 10 per cent off its costs if its Star Alliance metamorphosed into a full merger. Some estimates have suggested that the combination of BA and KLM could deliver cost savings of £1bn. And they will be able to juggle their flights by switching low-yielding transfer traffic to Schipol in Amsterdam, leaving Heathrow's slots free for the more lucrative direct flights. There is also speculation that BA could merge its low-cost carrier, Go, with KLM's equivalent, Buzz. "Over time, we're going to see a smaller number of airlines," says Mr Tarry. "There is room in Europe maybe for no more than three groupings which may then become single entities"

Ironically, the smooth path towards a global industry dominated by a few super-efficient carriers is blocked by one big hurdle: regulators. Ironic, because it was Mr Carter in the US and Karel van Miert, the former European Competition Commissioner, who inspired the deregulation that has prompted airlines to seek sanctuary in mergers and alliance. Their successors are now desperately trying to put the genie back in the bottle.

The best case of consolidation going too far is Canada, where airline duopoly this year became monopoly when Canadian International was taken over by Air Canada. The local authorities are not happy about the new airline's ability to raise prices - a danger that's exercising the European Commission too, one suspects. "Karel van Miert was very keen to put Europe on the map as an effective competition body," says Kevin O'Toole, editor of Airline Business. "They tore so many holes in the BA-American Airlines deal, it couldn't take place."

While the muscle-flexing by the commission could threaten BA's hopes of merging with KLM, United Airlines' ambition to buy US Airways may be thwarted by America's Department of Justice. Regulators seem to think consolidation, like the curate's egg, is good only in parts.

And the regulators are also squaring up to each other. Just as American law bars foreign airlines from offering internal US flights - a market Branson's Virgin Atlantic would love to crack - so the EC only lets US operators fly between European destinations if it's one leg of a longer flight.

Talks on opening up the market for flights between the UK and US reopen in London tomorrow. In the past, these Open Skies negotiations have been marred by the refusal of either side to give ground - or rather sky - across the pond.

So two battles are being fought. The commercial pressure on airlines to join forces has never been greater, but neither has the determination of the European and US competition authorities to prevent the concentration of too much power in too few hands. And the creation of truly global airlines is being prevented by the refusal of European and US regulators to give the other access to their airspace. But one thing is for sure. Running an airline is no longer just a hobby.

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