JOINT TRANSPORT RESEARCH CENTRE

Discussion Paper No. 2009-15
December 2009

International Air Passenger
Transport in the FutureDavid GILLEN
University of British Columbia
Vancouver, Canada

[ LOGO MADRID ]Discussion Paper No. 2009-15
November 2009

The Future for Interurban Passenger Transport
Bringing Citizens Closer Together
SESSION 1: TRENDS AND DEVELOPMENTS
IN INTER-URBAN PASSENGER TRANSPORTInternational Air Transport in the Future
byDavid GILLEN
Center for Transportation Studies, Sauder School of Business
University of British Columbia
Vancouver
CANADAThe views expressed in this paper are the author’s, and do not necessarily
represent those of the University of British Columbia, Canada, theInternational Transport Forum or the OECD.

TABLE OF CONTENTS

1. INTRODUCTION .................................................................................................................................... 3
2. FORECASTING AIR PASSENGER TRAVEL DEMAND ............................................................................... 5
2.1.

Empirical evidence on factors influencing international passenger traffic .............................11

3. INDUSTRIAL EVOLUTION OR REVOLUTION ........................................................................................13
4. NEW FORCES INFLUENCING PASSENGER AIR TRAVEL .......................................................................16
5. SUMMARY ..........................................................................................................................................19
NOTES .....................................................................................................................................................21
BIBLIOGRAPHY........................................................................................................................................23*I am indebted to Stephen Perkins, David Starkie, Michael Tretheway and Jean Paul Rodrigue forcomments and helpful discussion in developing this paper. I have also benefited greatly from theexcellent research assistance of Adam Robertson and Chen Wei, I thank them.

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1. INTRODUCTION

World stock markets fell further in mid June (2009) when the World Bank and International
Monetary Fund (IMF) both announced that the recovery from the current economic malaise would
be longer rather than shorter. The World Bank stated that the world economy would contract 2.9%,
compared with a previous forecast of a 1.7% decline. The Bank appears to be more pessimistic thanthe International Monetary Fund. The IMF is forecasting a global contraction of only 1.3% this yearand growth of 2.4% in 2010. Furthermore, the World Bank cut its forecast for the U.S. this year,
calling for a 3% drop in the world's largest economy, after predicting a 2.4% contraction in March.
Japan's gross domestic product (GDP) is predicated to shrink by 6.8%, more than the previous
prediction of a 5.3% decline. The euro area's economy may shrink 4.5%, compared with the previous
estimate of a 2.7% contraction. Global trade may drop by 9.7%, compared with a March forecast of a
6.1% decline.
In September 2009, Mr. Ben Bernanke told a Federal Reserve Board meeting that the ‘recession
was technically over’. He hastened to add the recovery will be long and slow. This has been
confirmed by IMF analysis that output per capita takes three years to recover after a banking crisisand seven years after output is 10% lower than if the banking crisis had not occurred. Output islower, trade is lower and trade and international air travel go hand in hand.
The forecasts and seemingly dire warnings of these leading financial and economic institutions
that the world economies will take some time before starting on the road to recovery is a triple blow
to the world’s international airlines. First, international aviation is driven in large part by GDP growth
and the nature and extent of the economic slowdown has led to substantial reductions in passenger
traffic.1 Secondly, airlines are by their nature cash flow businesses and with fewer passengers now
and in the future, there is less cash and this situation over a longer period threatens the survival of anumber of carriers.2 They have to be creative to survive; British Airways (BA) was asking employees
to give some wage free time, Air Canada simply asking for a USD 610 million bailout and most if not
all carriers are significantly reducing capacity. Thirdly, international airlines have been shifting theirbusiness model as the low cost carriers moved to capture a larger share of the domestic markets.
Legacy carriers started a few years ago to focus relatively more on long haul, particularly high yield,
traffic, both point-to-point and connecting, and this is the very traffic that is most affected by thecurrent world economic crisis.3
The objective of this paper is relatively straightforward, suggesting “what international air
passenger travel will look like in five, ten or fifteen years and why?” This requires answering twoquestions; what will be the principal determinants of the growth in international air travel, and what
impact will each of these drivers have on the growth rate? An imbedded question is: does history
have anything to teach us or are there new forces at work? Canvassing the current aviation tradepress finds two schools of thought, one taking the position that this is a deep recession but arecession nonetheless and once world economies start recovering air traffic will go back to thetypical growth of 4-5 percent annually. A second school is less sanguine, taking the position that it
will not be business as usual when economies stop sinking and move to recovery. Any economic
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recovery is going to involve fundamental changes in institutions, rethinking policies regarding
government participation in economies and changes in economic leadership in the world. There isalso the hydra of protectionism, most prominent now in the US but certainly being practiced
elsewhere, and what will happen to foreign ownership restrictions that, prior to 2009, were being
seen as hurting rather than helping world airlines. All of this will change international aviation going
forward.
The Organization for Economic Cooperation and Development (OECD) in a recent paper (seeOECD, 2009) has examined the economic downturn and the implications for the future development
of GDP. This ‘development’ refers to the magnitude and makeup of GDP. They distinguish three
scenarios on how the economic crisis will affect global growth patterns. First, the crisis is an‘accident’ due to the breakdown in the financial system, and once it is repaired it will be ‘business as
usual’. Second, they refer to ‘retrenchment’, describing a scenario of fundamentally changed global
trade patterns; changes due to both an unsustainable system that was built on artificial financial
foundations and due to policy responses. The ‘accident’ and ‘retrenchment’ scenarios are at eachend of the ‘what will the world look like’ spectrum. Somewhere in the middle lies an ‘adjustment’scenario, which is characterized by a weaker outlook for global GDP growth, adjustments in global
trade imbalances and weakened financial leverage. International air passenger travel would havedifferent levels of growth and patterns of distribution; networks would change and with it carriers
economic fortunes.
To understand where international air passenger travel may be heading in the medium- to longterm there are three sets of forces that should be investigated. First, what are the factors which have
driven the growth in air travel in the past and what will those forces look like in the future? An
examination of numerous air travel forecasting models indicates the key drivers as GDP and income
growth. Closely linked to these factors are trade growth and foreign direct investment. There havebeen policy changes, including the increasing liberalization of international aviation agreements, thechanging business models of carriers, the expansion of alliances and the growth in long haul aircraft
fleets. Given these were so important in the past, will they be important in the future and what will
they look like? If one believes in a model that an economic recovery will produce a set of world
economies which will look much the same as what we saw in 2007-2008, then knowing the expectedvalues and influences of old variables is what is important.
A second set of factors to consider arises from a possible change in world economies. What if
the economies of 2010 and 2015 are not going to be the same as what we observed in 2007-2008?
There may be new economic leaders, some or even many economies will undergo structural change
and trade patterns of the past may be vastly different in the future. For example, there seems to be aconsensus that the US economy will not see the levels of consumption it experienced in the post2000 decade; savings will be higher in the US and spending may be rising in China. A newmacroeconomic environment of particular importance will be the emerging role of the BRICs – Brazil,
Russia, India and China that, if they take over economic leadership, will alter international aviation
networks considerably.
The third set of influences to be considered in assessing the future of international passenger air
travel are those things events, policies and economic and political environment which are new.
What new forces will be at work in the future that will have an impact on international air travel?
Certainly environmental issues will be a key factor, and a number of studies have investigated how
emission trading schemes or carbon taxes would affect air travel particularly leisure travel. These
4

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studies have also investigated how such taxes or trading schemes may impact the structure of the
networks and perhaps the industry itself. Other new forces will be technology, such as improved
engine fuel economy, biofuels, improved air traffic control (ATC) in the European Union (EU), andelsewhere such as free flight and integration under Eurocontrol, levying of airport and country
specific taxes (e.g. United Kingdom and France), industry consolidation, and the influence all of thesewould have on fares and service as well as network reach and design.
The paper is organized in four main sections. Section two examines the travel demand forecastsof the past, what variables they relied on and what these variables are forecast to be going forward.
In section three, we consider what a structural economic change might do to the future of air travel,and section four examines how the ’new’ forces would impact air passenger travel. A summary andassessment for the future of air passenger travel is contained in section five.

2. FORECASTING AIR PASSENGER TRAVEL DEMAND

A number of organizations, airframe manufacturers and agencies have provided forecasts of
how they see aviation growing in the future. These forecasts by Airbus, Boeing and ICAO
(International Civil Aviation Organization) to name a few are summarized in Table 1; only values forinternational air passenger growth are included. All the values are fairly close, with ICAO being
seemingly more optimistic. These values are presumably reflecting some adjustments for the current
economic crisis. Interestingly, the Revenue Passenger Kilometres (RPK)/GDP growth ratio is
approximately 1.6 for both Boeing and Airbus, which is what it has been over the past decade or so.
This would seem to imply the airframe manufacturers are among those who take the view that onbalance world economies will emerge from the recession in the same structural condition as before;a business as usual view or, as the OECD has named it, ‘the current crisis is an accident’. In theirwork, the OECD points out that even in the case in which globalization continues there is substantial
foregone economic growth. The effects of the slump are large, with expected returns to previous
growth rates not being realized for up to 5 years. If there is a shift from a globalization regime, suchas retrenchment, this implies a whole regime change with significant long run consequences.
A particularly important insight from the OECD work is that even if a globalization regime isretained, the pattern of globalization must change since pre-crisis levels and patterns were notsustainable. Thus a stable, moderate and realigned globalization regime may emerge, but all of theforecasts reported in Table 1 do not reflect moderation or realignment.

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Table 1. Forecast growth in international air traffic
2008-2027 by various organisations

Sources: Boeing Current Market Outlook 2008-2027, Airbus, 2007 – (2007-2026) ICAO (2007),
Outlook for Air Transport to 2025.

In Table 2, reproduced from Boeing’s Current Market Outlook 2009, the expected growth in RPK
between various regions is presented. It seems quite surprising that traffic growth between Latin
America and Asia Pacific and Africa will be so bullish. This reflects the expected growth in GDP inthese regions (see Table 3). GDP growth has traditionally always been a significant driver in traffic
growth, and it appears there is a view that it will continue to do so – old drivers will be influential in
the future. If one looks at the ratio of RPK to GDP across these sets of countries, it varies from a lowof 1.3 between Latin America and Africa, to a high of 2.2 between Asia Pacific and Latin America; willthese be the primary nodes of economic activity?

Table 2. Growth in international air traffic
Boeing, 2009-2028

Source: Boeing Current Market Outlook 2009.

The forces which underlie the generation of air passenger travel, business and leisure, go
beyond simple macroeconomic factors such as GDP growth, trade development in both merchandiseand services, and foreign direct investment. There are also structural parameters such as distance,
populations, and activities and ideas of mutual interest. In addition, there are strategic decisions bycarriers in pricing, network design, service levels and alliance relationships.4 In the past, many used
trend projections based primarily on GDP growth; Gillen et al. (2007) report the elasticity of demand
for air travel with respect to income (per capita GDP) varies from 0.8 to 2.6, depending on whatcountries are being linked.5 The median value was 1.14 and average 1.5, and in many cases trend
forecasts were set equal to GDP growth 1:1.6 The variance in these estimates occur for manyreasons, an important one being exchange rate effects; the large increase in UK tourism abroad in
the 2004-2008 period has been attributed in large part to the rise in the value of the pound (£)
relative to other world currencies.
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Table 3. Assumed GDP growth rates for Boeing air traffic forecasts

Source: Boeing Current Market Outlook 2009.

Upon closer examination, it is clear the strength of the relationship between international
passenger traffic growth and GDP per se has generally been overestimated due to a failure toaccount for changes in other strategic variables, such as prices and network development and Open
Skies air service agreements (see below). The measure of passenger growth with growth of GDP
could be 1.5 or more.7 However, the reality is that while higher income countries generate more
trips than lower income countries, air travel does not grow increasingly with wealth. Specifically, theair travel share of GDP is independent of income. As Figure 1 shows, there is no clear relationshipbetween the growth in passenger travel and the growth in income. This lends credibility to theelasticity of 1 value; air travel in general is not a luxury good, as people get richer they do travel more
but they do not spend an increasing proportion of their income on air travel.

Figure 1. Air travel share as a percentage of GDP

Source: Swan (2009).
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What are the other factors which have been important in the past? First, changes in trade
regulations trade liberalization has led to what is termed globalization. Firms take advantage ofcountries’ and regions’ comparative advantage, investing in other countries and increasing theamount of both merchandise trade and trade in services with the creation of international supply
chains.8 Second, changes in regulations, in this case international aviation air service agreements(bilaterals), with the result that fares come down, service expands and potentially there could be
new firm entry. This improvement in service quality stimulates demand, but the extent of thestimulus will depend upon the degree from which, and to which, markets liberalize. Piermartini andRousova (2008) examined the impact of liberalizing air transport services on air passenger flows in asample of 184 countries. They find robust evidence of a positive and significant relationship between
the volumes of traffic and the degree of liberalization of the aviation market. An increase in the
degree of liberalization from the 25th percentile to the 75th percentile increases traffic volumes
between countries linked by a direct air service by approximately 30%. In particular the removal ofrestrictions on the determination of prices and capacity, and the possibility for airlines other than theflag carrier of the foreign country to operate a service, are found to be the most traffic-enhancing
provisions of air service agreements. The results are robust to the use of different measures of thedegree of liberalization, as well as the use of different estimation techniques.
Gillen (2009) examined the case for Canada and estimated that the elasticity of international air
passenger growth with respect to GDP was 0.45 (a 1% increase in GDP led to a 0.45 % increase inpassengers), the elasticity with respect to 5th Freedoms was 0.15 (introducing 5th freedoms in abilateral led to a 0.15% increase in numbers of passengers) and if an Open Skies agreement was
inked, the elasticity was 0.66. Swan (2008) argues that the Open Skies effect happens only once
(shifting the growth function) and has estimated that such events stimulate passenger growth overthe long term by approximately 2% on average. However, it may be that such agreements can havedirect (shift) and indirect effects as carriers adjust their networks and market structure changes.
There can also be continuous effects if multiple trading blocks are liberalizing sequentially.9 However,there can be large differences depending on which markets are being considered. In the case of an
Asia China Open Skies, this would add 10% to passenger growth.10 Korea would experience anestimated 6% boost from Open Skies, while Europe will see relatively small gains because of previous
liberalization; the changes are marginal (Swan, 2009).
In a recent study Oum et al. (2009) make an important point that the liberalization of air service
agreements leads to expansion in markets, but it also leads to more efficient continental andinternational networks which further stimulates traffic growth. The indirect efficiency effect would
reinforce the direct effect of liberalization on opening markets. The degree to which this would occur
depends on the extent of liberalization and the way it is done.
In the short to medium term, what changes would drive air traffic growth? Certainly the cyclingof GDP around the long term trend is a key factor. This has been fairly regular in the past, but overthe last few decades the various asset and credit bubbles have increased the amplitude of the swings
and the swings take longer to return to the trend. Figure 2 provides a stylized illustration of what
appears to be happening currently. Traffic growth moves above and below the trend due to changes
in the structure of economies as well as trade. Markets can change at different speeds.
Notteboom and Rodrigue (2009) illustrate the sequence of three different market bubbles
high tech, housing and trade. Each bubble accelerates the demand for international air travel andmay increase the rate of growth. For example, high technology industries and finance sector tend to
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be aviation intensive, so a rapid growth in this sector leads to even more rapid growth in air travel
than would be expected on average with growth in GDP. What is interesting about the three bubbles
is each successive one encompassed a larger and larger population. The tech bubble involved
relatively few people, since only certain segments participated in this sector. It did certainly have anon-proportional impact on international air travel as assembly and manufacturing spread toSoutheast Asia. The housing bubble, a consequence of Federal interest rates and financial policies in
the US, encompassed an entire nation and had consequences across many countries, but principallyin the US where it originated. The trade bubble was global and was driven in part, perhaps a largepart, by the housing bubble and the use of re-mortgages to increase consumption and purchasehousing as well as a wide range of consumer goods in the US. Trade and the development ofinternational supply chains drove an increase in international air travel.

Figure 2. Trends in GDP growth and swings about the trend

Source: Notteboom and Rodrigue (2009).

The increasing amplitude in swings about the trend has resulted in higher costs for carriers. On
the upswing, available capacity is expanded in increasing amounts and on the downswing thiscapacity drives fares lower and airline profits decline. The costs of adjustment increase. A second
consequence is on consumer confidence which moves in short bursts generally lagging the GDP cycle
but they move together. As the amplitude of the cycles about the trend increases it may beconsumer confidence will take a longer time to re-establish itself and once it does a moreconservative atmosphere may prevail.11 There are the vagaries of war, flus (SARS, Swine) and political
disruption. These work through the cycle but again can be more troublesome as the cycle changes.
For example, trade improves productivity which has a positive impact on growth. If the bubbles
reduce trade, the growth in GDP may slow more than proportionately due to loss of productivity.
In the longer term, the growth in GDP and the growth in trade which exceeds GDP growth has
driven international air passenger growth. The trend has been consistently upward and tied to
growth in GDP, but this growth is currently zero or negative in many cases. The growth rates ofexports of many countries are also negative (as illustrated in Figure 3) for selected countries.12
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International air travel is following its traditional relationship with GDP and is also declining at double
digits in some markets.

Figure 3. Year over year growth in total exports(February 2009)

Source: Notteboom and Rodrigue (2009).

The five fundamental traditional drivers of long-term international air passenger growth are
GDP growth, political disruption, cost changes (e.g. fuel costs), service quality changes and trade
growth. Political disruption would include terrorism, regime frictions such as with Iran and North
Korea but also protectionism. While protectionism reduces trade growth (discussed below) it also
appears in the form of reductions in foreign direct investment. Foreign ownership of ‘strategic
assets’, such as ports, energy and airlines are either up for review or simply prohibited. Such
constraints increase capital costs and reduce trade in the long term. Political disruption and friction
also increase costs in the form of security and regulation. These costs make shippers and service
providers worse off and lessen trade and air travel. Cost changes, particularly fuel costs, is a longterm threat. In the past growth in real fuel costs was zero or negative. In the future this will not be
the case as the real cost of energy will go up and environmental taxes will become a permanent
fixture. In the past cost reductions provided a 0.7% stimulus to passenger growth (Swan, 2009). It is
unlikely this will continue, and even advances in engine and fuel technology will not fully offset costsof raw materials inputs and taxes.
Quality changes occurred in the network over the last two to three decades. International
networks reorganized with gateway hubs and airline alliances. This increased accessibility andstimulated traffic growth. A significant quality change was the growth in new markets; old markets
did not simply get bigger but there were more routes opened and frequencies grew. Both of theseoutcomes stimulated traffic growth by one or more percent. In the future the network will not be
improving due to higher costs, hence bigger aircraft and less frequency; frequencies were asignificant stimulus to traffic growth in the past. As trade growth slows frequencies decline, fewer

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routes are added (some abandonment may occur) and underserved cities continue to beunderserved. All of this adds up to a negative net effect on past forecast traffic growth.
The slowing of trade growth over the longer term will also reduce the previous growthforecasts. As important will be the restructuring of trade as merchandise trade falls and trade inservices grows somewhat. In the past trade growth was double that of GDP growth and added one totwo percent to forecast air traffic growth. In the short term, with recession and trade reductions,traffic growth will also be negative. In the longer term, increased protectionism, a failure to reduce
tariffs and increased costs from security and regulatory barriers will mean zero stimulus from thetrend in the future.
The net impact of all of these factors could be traffic growth at 80% of what it was in the past;markets forecast to grow or actually growing at 4% will grow at 3.2%. This, as Swan (2009) contends,
could occur with slowing trade growth, slower GDP growth, higher costs from fuel and taxes and aslowdown in route development, this in the business as usual model.

2.1. Empirical evidence on factors influencing international passenger traffic
In a number of papers there has been an attempt to assess the extent to which air travel is to beaffected by current economic conditions. Oum et al. (2008), for example, estimate a model in which
they include GDP growth, fuel prices and some dummy variables to reflect events such as SARS, 9/11
and Asian financial crises. They use aggregate data from 1980 to 2008 to examine how these factors
listed affected total air travel – domestic plus international. They find the elasticity of air travel withrespect to GDP is 1.58, but argue this value is inflated because it captures influences which were notincluded in the model, such as increased services and new routes, the changes in air fares which
would have been very important for domestic air traffic.
The model estimated in this paper uses data from 1996-2008 to look at international traffic only
between eight regions: Africa, Asia, Europe, Middle East, Latin America, North America, SouthAmerica and Southwest Pacific region. The dependent variable is revenue passenger kilometres. The
explanatory variables include GDP growth, foreign direct investment into the region, total trade inmerchandise and services, price of jet fuel, dummy variables to capture the influences of events suchas SARS and 9/11 and a connectivity variable. The connectivity information was contributed by IATA
who construct the index using information on flight frequency, seat per flight, number ofdestinations and a weighting factor which is designed to measure the importance of the airport. The‘connectivity index’ is designed to measure how well a country, or region, is connected to theinternational air network. It is a measure of the number and economic importance of destinations
served, the frequency of service to each destination, and the number of onward connections
available from each destination. Connectivity increases as the range of destinations and/or frequencyof service increases. The index also reveals how connectivity changes over time. This index provides ameasure of service improvements, route extensions and increased frequency. The results arereported in Table 4.
The results differ considerably from the model of Oum et al. (2008), but this model was
estimated on only international air passengers, whereas their model was estimated on total world air
traffic. The model was composed of a panel data set with 8 cross sections (regions) and 12 years for

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each region. The variables are in logs so the coefficients can be interpreted as elasticities. Note theGDP elasticity is quite low, a mere 0.06, which is sensible in that the amount of international travel
will be influenced but only in a small way by domestic growth. Also having trade, foreign investment
and connectivity in the equation takes a good deal away from the magnitude of the coefficient. If one
estimates essentially the same model as Oum et al. (2008) the estimated elasticity is only 0.31,
considerably less than 1.58 of the Oum et al. model. What really matters for International travel isthe amount of trade in merchandise and services; the elasticity is 0.83. Thus a drop in trade of 10%
leads to a drop in international air travel of 8.3%. The next most important variable is connectivity inwhich an increase in connectivity of 1% leads to a 0.2% increase in international air traffic.

Table 4. Panel fixed effects modelOver the most recent 3 years in the data the connectivity index has risen on average by 8%
across the world, thus boosting traffic growth by 1.6% on average. As connectivity declines throughroute abandonment, industry consolidation and capacity reduction, one can expect traffic to shrink
accordingly.
The increase in jet fuel prices has a sizeable impact on international air traffic; the elasticity is-0.3, so a 10% increase in fuel prices leads to a 3% decrease in traffic. Estimates show the elasticity offuel prices with respect to increase in world oil prices is about 0.26 for auto fuel; because ofdifferences in taxes this elasticity in aviation would be higher at 0.4 (see Gillen et al, 2006)
Another important factor not previously considered is the magnitude of foreign direct
investment (FDI) inbound; that is, foreign investment from outside the region. This is a roughmeasure of the degree of globalization, and as more investment takes place air traffic increases. The

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elasticity of international air traffic with respect to FDI is 0.13. A time trend variable was inserted topick up temporal trend effects and it shows a positive gradual increase in international air traffic
What do these estimates indicate regarding future international air traffic growth? Table 2 andTable 3 provide forecasts of interregional air traffic and growth in GDP accordingly. This model
indicates it is not GDP growth we should be looking at but rather trade in goods and services,changes in connectivity and changes in foreign direct investment. As well, fuel price increases andthe application of fuel surcharges can have an impact. It is unlikely that fuel prices will reach thelevels they did in summer 2008, but oil is trending upward over the longer term. The Energy researchInstitute forecasts fairly steady prices for jet fuel in the next year. The IMF however forecasts a
decline in GDP growth by 1.4% and an increase in 2010 of 2.5%. The IMF also forecasts FDI will fall bynearly 30% to 2010 and trade in goods and services will decline by 11% in 2009 and increase in 2010
by only 0.6%. These numbers suggest that international air traffic will fall in the near term and be
weak in the foreseeable future.

3. INDUSTRIAL EVOLUTION OR REVOLUTION

What is unknown is what type of economies will emerge as the current economic crisis plays
out; what will be the new macroeconomic and trade world? At present there appears to be both anindustrial revolution and a carbon revolution. Together they could well reshape economies and trade
into a set of multi-location global centres. The relative power of the US economy will decline with its
old infrastructure and old factories and reversion to protectionism. The industrial revolution at theturn of the 18th century sprung from new technologies of transportation and communication andenergy. The geography of trade and economic development was much influenced by coal and thegeography of coal. This revolution took 100 years. If there will be another industrial revolution basedon new technologies, environmental and energy efficiency will be central to competitiveness.
Investments will need to be made in ‘soft infrastructure’ of governance and reducing the friction ofpolitics. How important will be comparative advantage be in driving trade? If economies in the BRIC
countries create a set of multi nodal economies where no one country really dominates how will they
trade, what do they trade and how does this drive air passenger travel?
There are two schools of thought on the evolution-revolution outcome. Some take the view thatwhat we observe is a ‘blip’ and those economies will return to normal. This might be regarded, as
stated earlier, as the business as usual model. The OECD (2009) characterization is the current
situation was an ‘accident’ in financial markets and once fixed economies would return to their 2007
growth paths. The other school agues that a [fundamental] paradigm shift is taking place and what
will emerge is a new macroeconomics and new trade flows. The extent of the change could vary from‘retrenchment’ in which trade flows and centres of production are radically altered to a moderate‘adjustment’ which would see not a move away from globalization but certainly a tempering of tradeand economic growth. There are a number of factors that have come together to generate such an
outcome. First, there is most likely an end of asset inflation and debt derived consumption (at least
temporarily). This will drive a re-equilibrium of trade flows, as well as standards of living to somedegree. The “normal” of the last few years particularly in the US, which drove so much of what was
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taking place in globalization and trade flows, was essentially a macroeconomic deception. Personaland government debt may, perhaps will, drive lower levels of consumption and discretionary
mobility per capita. Second, energy prices are going to remain high and trend upwards; someanalysts argue that oil may be at USD 100 by the end of 2010.13
A third factor is the aging of the population, an issue that is often neglected. It could well belinked with two macroeconomic forces; an aging population is less mobile – an issue not considered
by forecasting models and, second, the retiring population is very likely to be much less wealthy than
expected as their two major assets, house and retirement plan, will be worth much less. For many,
the expectations behind the quality of life in retirement are going to be readjusted substantially
downward. In other cases pension plans may go into default waiting for government bailouts. This ismost likely with defined benefit plans and Europe is particularly vulnerable in this regard.
A startling statistic is the US has 4.5 % of the world’s population and spent USD 10 trillion
annually, while India and China have 40 % of the world’s population and spent USD 2 trillion
annually. There is an USD 8 trillion gap, and with the US faltering is it reasonable to believe the BRIC
countries will make up the difference? The business as usual school must believe this to be the case.
In the US consumer spending rose from 67% of GDP in 1980 to 75% in 2007, while thehousehold savings rate fell from 10% of income in 1980 to near zero in 2007. Householdindebtedness went from 67% of income to 132%. These shifts in spending drove trade and resulted
in the US having a current account deficit of nearly 6% of GDP by 2006. The financial crisis in 2008
lead to the collapse of consumption with more than USD 13 trillion in consumer wealth lost.
However, the collapse has endured due to a shift to greater savings, up to 5% of income now. Someof this spending has been replaced by the fiscal stimulus in the US as well as elsewhere. But thisoffset is minor since it serves to stabilize, not to replace, consumer spending and secondly much of
the spending is national with requirements for domestically produced goods and services mandated.
This rise in protectionism will exacerbate the lack of global growth whereas the US consumer had
been its heart and soul for the past several years.14
Many take the position that the new US model will be more based more on export growth andless on consumption. This is in contrast to what fueled the boom previously and it is unlikely thatgrowth in exports will compensate for the consumer sector. There are requirements that resources
be shifted into production in tradable products and productivity to improve, particularly in export
sectors. The externality of the US led economic crisis on the rest of the world, notably Europe will
work against such export led recovery. The resulting sluggish economy will see protectionism as anecessary condition to succeed. We see this increased protectionism in the US across many sectors,
and the financial and economic crisis has led to shift left in the political spectrum, with a future of big
government, parochialism and greater focus on domestic markets and less on developing trade.
The underlying causes of the economic recession and the current state of world economies
leads some to a conclusion that the new macro economy is not going to look like the old macro
economy (OECD, 2009). Centres of production will differ and trade patterns will change. Greater
domestic production and consumption particularly in the US will lead to greater regional anddomestic air travel with a relative decrease in international air travel. If airlines fail, consolidate andreduce service and capacity to survive, all of this will mean even less international air travel.

14

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Growth in GDP and trade will continue to be important drivers of RPK from traditional factors.
Industry behaviour in pricing, route development and network restructuring will have important but
second order effects. Unknown is what world economies will look like in the future and when will
economies show positive growth? This is what the world looks like now (IMF, 2009); see Table 5.
What is notable, looking in the table, is the value of 2009 figures in comparison to values in othereconomic downturns. The 2009 values are orders of magnitude larger for every indicator.
These figures underlie what we are seeing in terms of double-digit deceases in international air
travel, except for the Middle East; it appears no major international airport or gateway has beenspared, with even Dubai showing zero growth for the first period of 2009.
Below (see Figure 4) is an indication of what the IMF thinks may happen in various regions of
the world and when such changes might occur (in the figures years are on the horizontal axis andgrowth in GDP on the vertical axis). The key indices to watch are the ratios of government deficit toGDP, private savings to GDP (in March 2009 the US recorded the highest savings rate since 1946) andcurrent account to GDP.
Both the benign and downside scenarios illustrated in Figure 4 are bad news for international
aviation, as GDP growth will be slow to recover in all regions and in both the US and Asia turn down
again in a few years. Industry restructuring is inevitable but the final outcome is highly dependent on
regulations, domestic competition law enforcement and foreign ownership restrictions. Increased
concentration may lead to higher fares and reduced route development both of which will diminish
traffic growth.
Table 5. Global recessions: Selected indicators of economic activity

Source: IMF 2009.
Gillen – Discussion Paper 2009-15 - © OECD/ITF, 200915

4. NEW FORCES INFLUENCING PASSENGER AIR TRAVEL

The most influential new factors which will affect air traffic growth will be environmental taxes,
regulations and emission trading schemes. As governments link their carbon strategy with theireconomic and energy strategy there will be direct impacts on the aviation sector, as well as indirect
effects as economies and industry in general restructure, but also as the airline industry restructures.
The introduction of carbon taxes or emissions trading will lead to changes in market structure which
will affect fares, service and carrier profits. An issue of considerable debate is how much of the tax orcost of emissions permits will be passed through to consumers. If the emissions cost become aprofits tax, this will result in some failures and potential consolidation. If it is fully passed throughthere will be some reduction in demand.
Gillen and Forsyth (2008) analyze outcomes under differing market structures assuming single
price equilibrium and linear demands. Under competitive market conditions the cost pass through is100%, with fares rising by the amount of the tax or permit cost allowance in the long run; in the short
run fares rise by less and airlines incur loses. Long run equilibrium output is lower and fares arehigher; in competitive markets traffic loss in the future may be from 0.7 to 1%.
On monopoly routes the pass through is 50%, with profit falling and exit taking place frommarginal routes. The impact on the long term passenger forecast for these routes is minor. One
would expect in the absence of government restrictions that such markets would evolve to be
more competitive and therefore have a higher pass through. In oligopoly, which would characterize
the majority of international routes, if they were liberalized there would be incomplete pass through,lower profits and less output. Growth is constrained. If the international routes have restrictive
bilaterals, this is equivalent to the outcome with a slot constrained airport. Fares are set in themarket on the basis of bilateral restrictions, therefore any increase in costs due to allowances orcarbon taxes will be a profit tax and fares will not change; any increases in costs are paid out of rents
arising from bilateral restrictions. If rents are monopoly rents there is a 50% pass through, but if rents
are scarcity rents there is no pass through. In oligopoly in the long run there will be lower growth,
lower growth than without the charge, firms will adjust to higher costs with exit from some routes.
The route exit effect will reinforce the higher cost effect in reducing future air passenger growth,
perhaps as much as 1%.

Gillen – Discussion Paper 2009-15 - © OECD/ITF, 200916

Figure 4. Benign and downside scenarios for GDP growth

Another view with respect to cost pass through is provided by two studies commissioned by the
UK Department of Environment, Food and Rural Affairs in 2007, and 2008. These studies examined
the impact of the EU Emissions Trading Scheme (ETS) on ticket prices and airline profits, respectively.
What is notable in these studies is the claim there may be more than 100% pass through under somecircumstances. Specifically the report claims cost pass through could run between 80 and 150%, andthe key determinants are the level and elasticity of demand, the objective function of the airline(profit, sales or market share), the market structure and the type of rivals (business model)
participating in the market. In the majority of cases the pass through is at, or near, 100%, a finding
consistent with the literature. In cases where the pass through exceeds 100% the demand elasticity is
assumed to be constant and inelastic.15 A greater than 100% pass through is not possible on the
average of fares provided; firms are profit maximizing to begin with and even in the case ofdifferential pricing (yield management) no one price would be increased greater than the amount of
the emissions charge with profit maximizing firms.16 The study also found, correctly in my view, thatthe method of allocation of the emission permits would have no effect on the magnitude of the passthrough.
The second key issue is what amount is passed through; how much ticket prices will rise will
depend on the cost of the permits or the level of the carbon tax? Scheelhaase and Grimme (2007)
report that short haul LCC fares would rise by 2.6%, while short haul legacy carriers fares would riseby 1.15% based on an assumed value for emission permits of €15, €20 and €30; the reality is there
will be a range of fare increases which correspond to a range of permit prices. Their long haulcalculations of fare increases were airline specific; 3.3% for Lufthansa and 3.5% for Emirates. Trucost,in a 2004 study, calculated the following for expected price increases: see Table 6. Oxera (2003)
calculates that on average, with CO2 at €50/ton, fares would go up 3.08% and passenger demand
would fall by 3.02%.
Table 6

Gillen – Discussion Paper 2009-15 - © OECD/ITF, 200917

Table 6. Impact of cost increase from EU ETS on fares and demand

Source: Based on Trucost (2004).

Albers et al. (2009) examine whether the EU ETS will result in a change in network configuration.
In their analysis they estimate that with a 100% cost pass through, fares would increase by from 1%
to 3.8% (long haul flights), with the result that demand would fall by up to 3%; but in most cases it
was approximately 2% of countries long haul travel, primarily tourism. In their work they estimatedthat the 25 richest countries (by GDP per capita) account for 51% of world GDP, 15% of world
population, 45% of world tourism GDP, 69% of international passenger volume and 70% of total
passenger volume. The GDP impact of a 10% fuel tax would range from 0.03%for the US, 0.1% forAustralia and 0.12 % for South Africa.
An important sector which has a considerable impact on international passenger aviation traffic
is the global investment and financial sector. The banking crisis has resulted in numerous bank andinvestment house failures. Profits collapse in a financial crisis as credit becomes more expensive
which means as firms have less to invest, the economy slows. Centres of activity migrate and withthem the centres of finance; the exodus of personnel from the financial sector in London is a good
example of the consequences of such shifts.17 The Global Financial Centres (GFC) Index released in
September 2009 indicated the top ten global financial centres had not changed from 2007 but they
all had lost in ratings. A change in ratings illustrates some new dynamics in play. The top global
financial centres have not changed since last year (London, New York, Hong Kong, Singapore, Zurich,Frankfurt, Geneva, Chicago, Tokyo and Sydney) but all except Singapore have lower ratings from theprevious year18. Also new centres have emerged in China, the Middle East and Africa. Osaka has
dropped 33 points in ranking while Bahrain and Johannesburg have gained 59 and 48 points
respectively. The GFC index provides some support for the notion of shifts in paths of international
passengers. What is needed is information on shifts in direct foreign investments as well.

18

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5. SUMMARY

This paper had the objective of trying to understand “what international air passenger travel will
look like in five, ten or fifteen years and what were the underlying drivers”. This required answering
two questions; to identify what will be the more important determinants of international passenger
travel in the future and secondly to translate the impact of these factors into expected changes infuture passenger growth. Identifying the drivers was relatively successful in determining which aremost relevant and how large each of the effects would be on traffic growth was less successful.
Three groups of factors were identified; the ‘old’ variables which have been identified as driving
air traffic growth, the new variables which may result from industrial revolution rather thanevolution and the ‘new’ forces such as those resulting from the carbon strategy being adopted in the
EU and which will be followed elsewhere.19
Among the established key factors is, of course GDP growth. Some believe that even with aretained globalization regime growth recovery is 5 years away. However the return will not bebusiness as usual for two important reasons; first, protectionism is growing and not just inmerchandise trade. Restrictions on financial intermediation will prevent pre-crisis types of economic
interactions from returning (OECD, 2009). Second, the crisis was a consequence of global imbalances,which have since been moderated. Global restructuring means those countries which were large
exporters (China and German) will have to adjust. Exporting overcapacity will be absorbed bydomestic demand, reduced output or changes in exchange rates.
The new forces of change both contribute to and deter traffic growth. Carbon taxes and cap andtrade systems will reduce growth but not to a significant degree unless the number of permits is
reduced or the carbon tax is increased. In the short to medium term neither is likely to occur. New air
traffic control governance in conjunction with new hard and soft technologies, such as free flight and
EU integration under Eurocontrol, will have a positive impact on growth without necessarily having
an offset from emissions increases.
Boeing in its Economic Outlook (2009) forecasts economic growth of 3.1%, a forecast growth inpassengers of 4.1% and a growth in revenue passenger km of 4.9%; this implies a ratio of 1.6 of RPK
to GDP. This scenario is based on what appears to be a model of industrial ‘evolution’ – the economicorder will repeat itself in the recovery and is predicated on lower fares, point to point service andhigher frequency.20 Boeing’s forecast of these optimistic growth rates are based on a trend ofincreasing growth in RPK.
The trend that is observed in traffic growth has been driven by growth in GDP (more countries
getting richer) and increasing competition and liberalization which reduces average fares andexpands service in terms of route development and frequencies. The point of diminishing returns
may have begun to set in for OECD countries which have liberalised aviation markets to a degreewith growth tapering to a trend GDP growth. However if we do have an industrial revolution taking
place, how new economic and carbon/energy strategies will affect international air traffic growth isGillen – Discussion Paper 2009-15 - © OECD/ITF, 200919

difficult to establish. It is not just GDP but the composition of GDP, it is not simply air service
agreement liberalization but the type of liberalization and what the starting point is, it is a shift fromtrade in merchandise to trade in services and a shift from globalization to regionalism and regional
trade pacts. Globalization is heavily based upon liquid capital markets. It is made to happen by
consumers and traders. Traders depend on cheap reliable transportation for people andmerchandise. The current crisis has revealed that globalization means integration and integration canbe fragile, as has become clear. Going forward it may be that a more risk averse world wishes for lessintegration. Protectionism may exacerbate such a shift.
Swan (2009) has pointed out that expenditures on air travel are on average 1% of GDP indeveloped and developing countries. This is for all air travel not just international air travel. Oum etal. (2009) develop a set of forecasts for both intra and inter regional travel. Their model is based on
measured impacts of GDP, liberalization and exogenous events (e.g. wars) on air travel growth in thepast. Interestingly, they forecast that inter regional air travel growth will generally exceed intra
regional growth. The implication being that past influences will continue into the future and it is justa matter of when a recovery starts to take place.21
Notteboom and Rodrigue (2009) have examined what is happening in liner shipping. They makethe point that the current set of circumstances has no contemporary ‘frame of reference’,
international aviation like shipping is facing a global and persistent decline and as they say this canlead to unintended consequences. In their view liner shipping will undergo a paradigm shift rather
than a contemporary recovery. International aviation has come through boom and bust cycles andhas weathered the vagaries of war, pandemic and financial crisis but international aviation likeshipping will more likely than not undergo a paradigm shift as well.
While fuel prices and changes to air service agreements will have an impact on international
aviation, the most important impact will come from industry and economic re-organization. The
shifts in trade flows and the potential for a reduced pace or even decline in globalization and a shift
to regionalization will affect trade flows and hence international aviation. The persistence of thecurrent economic malaise, some have suggested a four to five year horizon before growth will
recover, will lead to a number of firms failing.22 Consolidation will take place with some capacity
reductions either directly or through alliances where the alliance will manage the capacity. This willlead to higher fares and less route expansion. Both will result in a reduction in international air travel.
There is the prospect of LCC entry into international markets but this is dependent on liberalizationof air service agreements continuing and on an expenditure elasticity of one. In the past the US was amajor force for liberalizing international air markets, it is unclear whether this will continue; the US
economy is weak and there is less to be obtained from more liberalized markets and the US is
moving to economic protectionism which also lowers the return from liberalized air service
agreements.
Trade is not the cause of the current economic crisis but it may be one of its casualties. Trade
increased with globalization which created international supply chains – complex international
networks for the manufacture of goods; goods cross borders many times from inception to final
consumption. A decrease in demand is amplified across all borders because of these supply chains.
This decrease may also lead to increased protectionism. It is these combination of factors which may
make international aviation as we know it also a casualty.

20

Gillen – Discussion Paper 2009-24 - © OCDE/ITF, 2009

Pre-crisis growth and trade patterns were inflated by global imbalances and therefore
expectations of future trade growth should be moderated. Global economic activity in the future
may well be less trade intensive; moderate growth and moderate trade. This moderation may be aconsequence of protectionism or exchange rate adjustments.23 In either case international passenger
traffic is likely to decrease but more importantly there will be a shift in paths from pre-crisis periods.
How this will play out is an open question. The old GDP elasticities of RPK demand were based on
established patterns of trade and non sustainable growth rates so extrapolating from pre crisis
information is likely misleading. As economies begin to recover the consensus is that recovery will be
slow. This may lead to industry restructuring as marginal carriers cannot continue with the losses.
This restructuring, may well lead to reductions in competition so gains made from liberalization of airservice agreements will be tempered and international air travel will be further impacted.

NOTES

1.

This is not to suggest domestic aviation activity is not responsive to GDP growth, it certainlyis, but ‘visiting friends and relatives’ (VFR) and leisure traffic also constitute a large part ofdomestic travel.

2.

Airlines use cash from future customers to finance current production. Most businesses
receive payment when the product or service is delivered.

3.

It is also the front of the plane traffic which paid the premium yields and accounted for asizable proportion of overall revenue.

4.

McKnight (2009) makes a distinction between potential demand and passenger traffic.
Macro factors generate the potential market while strategic carrier decisions influence howmuch of this potential market travels and who gets what market share.

5.

Finance Canada (2008) reports elasticity values of traffic growth with respect to GDP of 1.9
for Europe to 2.88 for China.

6.

See Swan (2009).

7.

See Oum et al. (2009).

8.

Trade in services tends to be relatively aviation intensive.

9.

This is the case with the EU approaching adjacent countries to EU member states andnegotiating Open Skies agreements; Middle-East and Mediterranean countries are the firstcandidates.

Gillen – Discussion Paper 2009-15 - © OECD/ITF, 2009

21

10.

This figure would include short haul international between China and Taiwan, Japan and
Korea.

11.

Speculation is that US consumers will save more and spend less while Chinese consumers
will do the opposite.

12.

Numbers are based on a calculation of annualized GDP growth for first quarter of 2009
based on 4th quarter 2008 data.

13.

Peak oil will assert itself, remains to be seen if this will be gradually or suddenly.

14.

In Japan in the 1990s demand was suppressed for a long period after the bubble.

15.

There are two issues to consider; first, the analysis did not consider whether the route wasslot constrained and second, is it reasonable to think that sensitivity to price would remainunchanged with a greater than 100% pass through. Finally an assumed constant inelastic
demand implies a monopoly market would not be in equilibrium when the emissions
charge is imposed.

16.

In cases in which there is a predicted greater than 100% pass through, firms cannot be
profit maximizing in the first place and it is not clear what objective function would
generate this result.

17.

British Airways has suffered considerably with the drop in premium traffic much of it
generated from London’s financial district.

18.

The report states that a change in rating of 1-10 points is considered insignificant, between
10-30 is a signal of changing competitiveness and >30 signifies major change.

19.

These include carbon taxes or cap and trade.

20.

The Boeing forecast was the only one that is current. Airbus last available forecast is from
2007.

21.

Their models were estimated on all traffic rather than separately for intra and inter regionaltraffic separately.

22.

Although governments in many jurisdictions seem intent on protecting favored or flag
carriers.

23.

Hummels (2009) also argues rising energy costs which increase the cost of transportation,
environmental initiatives, and changing channels of trade in merchandise will underlie theshift to moderation.

22

Gillen – Discussion Paper 2009-24 - © OCDE/ITF, 2009

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