Piecemeal policy making has played havoc with the health of India’s airlines. What can propel the industry back to greater heights?
As the Indian economy stumbles many eyes are on the airline industry, for nothing epitomizes the promise of India more than its ambitious airline companies and spanking new airports. But this industry is drowning in debt and whether it can turn itself around will depend greatly on the government’s ability to move away from the status quo.
“Over the last six or seven years the airlines have accumulated losses of US$8.5 billion and they are carrying an estimated debt of around US$16 billion,” says Kapil Kaul, CEO South Asia at CAPA India, an aviation consultancy, which estimates that investments of US$25 billion have been poured into the sector since 2004.
Kaul adds that the debt burden of India’s full-service and no-frills airlines is expected to go up by between US$2 billion and US$3 billion in 2013 after Air India takes delivery of three Boeing 787 Dreamliners. Air India has ordered 27 of these aircraft.
As oil prices hover around US$100 a barrel and with the global economy in trouble, airlines all over the world are under pressure. However, the financial challenges facing India’s airlines – state-owned Air India and five private carriers: IndiGo, SpiceJet, GoAir, Jet Airways and Kingfisher Airlines – have been exacerbated by an over-expansion of capacity that triggered a fierce scramble for market share, which has driven air fares down.
“The airlines themselves built business cases which were inadequate to the requirements of the market,” contends Kaul. “Some built business plans which were not properly funded, not aligned to the needs of the market, ignored the challenges of the industry in terms of poor regulatory and policy framework, poor infrastructure, poor manpower infrastructure, high cost of operation – they ignored all these and built over-aggressive business plans.”
Kingfisher, which has been operating since 2005 and until recently was India’s third-largest airline, is a case in point. The airline has been desperately seeking financial stability after suffering a series of losses and accumulating debt of over US$1.5 billion.
Indian companies do not have the luxury of going into a Chapter 11-style court-assisted insolvency that will allow them the time to restructure. Having lost the support of its bankers and also the government, which has refused to bail it out, Kingfisher can only hunker down and wait it out.
The lack of a coherent and long-term government policy on civil aviation has also taken its toll on India’s airlines. “All the airlines are being affected by the regulatory issues,” says Sidanth Rajagopal, a New Delhi- based partner at Clasis Law, who heads the firm’s aviation practice. “If the regulatory environment was different, airlines doing badly right now would be doing alright and those doing alright would be doing well.”
Observers point to a lack of expertise at the Directorate General of Civil Aviation (DGCA), which enforces civil air regulations, air safety and airworthiness standards. The recently formed Airports Economic Regulatory Authority, which regulates tariffs for aeronautical services at India’s airports, is also struggling on account of lack of adequate personnel.
“There is a general reluctance to take corrective action in policies,” says Saroj Datta, a former executive director and board member of Jet Airways. Datta points out that route dispersal guidelines issued in 1994 are still applicable today even though the number of carriers has gone up.
The airlines have also had to make do with piecemeal policies that often favour Air India at the expense of the private carriers.
“Air India has the upper hand on what is to be done and how. This distorts the market and is a matter of concern for the airlines,” says Datta, who began his career with the state carrier.
However, Air India’s expensive problems with its pilot unions following its merger five years ago with Indian Airlines, the state-owned domestic carrier, may be slowly changing its status as the most favoured carrier.
In February, the Ministry of Civil Aviation announced that all Indian carriers would be given equal access to operate on foreign routes allocated to India through bilateral agreements. This change of heart brought considerable cheer to the private airlines as until now Air India has enjoyed right of first refusal over these routes.
The ministry recently announced that it was formulating a civil aviation policy and invited suggestions from the public to help put it together.
Despite these challenges, domestic traffic has grown at close to 20% each year since 2004. The main beneficiaries have been the low-cost carriers such as IndiGo and SpiceJet. These airlines have also done well as a series of mergers – between Air India and Indian Airlines, Kingfisher and Deccan and Jet Airways and Air Sahara – have preoccupied the airlines involved. As a result, figures from the DGCA for April show the low-cost carriers have around a 55% market share.
However, the high cost of aviation turbine fuel (ATF), on account of both high base prices and high taxes, has wrought havoc on the airline industry, which is increasingly making do with wafer-thin margins. The problem is made worse as the taxes, levied by state governments, vary between states and range from 4% to 30%.
“ATF is 60-65% costlier in India than in competing hubs such as Dubai, Singapore and Kuala Lumpur,” says Amber Dubey, a partner at KPMG-India who heads the firm’s aviation practice.
Aircraft fuel accounts for 40% to 50% of the operating expenses of airlines in India. All the airlines are equally affected as both full-service airlines and no-frills carriers have similar cost structures. Despite years of lobbying by the airline industry, the state governments have been unwilling to lower taxes.
“This is politically very difficult,” says Dubey, adding that although the economic benefits of lowering taxes are inevitable, it would take five to six years to realize them. “Hence this may require a very bold approach by the government.”
But it seems a tipping point may have been reached and the government is being forced to act.
In February, the Ministry of Civil Aviation announced that airlines could import ATF directly and thereby avoid state taxes. At least three airlines have since obtained licences to import ATF.
However, without the infrastructure in place for airlines to transport ATF from the port to the aircraft, the action taken by the government is being seen as impractical and a temporary solution at best.
In addition, India is an ATF surplus country that in 2010 exported nearly 45% of its ATF, as KPMG points out in a recent background paper on the aviation sector. Therefore, allowing the direct import of ATF “just to work around the prevailing taxation policies” may appear strange.
Such a policy would be more appropriate in a country such as China, which imports around 40% of its ATF requirements and has high taxes on ATF.
“A better solution is to rationalize fuel prices within the country without anyone needing to import it,” says Lalit Bhasin, managing partner of Bhasin & Co, who has long been legal counsel to players in the airline industry.
The Ministry of Civil Aviation has recommended that ATF be included on a list of goods of special importance – so-called “declared goods” – that under section 15 of the Central Sales Tax Act, 1956, can only be taxed at a uniform rate of 4% by all the states, but this is yet to happen. ATF for turboprop aircraft is already included, along with goods such as sugar and cereal.
“The government – central as well as state – now realizes that unless fuel prices are rationalized the sector will come to a grinding halt,” remarks Bhasin.
Knights in the wings?
But the current troubles of the airline industry go beyond high ATF prices. With margins low or non-existent and high levels of debt, the airlines have been lobbying the government to allow foreign airlines to invest in Indian carriers.
As it stands, foreign direct investment (FDI) rules allow 49% FDI in airlines but only from non-airline investors, which are often wary of investing in such high-risk and low-margin ventures.
The government has all but agreed to allow investment by foreign airlines, with the minster for civil aviation, Ajit Singh, actively championing it. However, observers are sceptical of such investment being possible or even making a difference.
“I don’t believe that the environment is good or correct for a foreign airline to be investing money in an Indian carrier,” says Datta. “Why should they pour in money and get to the 49% mark, if they are not going to be allowed to control the business of the company and when the policies are unfavourable?”
Others, like Rustam Gagrat, a partner at Gagrats in Mumbai, are wary about commenting on the prospects of a foreign airline investing in an Indian carrier without a policy being in place.
“There are attendant challenges to a foreign airline investing in India, but on the other hand there are huge opportunities,” says Gagrat, adding that the government could stipulate conditions and criteria for foreign airlines to invest.
Whatever the prospects, allowing FDI may help the government improve its image.
“Even if FDI is not going to achieve what everyone expects it to achieve, allowing it shows positive intent on the part of the government – right now nobody knows what the intent is,” says Rajagopal at Clasis Law.
Foreign airlines have been allowed to invest in Indian carriers in the past. Kuwait Airways and Gulf Air owned a minority stake in Tailwinds, the Isle of Man-registered parent of Jet Airways, until 1997, and Lufthansa held a stake in ModiLuft, a small full-service airline that ceased to exist in 1996. ModiLuft’s air operating certificate is today used by the low-cost carrier SpiceJet.
FDI “may be useful and may help, but not if government comes up with regulations against a carrier flying a particular route or if it continues to be the mother of Air India giving it money to compete, etc.,” says Datta.
The government rationalizing and liberalizing the sector is seen as the key to the long-term survival and prosperity of the airlines.
As Dubey at KPMG-India points out, aviation reforms should include the rationalization of taxes in the maintenance, repair and overhaul (MRO) industry. A 30% tax differential between domestic and foreign MRO providers has severely curtailed the domestic industry. The MRO industry in China is currently four times the size of the Indian industry.
“It is cheaper to fly an aircraft empty to Singapore and repair it, than have it repaired in India,” Dubey says ruefully, adding that unlike other countries, India does not levy an export tax to prevent this loss of business.
“It’s a travesty that while these aircraft are owned by Indians and earn money from Indian passengers, the MRO revenue and MRO jobs get exported to other competing locations.”
India’s MRO industry, which is expected to triple in size by 2020, was given a boost in the recent budget when the government said new or retreaded tyres as well as testing equipment for aircraft that is imported by third-party MRO units would be exempted from customs duty.
Information collected by KPMG shows that since 2005 at least 14 ventures set up to provide MRO services have stalled as the policy framework is not favourable. However, in 2011 an MRO joint venture between MAS of Malaysia and the GMR Group was launched in Hyderabad.
Despite the current problems faced by the airline industry, its potential cannot be ignored.
A report by a working group of the Ministry of Civil Aviation says that air travel penetration for India currently stands at 0.04 air trips per capita per year, compared with 2 air trips per capita per year for countries such the US and Australia.
China, which has a population that is only 10% larger than India’s, has five times the domestic traffic of India.
India aims to be the third-largest aviation market in the world by 2020. It is already in the top 10, but to do any better it will need to improve both the policy of the government and the business model of individual airlines.
“The aviation sector was in trouble and is now on the razor’s edge between being in trouble and no longer in trouble,” says Rajagopal at Clasis Law.
The infrastructure puzzle
Huge fee increases at Delhi airport suggest that India is ignoring the competitive dynamics of the region
In July 2010, when a new terminal at Delhi airport, T3, was inaugurated, the minister of civil aviation at the time, Praful Patel, said that “[it’s] not just a building, it’s a statement”. He also said that while the cost to build the terminal was higher than estimated, people would not mind paying the special airport usage fee.
But when the Airports Economic Regulatory Authority (AERA) recently approved a 345% increase in aeronautical charges at Delhi airport, the airlines that use it were less accommodating. Writing in the Economic Times, the director general and CEO of the International Air Transport Association, Tony Tyler, cautioned it “could be the start of a downward spiral that dismantles Delhi’s ambition to play a key role as a major regional hub”.
Delays in setting up AERA have meant that the higher charges at Delhi airport were approved only in April, three years into the first five-year tariff period set for the joint venture company that runs the airport, Delhi International Airport Limited (DIAL). As a result DIAL is relying on the next two years to reach its targeted revenue for the entire five-year tariff period.
The percentage increase would have been lower if the new charges had come into effect in 2009 – as originally intended – and should fall during the second five-year tariff period that begins in 2014, which may be of some comfort to the airport’s users.
However, Delhi airport’s track record will inevitably be judged against that of airports in the region that have managed to keep charges “low, stable and at times discounted”, such as Singapore, Bangkok, Beijing and Dubai, as Tyler points out.
The 345% increase in fees – landing and parking fees for aircraft and a user development fee for passengers – has also raised questions about the public-private partnership (PPP) model that was used in the redevelopment of Delhi and Mumbai airports.
As widely reported, a recent draft report by the Comptroller and Auditor General of India (CAG) pointed out that a user development fee was not envisaged in the original bid documents or key agreements signed when DIAL was awarded the concession to redevelop and run Delhi airport.
Neither the 184-page operation, maintenance and development agreement (OMDA), according to which DIAL is to pay the Airports Authority of India (AAI) an annual fee of 46% of projected revenues, nor the state support agreement, which outlines principles for tariff fixation, mentions a user development fee.
Accordingly, the draft CAG report says that allowing DIAL to levy such a fee to recoup its costs “vitiated the sanctity” of the bidding process and was a post-contractual benefit provided to DIAL.
In addition, the agreements between DIAL, the AAI and the government, signed in 2006 – three years before AERA was established – have been criticized as lacking in transparency and predictability as far tariffs are concerned.
“The principles of tariff determination [as specified in the state support agreement for Delhi airport] are prone to multiple interpretations as they are very general and high level and have not been objectively defined,” says Hemant Sahai, managing partner of HSA Advocates in Delhi.
Sahai contends that the PPP model adopted specifically for Delhi and Mumbai airports “is inadequate … at least as far as predictability of tariff determination is concerned”.
Sahai was engaged by the Planning Commission in 2005-06 to investigate the potential for unfettered real estate development in the OMDA for Delhi airport while it was being finalized. He subsequently advised the Planning Commission on drafting a blueprint for future OMDAs to be used in airport development that he says “set out the tariffs and the escalation of the tariffs up-front in a transparent and predictable manner”.
However, Jatin Aneja, a Delhi-based partner at Amarchand Mangaldas who assisted and advised the Ministry of Civil Aviation and the AAI in drafting the agreements for Delhi airport between 2003 and 2004, rejects any suggestion that the documents were not watertight.
Robustly defending the “very clear mechanism” for determining tariffs in the state support agreement, Aneja says: “The agreement provides for a mechanism for determination of tariffs … in the absence of AERA being there. Once the AERA is there, it will prescribe the mechanism for determination of tariff … that is the law of the land.”
The Airports Economic Regulatory Authority of India Act, 2008, “clearly states that it is for the regulator to determine the tariff … when there is a regulator to determine the tariff the contract can’t do anything,” adds Aneja.
The Delhi airport OMDA, in a chapter titled Tariff and Regulation, states that the aeronautical charges levied shall be as per the provisions of the state support agreement. Schedule 1 of the state support agreement in turn lists 10 principles for fixation of tariffs which will be observed by AERA – subject to applicable laws – when it approves tariffs and user charges. Schedule 1 also provides a mathematical formula for calculating aeronautical charges.
Analysing the source of differences on the tariff question, aviation consultancy CAPA India, in its submission on a civil aviation policy to the Ministry of Civil Aviation, said: “the award of concessions at Delhi and Mumbai in the absence of a defined economic regulatory framework is responsible for the ongoing debate. The permissible structure for charges should have been made known at the time of the tender so that consortia could have bid accordingly and the appropriate level of investment could have been expended on the airport development.”
While the experiment with PPPs for the development of both brownfield and greenfield airports has set important precedents for the infrastructure sector, concession agreements used by different agencies and state governments still lack uniformity.
The Planning Commission has drawn up model concession agreements for use in sectors such as highways, ports, water and health. Projects that require viability gap funding from the central government are cleared faster by the Ministry of Finance if they use a model concession agreement.
The ministry’s Department of Economic Affairs issued a 26-page draft National Public Private Partnership Policy last year and draft PPP Rules in March this year. But as yet no definite policy on PPPs or the use of model concession agreements has been formulated.