Airline regulation: What you need to know with Brexit approaching

The UK’s vote to leave the European Union (EU) on 23 June 2016 has led to immediate political and economic consequences for the UK, including a change in Conservative Prime Minister and sharp falls in the value of the pound against other currencies. The details of the UK’s future relationship with the EU remain elusive. While Prime Minister Theresa May has announced an intention to trigger negotiations for UK exit of the EU by formally invoking Article 50 TEU before the end of March 2017, no firm indication has been given of her negotiating priorities or strategy. Consequently, a spectrum of possible outcomes remains on the table, ranging from a close future relationship with the EU including membership of the European Economic Area (EEA) and the European Free Trade Association (EFTA) - the current position of Norway - to a situation with no express UK-EU trade agreement, with the UK relying on World Trade Organisation rules as the basis for its trading relationship with the EU, an outcome commonly referred to as “hard Brexit”. Recent indications that the UK is leaning towards a hard Brexit – or that the EU would only be willing to accept Brexit on “hard” terms – may be little more than posturing before the true negotiations begin.

A recent additional factor is the UK Government’s challenge to the high court’s ruling that parliamentary agreement is needed before invoking Article 50 TEU and a Supreme Court decision is expected on this early in 2017.

The impact of Brexit on the aviation industry is similarly unresolved. Prior to the referendum, executives of several leading airlines came out in public support of the UK’s continued membership of the EU, citing freedom to fly across Europe as the foundation of modern low-fare air travel, and pointing out the dampening effect of uncertainty on demand. Although there have as yet been no changes to UK law as a result of the Brexit vote, there was an immediate and sustained impact on the share price of leading European airlines. For example, International Consolidated Airlines Group (IAG), the consolidated group comprising British Airways, Iberia and Aer Lingus, saw its share price fall from 528p on the day of the referendum to 345p the following Monday. This represented a fall of nearly 35%, from which IAG’s share price had not substantially recovered at the time of writing. There was a similar impact on the share price of other major airlines serving the UK as can be seen in Fig 1, in contrast to the FTSE All-Share index, which thus far recovered relatively quickly from the Brexit result. It was notable that the share prices of EU airlines such as Air France-KLM and Lufthansa were also negatively impacted by the Brexit result.

Fig 1: Impact of Brexit on airline share prices

We begin by discussing the significant expected impact on flying rights and airline ownership regulations, before considering additional areas of regulation, and concluding with a brief consideration of areas which are likely to remain unchanged.

Before the EU undertook a project of liberalisation, competition in international air transport markets was constrained by a strongly protectionist framework. Most airlines were national, state-owned “flag carriers”. The right to operate international flights between states was governed by a network of bilateral air services agreements (ASAs), which had the effect of protecting the flag carriers of the contracting states who were typically assigned reciprocal flying rights to each other’s territories to the exclusion of competitors. In certain cases, the two flag-carriers also pooled revenues, effectively monopolising service on routes between their respective nations.

A significant step in this process came with the European Court of Justice’s decision in the Open Skies cases, where nationality clauses in agreements between eight EU Member States and the US were found to be contrary to the provisions of the EC Treaty. This development was followed by a Road Map identifying the following “three pillars” of EU aviation policy:

1. Bringing existing ASAs in line with EU law (by removing nationality clauses);
2. Concluding comprehensive aviation agreements with key strategic partners; and
3. Creating a Common Aviation Area within the EU, and with its neighbouring countries.

Progress was made on the second of these pillars with the signing of the EU-US Open Skies Agreement in 2007. This granted EU and US airlines unlimited rights to operate services to each other’s territories, and the right for US airlines to operate “behind and beyond” services within the EU on flights to/from the US but no reciprocal access for EU airlines to the US domestic market. The Open Skies Agreement is likely to have been a contributing factor to the 18% increase in transatlantic traffic from 2006-2016, with the number of available transatlantic city pairs increasing by 30%, and the number of annual transatlantic passengers increasing to over 52 million.

The third pillar of the roadmap entailed the creation of the European Common Aviation Area (ECAA), a structure by which the market liberalisation opening air transport markets to airlines in Member States has been extended to various non-EU States. Switzerland is not a member of the ECAA but rather benefits from access to the EU market under a separate bilateral agreement with the EU on air transport. The terms of the EU-Switzerland bilateral agreement impose on Switzerland the majority of EU aviation legislation, the EU nationality airline ownership rules, and – in conjunction with other parallel bilateral agreements – free movement of people, an asserted red line for the UK Government.

As things stand, the UK Government has indicated it will push ahead with Brexit, including giving notice under TEU by March 2017. With a “hard” Brexit, the UK might gain the rights to formulate an independent aviation policy, and no longer need to comply with EU aviation rules (at least within the UK), but could lose flying rights and other associated benefits of being an EU member state. Under “soft” Brexit, this dynamic would be reversed, with the flying rights and other benefits of EU membership likely retained, but less ability to formulate independent aviation policy.

The aviation solution does not have to be completely aligned with that in other industries, but a “hard” Brexit as regards other policy areas may make a “soft” Brexit solution for aviation more difficult. In this context it is worth bearing in mind the economic factors at play clearly favour the retention of an open aviation area between the UK and EU. The UK is currently by far the most significant contributor of air passenger traffic within the EU. UK passengers account for around one third of all intra-EU journeys, and around one quarter of all journeys from the EU to third countries. UK passengers make a significant contribution to the EU economy as tourists (notably in Mediterranean destinations) facilitated by unfettered air access – with the travel balance heavily outbound, with around 54 million UK-to-EU round trips in 2015, compared with 26 million EU-to-UK round trips.

Transatlantic travel

With regard to transatlantic travel, in the “hard” Brexit context, the UK would have the option of seeking to reinstate the pre-EU protectionist position which prevailed under the previous ‘Bermuda II’ agreement with the US. This could limit UK-US flying rights to certain national carriers. However, the US may well be reluctant to agree to such a move, and there is also the question as to whether the old “jewel” of Heathrow access rights would remain as attractive in the post-Brexit world - notably if EU flying rights to and from the UK are limited.

Intra-EU travel

With regard to intra-EU travel, restrictions on flying freedom between the UK and EU would have a dramatic impact on UK citizens, but also on UK-EU trade, and must be considered an unlikely outcome given the generally liberalised approach to flying rights encouraged by both the UK and EU in recent years. The most effective way for the UK to retain access to the EU air transport market post-Brexit would be to join the ECAA. However this is not necessarily straightforward. The text of the ECAA Agreement requires that a candidate for joining the ECAA must: (i) comply with EU aviation laws; and (ii) establish a framework of close economic cooperation or “Association Agreement” with the EU. Even if the UK meets these requirements, all current signatories to the ECAA Agreement would have to agree to the accession, which could expose the UK to the risk that other ECAA member States see an opportunity to exclude disruptive UK low-cost airlines from the EU market. However, given that the UK accounts for the greatest share of passenger air traffic of any Member State, other EU Members may be wary of taking steps which would limit their access to this valuable market.

EU law requires airlines which are granted operating licences by Member State authorities to be majority owned and controlled by EU nationals in order for them to benefit from the right to operate intra-EU air transport services. Similarly, under bilateral air services agreements, in many cases airlines need to be owned and controlled by nationals of the relevant countries in order to be eligible for flying rights under those agreements.

Currently, for intra-EU flying and flying to third countries which have agreed “EU designation” clauses in place of national ownership and control requirements, the flying rights of all EU carriers are equivalent. However, in the post-Brexit environment, these national ownership requirements could have complex implications for certain airlines. In the case of IAG, for example, separate “nationality structures” are in place to ensure that for each of British Airways, Aer Lingus and Iberia, distinct bodies of British, Irish and Spanish shareholders respectively can be identified and have their voting rights magnified in respect of any issues relating the airlines’ ability to meet “national” ownership and control requirements required by their route licences. Because the majority of services served by these carriers are currently governed by EU designation clauses, this structure is not extensively tested. However, in a post-Brexit world such structures could come under much closer scrutiny, making mergers between UK and EU airlines more challenging.

Post-Brexit, the potential airline ownership options are interesting. The UK could further relax airline ownership nationality restrictions to permit the full merger of UK and non-UK airlines. The UK’s Civil Aviation Authority (CAA) is thought to be more open to such consolidations than its European counterparts, having previously spoken of its desire to “allow capital to flow.” Such a move might result in higher investment in UK airlines from the Gulf, as well as an increased likelihood of a full merger between UK and non-UK airlines, such as Delta and Virgin Atlantic. However, the challenge would remain that non-UK majority ownership could pose problems for such UK airlines where they rely on UK nationality in order to be designated for flying rights under bilateral ASAs governing their international route licences.

Moreover, it remains to be seen whether a post-Brexit UK will trend towards this kind of additional liberalisation, or conversely will begin instigating more protectionist policies. The UK Prime Minister has been critical of the UK Government’s handling of the failed takeover of AstraZeneca by Pfizer, stating that “a proper industrial strategy wouldn’t automatically stop the sale of British firms to foreign ones, but it should be capable of stepping in to defend a sector that is as important as pharmaceuticals is to Britain.” This, along with repeated references to “industrial strategy”, and establishment of a Department for Business, Energy and Industrial Strategy, suggests greater economic liberalisation may not be the UK’s post-Brexit priority.

The position of Heathrow, with its recently announced expansion with a third runway, could be interesting in the post-Brexit world. Heathrow currently serves both as London’s leading airport for point-to-point traffic, but also as an important hub for EU traffic flowing transatlantic or elsewhere in the world. It is one of the busiest airports in the world for international traffic and home to the most valuable airline route in the world: Heathrow – JFK. The new Heathrow runway is a consequence of severe capacity constraints at the airport resulting in single pairs of airport slots trading for a reported $75 million.

But if Brexit reduces flying rights between the UK and the EU, will Heathrow remain as attractive as a transatlantic stopover, or will more traffic flow over Dublin, Amsterdam or other gateways to the EU unaffected by changes to post-Brexit flying rights? Some diversion of traffic at least seems inevitable if the UK does lose unrestricted EU flying rights.

We consider a potential timeline for a third runway at Heathrow in a separate article in this December edition of Legalflyer.

Regulation 261

If the consequences of Brexit for UK airlines include losing the benefit of unlimited access to EU markets, they could equally be relieved of the burden of much EU aviation regulation. In the field of consumer protection, Regulation 261/2004 gives passengers rights of financial compensation, refund and care in the event that their flight is delayed or cancelled. The regulation has been criticised by airlines for imposing liability on them for events outside their control, such as adverse weather conditions. UK airlines may welcome some reduction in exposure to these rules. Regulation 261 applies to flights (i) departing from the EU; and (ii) arriving in the EU, if operated by an EU airline. If Regulation 261/2004 was repealed post Brexit, UK airlines would therefore no longer be liable for claims relating to flights from the UK to the EU, or from the UK to third countries, reducing the costs of operating such services. However, any savings would be limited if the UK chose to introduce equivalent domestic protections and, in the event that the UK seeks to remain inside the ECAA, no saving at all would be made as compliance with Regulation 261/2004 is a term of the ECAA agreement.

Safety standards

Similarly, a new position outside the EU could permit the UK to diverge from the European aviation safety regime and exercise greater domestic control in this area. This would however entail a loss of influence – the UK currently has a say in European safety standards both through its representation on the Council of the European Union and its place on the Membership Board of the European Aviation Safety Agency (EASA). As with consumer protection, compliance with European aviation safety regulation is required under the ECAA agreement and it may be doubted whether the UK would prioritise greater domestic control in this area over the benefits of EU market access offered by continued ECAA membership.

Bargaining power

A position outside the EU aviation framework may also see the UK lose bargaining power when it comes to international negotiations. During the past decade, the EU and Russia have repeatedly clashed over the latter’s imposition of Siberian overflight charges on EU airlines operating routes to Asia. Russia and the EU reached an agreement in December 2011 to phase out the charges, a result which the UK might have struggled to achieve without the collective influence of other EU Member States. On the other hand, Russia has since failed to comply with its obligations under the 2011 agreement, which raises questions about the effectiveness of the EU’s collective bargaining power.

Aircraft demand

In contrast to the potentially significant changes discussed above, Brexit is likely to have a lesser impact on other aspects of the aviation industry. For example, global growth in demand for aircraft will continue, with Asia the main driver and Brexit likely to be seen as a regional issue. This will mean that the demand for aircraft, aircraft engines and parts, and aircraft finance services, will be largely unaffected by Brexit. The position of Airbus will be interesting given it will have a presence both within and outside the EU, but there should not be any material impact on overall demand for their products.

English law

English law is likely to remain the preferred choice to govern aircraft financing and other commercial contracts, given the flexible range of security options and attractive remedies available to creditors - factors which will be unaffected by the UK’s departure from the EU. Brexit should have no impact on the effectiveness of parties’ choice of law – the common law position in the UK suggests courts will respect express choice of law clauses, as will courts in the remainder of the EU due to the requirements of the Rome I Regulation.

A similar picture emerges for English courts as a choice of jurisdiction. Upon leaving the EU, the UK would cease to be subject to the Brussels Regulation, and so no longer benefit from the mutual recognition of jurisdiction of Member States’ courts and accompanying provisions for enforcement of judgments across the EU. The uncertainty brought on by this change could be mitigated by the UK joining the Lugano convention, which incorporates substantially equivalent terms, and which counts non-EU states such as Norway and Switzerland as signatories. In any case, many aircraft financiers will continue derive comfort from the UK’s network of bilateral treaties, which provide for recognition of English court judgments in many jurisdictions outside the EU.

There can be no certainty on the issues discussed above until the terms of the UK’s exit from the EU are negotiated with its remaining members, a process which is expected to be slow and onerous. Whatever the shape of the deal that emerges, aircraft finance is unlikely to see major changes but the future approach to a host of issues of importance to airlines – notably UK airlines - remain unclear. It is in both parties’ interests to negotiate a deal which as far as possible maintains the status quo, and a deal that includes UK membership of the ECAA, or agreeing a bilateral treaty with similar terms, would be a positive outcome. Perhaps unsurprisingly, however, the EU’s liberalised aviation framework is closely tied to wider issues of European integration, such as acceptance of the four freedoms of the single market. It is to be hoped that the UK Government is able to secure an outcome which does not compromise liberalised air services across Europe.