Justin Chow and Helen Morris provide an insight into the increased competition which Hong Kong’s aviation sector faces from neighbouring countries, while signalling challenges to the GDS distribution model
1. Currently, what are the main issues (strategic and political) affecting those in the aviation sector in your jurisdiction?
Hong Kong’s location has traditionally enabled it to act as a gateway to Mainland China. Hong Kong’s International Airport (“HKIA”) and the aviation sector in general is, however, facing increased competition. Countries such as Korea and Singapore have expansion plans in place for their main airport(s), which will, amongst other things, enable them to offer a wider choice of routes and flights. Hong Kong will also be affected by the expansion of Mainland China’s High Speed Railway (“HSR”) network. The construction of the Hong Kong portion of the HSR is due to be completed in 2019, and will effectively connect Hong Kong to Beijing and many other cities in Mainland China. The HSR is assessed to pose a significant threat to the aviation sector in Hong Kong, with convenient station locations, lower ticket prices, and train speeds traveling up to 350km/h. The opening of the HSR in Mainland China has been enthusiastically received and has already reduced aviation traffic, with several routes being suspended or a reduction of flight frequencies. Hong Kong may be similarly affected once our section of the HSR is operational.
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?
In the past 12 to 18 months, Hong Kong has seen a significant growth in the presence of low cost carriers (“LCC”). Further, in January 2016, the world’s first low cost carrier alliance, U-FLY Alliance, was formed. The alliance currently consists of HK Express, Kunming’s Lucky Air, Urumqi Air, Eastar Jet and Chongqing’s West Air.
Whilst we do expect LCCs to continue to grow over the next 12 months, LCCs may, however, face difficulties as they can only offer low prices at early or late time slots, which passengers may find increasingly unattractive, and HKIA, being a first-tier hub, is unlikely to forego profits by offering lower fees to LCCs for more convenient time slots. It should be noted that successful LCCs elsewhere tend to operate in second-tier hubs. It should also be noted that LLCs still primarily offer only short haul services, following the failure of Hong Kong’s long haul budget airline, Oasis Hong Kong Airline, in 2008.
3. Does the GDS distribution model continue unchallenged as the most popular model for flight distribution?
Whilst GDS remains the most popular model for flight distribution in Hong Kong, it is not, however, unchallenged. For example, the traditional GDS model is evolving with the emergence of companies such as Gagfare, a Hong Kong-based booking application, which incorporates several GDS distribution systems into one single application, and enables users to book flights and then pay the balance later.
Further, the GDS model needs to address the following issues if it is to retain its supremacy:
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)?
In 2015, HKIA handled 68.5 million passengers, 4.38 million tonnes of cargo, and 406,000 air traffic movements. In regards to air traffic movements in particular, this figure represents four times the expected 2015 growth. As a result, HKIA is expected to reach maximum capacity within 2016 or 2017.
In light of the aforementioned, Hong Kong has undertaken three major projects to increase and re-organise HKIA’s capacity.
In December 2015, a new midfield concourse was opened to the west of Terminal 1. The new concourse has an area of 410,000 square metres, 20 parking stands and the capacity to serve an additional 10 million passengers every year.
In June 2016, HKIA began the transition to a new Air Traffic Management System, Raytheon’s Auto Trac III, after three years of delay. The new system includes numerous features such as enhanced flight information, data processing capabilities, satellite-based technology and allowing air traffic controllers to effectively manage air traffic to reduce delays and increase airport capacity. The Air Traffic Management System will not be fully operational until the end of 2016, and approximately 2,500 flights are expected to be cancelled during October and November 2016 to ensure a smooth and safe transition.
In August 2016, construction began on HKIA’s third runway and is expected to be completed in 2024. The completed third runway, and connected concourse and passenger building, are expected to enable HKIA to handle 100 million passengers, nearly 9 million tonnes of cargo and 607,000 air traffic movements by 2030. The third runway project will also include the expansion of the current Terminal 2 and implementation of a new baggage handling system.
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?
The main airlines of Hong Kong are Cathay Pacific Airways Limited (“Cathay Pacific”) and its wholly-owned subsidiary Hong Kong Dragon Airlines (“Dragonair”). In 2015, Cathay Pacific and Dragonair together handled 34,100,000 out of the 64,700,000 passengers through HKIA. As such, out of approximately 108 airlines operating in HKIA, Cathay Pacific/Dragonair accounts for over 50% of the passengers flying in and out of Hong Kong.
Dragonair was once Cathay Pacific’s greatest local competitor for short-haul services to Mainland China and other countries in the Asia-Pacific Region. In 2006, Cathay Pacific acquired Dragonair and has since managed to fully utilise and exploit its extensive network in Mainland China.
In recent years, Cathay Pacific has faced greater competition from other international airlines, such as Singapore Airlines, Emirates and Qatar Airways, which also offer similar routes and premium services. Due to the aforesaid merger, however, Cathay Pacific has been able to retain its position by offering better schedules and faster connections. Cathay Pacific has also benefitted from the authorities’ reluctance to grant licences to new market entrants, as described in the next question.
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?
As already mentioned, a new budget airline alliance was launched in Hong Kong in January 2016. Further, the Air New Zealand and Cathay Pacific alliance was extended for an additional three years in August 2015. As such, there has not been any major regulatory intervention in Hong Kong in regards to airline alliances in recent months.
In regards to licensing, however, after a two-year application process, the Air Transport Licensing Authority (“ATLA”) officially refused Jetstar Hong Kong’s (“Jetstar HK”) application for an air transport licence (“ATL”) on 25 June 2015.
Jetstar HK was formed in 2012 as a joint venture between China Eastern Airlines and Qantas; however, Jetstar HK’s application was rejected because the Basic Law of Hong Kong provides that airline licences may only be issued to companies incorporated and having its principal place of business in Hong Kong (“Basic Law Hurdle”).
In an attempt to clear the Basic Law Hurdle, Shun Tak Holdings Limited, a company listed on the Hong Kong Stock Exchange, initially acquired a 33.3% stake in Jetstar HK and subsequently obtained 51% shareholding voting rights. Despite the foregoing, ATLA was of the view that Jetstar HK’s business decisions were, ultimately, made by the Jetstar Group which is not a company incorporated and having its principal place of business in Hong Kong.
Had the licence been granted, Jetstar HK would have become Hong Kong’s fifth local carrier to compete against Dragonair, the current leader in short-haul flights. Jetstar HK’s application was fiercely resisted by Cathay Pacific and other local airlines. Although ATLA’s reasons of refusal are available to the public, accusations of protectionism were made.
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?
Like the rest of the world, UAVs/drones (“UAV”) have become affordable and popular in Hong Kong. Whereas non-recreational operation of UAVs, regardless of size and weight, requires approval from the Civil Aviation Department (“CAD”), recreational use of UAVs does not, provided that the relevant UAV weighs less than 7 kg (without fuel).
As UAVs may, however, pose serious safety issues to operational aircraft if flown into their airspace, or to individuals if flown in highly populated areas, as such, certain restrictions have been imposed to regulate such technologies. For example, UAVs must only be flown in daylight hours, good weather conditions and below 300 feet. Further, UAVs cannot be flown over populated areas, within Aerodrome Traffic Zones or within 5 km of any aerodrome.
Beyond the aforesaid, the regulatory environment relating to UAVs remains comparatively relaxed in Hong Kong. For example, there are currently no privacy laws specifically governing their usage.
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?
To save costs, more and more airlines are choosing to lease, rather than purchase, their aircraft. Amongst the 20,000 aircraft, as at the end of 2015, approximately 40% were leased. This is a huge contrast to the approximately 2% of aircraft which were being leased in 1980. It is expected that amongst the 10,000 new aircraft, valued at around US$1,450 billion, to be delivered in the next decade, half will be financed through lease agreements. As of the end of 2015, there are 158 aircraft leasing companies worldwide, most of which are domiciled in low tax regimes, such as Ireland and Singapore.
There are, however, challenges in this market. Leasing is a more efficient option for the airline because it allows them to upgrade their fleet regularly, for a comparatively smaller investment than buying new aircraft. For the lessor, however, this means that their aircraft rapidly lose their commercial appeal. One way by which lessors have been responding to this challenge is to take advantage of the trend for aircraft parts depreciating at a slower rate than the aircraft as a whole. As such, whereas the average life expectancy of an aircraft is approximately 25 years, some aircraft have retired after only six years as their pieces are worth more individually than as part of a whole aircraft. Repurposing passenger aircraft for freight work is another way by which lessors have addressed this issue.
The lessors can also manage their risks by carefully considering jurisdiction to base their leasing operations. For example, Hong Kong’s Chief Executive, in his 2016 Policy Address, announced that measures are to be formulated to "develop Hong Kong into a centre for aerospace financing". This position was then affirmed in the 2016-2017 Budget, which states that the Hong Kong Government would explore the feasibility of introducing "tax concession to boost aircraft leasing business".
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 previous cycles of OEM products were based on traditional ‘Big’ OEMs – mainly Airbus, Boeing. The new cycle of OEM products launched by emerging OEMs, namely Mitsubishi, Bombardier and Embraer, focus on narrow body jets with a single-aisle, lower fuel burn and lower maintenance costs to improve efficiency, and to capture the lower-end market. In times of high fuel prices, and with the growing trend of LCC, there has been an evident demand for new OEM products and suppliers.
In order to compete in this new market, the traditional OEMs have similarly introduced single aisle aircraft such as the Airbus A320. Specifically, Boeing and Airbus project that single aisle aircraft will account for 73% of all deliveries from 2016 to 2035. Boeing forecasts that it will manufacture 28,140 Single Aisle aircraft by 2035, whereas Airbus forecasts that it will manufacture 23,531 Single Aisle aircraft by 2035. The newly developed Single Aisle series, Airbus’ A320 neo and Beoing’s 737Max, has been well received globally from a range of LCCs; for example, Hong Kong Express currently owns 14 A320s. Further, traditional OEMs have begun to provide far-reaching product support. To further compete against emerging OEMs, Airbus introduced real-time aircraft “health monitoring”, simple e-solutions and individual part maintenance to reduce maintenance costs. Moreover, Boeing has set up a ‘Startupboeing’ programme to assist entrepreneurs in launching new airlines. This programme covers key aspects of the start-up process, from support in selecting aircraft to aircraft financing options.
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?
Major airlines have been slow to pass on savings from cheaper oil prices, as they have generally preferred to maintain their usual ticket pricing policies, and then reinvesting their increased profits into their businesses. The cheaper oil prices have, however, enabled LCCs to enter the market and/or expand by offering lower fares and more routes.
For lessors of aircraft, this would likely be a mixed blessing – fewer old aircraft will need to leave the fleet meaning existing leases can continue; on the other hand, as older aircraft will remain in the existing fleet, lessors will have to bear the expenses associated with aging machinery.
For suppliers of aircraft, they are likely to reap the benefits of cheaper oil, as airlines save from lower fuel costs to invest in new aircraft (according to IATA data, 1,900 new aircraft will be added to the fleet of commercial airlines by the end of 2016).
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?
The UN sanctions against Iran were implemented in Hong Kong pursuant to the United Nations Sanctions (Iran) Regulation (Cap.537AF). These sanctions were, however, amended after the UN’s decision in January 2016 to ease financial and economic sanctions under the Joint Comprehensive Plan of Action (“JCPOA”).
Iran has been relatively optimistic about their market growth in the aviation sector since sanctions were lifted. For example, the Transport Minister of Iran has signalled that its fleet will be renewed with around 400 aircrafts, and, to date, 118 have already been purchased. In addition, Iran is undertaking a massive overhaul of its aviation infrastructure, including its 300 domestic airports.
Whilst these developments do offer attractive opportunities for all participants in the international aviation sector, from lessors to OEMs, risks do remain, as sanctions may be re-imposed if the country violates the terms of the JCPOA. Investors in this area should therefore consider preparing contingency plans in the event of the re-imposition of sanctions, before investing significant sums in this new market.