Tuesday, March 19, 2013

Promotion of air-connectivity to remote areas

India's civil aviation ministry is considering two proposals - a direct subsidy and a market-based seat-credit trading mechanism among airlines - to boost air connectivity to less-developed markets and remote areas of the country.

The current Route Dispersal Guidelines of the Civil Aviation Ministry mandates all scheduled operators to deploy atleast 10% of their trunk-route capacity on flights to less well-served areas, or so-called category II routes (like northeast, J&K, Andaman, Lakshadweep), and 50% of trunk-route capacity on Category III routes (smaller towns like Coimbatore).

Under the seat-credit trading mechanism, all airlines would be allotted a minimum number of mandatory remote areas connection requirements. Airlines could meet their connectivity deficit by purchasing seat-credits from other airlines who have already met their requirements. Livemint writes,
Under the ministry’s proposed seat-credit mechanism, small air taxi operators can fly to a particular small city destination and earn seat credit that can be sold to a scheduled airline such as Jet Airways or SpiceJet. The bigger carriers will be able to use such credits to meet their requirement of having to connect such remote areas without having to lose money on such operations.
It is reasoned that the seat-credit trading would incentivize small regional air-taxi operators with smaller airplanes to service the small town airports, leaving the more established operators with their regular sized aircrafts to service the bigger towns. The operators themselves or the government would have to establish an exchange which would facilitate efficient price-discovery and trading of seat-credits.

An alternative to the seat-credit trading mechanism is a proposal to encourage regular airlines service the 80 Category-III towns by offering them a subsidy and a monopoly over the route for 2-3 years. The routes could be auctioned off to the airline that would bid for it at the least subsidy. The subsidy would be paid from an Essential Air Services Fund, mobilized from a combination of budgetary grant and a cess on the major route tickets.

Though both these are interesting proposals, it may not be possible to make definitive judgements in favor of either given the complex nature of airline markets in extremely price-sensitive countries like India. However, I am inclined to the latter for the following reasons

1. A direct subsidy suffers from much less information asymmetry. The reverse auction will help transparently and efficiently (atleast better than anything else) identify the amount of subsidy. Once this is done, it is much more easier to administer than the seat-credit trading mechanism. Further, such a subsidy support is likely to help establish the market and also facilitate the integration of these markets to the mainstream. A seats-credit sharing would merely exacerbate the existing market stratification of these areas.

Typically, some risk insurance or viability gap financing is necessary to break open any such market and only governments can finance this. In other words, given the inevitability of such a subsidy support, a reverse auction based direct subsidy may be the least distortionary and most cost-effective subsidy transfer design.

2. The seat-credits model does little to address consumer welfare. Relative to the larger airlines, the smaller air-taxi operators (unless some large players emerge) will have neither the incentive nor the capability to pass on the benefits of an expanding market by way of lower ticket prices. Given the risks involved, it is difficult to imagine airlines operating exclusively on these routes ever acquiring the balance-sheet cushion to lower prices in any meaningful (read market-creating) manner.

3. Lower prices can contribute to sharply increasing volumes, which in turn enables operators to benefit from economies of scale. In the absence of lower prices, these price-sensitive markets are likely to remain stuck up in a low-volume equilibrium. The fact that the seat-credit trading mechanism physically divides the market into two parts, with different operators and their business models, makes a low-level equilibrium a strong likelihood.

4. Finally, there is the Achilles Heel of all trading mechanisms - the initial allocation of mandatory remote-areas connections requirements to each airline. In the absence of a satisfactory process to discover an efficient initial allocation, airlines are more likely to get away with smaller quotas that would be easily met by purchasing from the existing air taxi operators. An efficient initial allocation would have to based on an estimate of the traffic growth in these nascent markets, a highly unreliable exercise at most times. There is also the danger that the seat-credits would end up subsidizing the air taxi operator's traffic expansion that would have happened anyways in the business as usual conditions. As with all such discretionary decisions, corruption can never be far away.

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