Current Issues

August 18, 2006

The future of the hub strategy in the air transport industry*

Air traffic remains squarely on course for growth. Revenue passengerkilometres are poised to climb by nearly 5% p.a. on average over the next 20 years. The growth rates in cargo traffic are forecast to average about 6% p.a. Thus, the sector is expected to continue expanding at a faster rate than global GDP and world trade. Air transport industry beckons with sufficient growth opportunities for both the hub-and-spoke strategy and the point-to-point system.

International topics

Competition between the two concepts is most pronounced on intracontinental flights. In future, the business models of scheduled carriers, low-cost carriers and charter airlines will converge and overlap even more. In intercontinental traffic, traditional scheduled carriers and strategic alliances are less vulnerable to competition.
The strategic alliances will continue to concentrate on their major hubs, especially with intercontinental flights. This holds particularly for

Europe and Asia/Australia (i.e. for flights between these regions). Point-to-point traffic between Europe and the US as well as Asia and the US could gain importance. Within Asia there will be good growth potential for both point-to-point and hub-and-spoke traffic.
The airport landscape will gradually change. Going forward, three categories will play an important role: Major hubs: This is where the

Author Eric Heymann +49 69 910-31730 eric.heymann@db.com Editor Hans-Joachim Frank Technical Assistant Bettina Giesel Deutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 Managing Director Norbert Walter

leading scheduled carriers and strategic alliances will focus their traffic (e.g. London, Paris and Frankfurt). Secondary hubs: They have an attractive catchment area, function as feeder airports for mega-hubs, and have a hub function for small partners of a strategic alliance or for certain regions (e.g. Barcelona, Munich and Zurich). Secondary airports: They have an attractive catchment area, an important feeder function for the big hubs and offer a certain number of direct scheduled connections, although intercontinental flights are the exception here. Secondary airports do not have a hub function (e.g. Geneva, Hamburg or Valencia).
As things stand today, Zurich Airports current position as a secondary but important hub for the Star Alliance seems rock solid.

From a business point of view, the airport fulfils all the prerequisites to participate in the growth in air traffic. But it is undeniable that (local) political restrictions on flight operations threaten to undermine the airports growth potential. They could cause a loss of market share and a decline in importance to the level of secondary airports, which fundamentally are poorly positioned for direct intercontinental traffic. Additional value and jobs would then be created at other airports in Europe. * This report was commissioned by Unique (Flughafen Zrich AG).

Current Issues

There has been much discussion of late about whether international air transport will mainly be based on the bundling of traffic flows at major airports (hub-and-spoke concept) in future or whether point-topoint traffic will gain in importance. In the following we shall discuss the prospects for the two concepts. First we shall look at the longerterm outlook for air transport. Then to conclude we shall focus on practical application of the business models using Zurich Airport as an example.

1. Outlook for air transport

The lean years are over
Traffic volume registered by IATA airlines, % yoy 15 10 5 +/- 0 0 -5 -10 2000 2001 2002 2003 2004 2005 Passengers (RPKs) Freight (tkm)
Source: IATA

International air passenger traffic volume as measured in revenue passenger-kilometres (RPK) rose by 7.6% in 2005 to a new record 1 high. The RPK reading had already expanded by 15% in 2004; including domestic services the figure came close to 13%. This means that the industry has recovered well from critical events such as the terrorist attacks of September 11, 2001, the wars in the Middle East, the outbreak of the infectious respiratory disease SARS, high oil prices and numerous attacks on tourist centres the world over. All the same, airline balance sheets are still suffering from the repercussions of these external shocks. For years now many airlines have only been able to stay in business thanks to extensive government subsidies or aid programmes; this holds especially for the US, but partly also for Europe. As a result, there has been virtually no real market shake-out among the carriers. During Q1 2006 the growth of international air transport continued with nearly unabated momentum. Passenger traffic was up by around 6% on the year-earlier quarter. The growth is likely to average about 5% per year in 2006 and 2007. Air cargo traffic has also posted invariably high growth rates of late. Air freight volume (measured in tonne-kilometres, tkm) expanded by about 13% worldwide in 2005 likewise a new record. By nature, cargo traffic is much less vulnerable to external shocks, such as terrorist attacks, than passenger traffic. Already in 2002, the traffic in this segment increased by 11.5%. However, weak phases in the global economy generally have a stronger impact.

Air traffic (back) on course for growth

Traffic volume and passenger numbers of AEA members 800 600 400 200 0 75 80 85 90 95 00 05

Aviation should remain a growth industry over the medium to long term
Air traffic will remain squarely on course for growth in the years ahead. According to forecasts from Airbus and Boeing, revenue passenger-kilometre volumes are poised to climb by about 5% per year on average over the next roughly 20 years. The forecast for cargo traffic for the same period is average growth of about 6% p.a. Thus, the sector is expected to continue expanding at a faster pace than global GDP and world trade. On the demand side, the reasons for the constant growth in air traffic volume lie in the progressive integration of the world economy, which generates additional demand for business trips. Globalisation and the international division of labour (outsourcing and offshoring) lead to extra demand for mobility. This holds for both passenger and cargo traffic. Since Asia and Latin America are becoming more

Traffic volume (bn RPKs) Passengers (m)

Source: AEA

The figures are based on data from the International Air Transport Association (IATA) for international scheduled airlines. They cover 94% of this segment. Final figures for the development of domestic air traffic are not available yet. In this segment, passenger traffic probably grew by about 5%. August 18, 2006

The future of the hub strategy in the air transport industry

Most important segments of global scheduled market

% of total RPKs, 2004

strongly integrated into the international value chain, the automatic consequence is flights over longer distances. Owing to the plethora of just-in-time production processes aircraft are the transport means of choice for more and more goods. This is a major reason why the forecasts for cargo traffic outstrip those for passenger traffic.

Others 26.4

Within North America 23.6

Tourism is still in its infancy in many regions

In the private air travel segment, the sector benefits from the very pronounced need for individual mobility seen the world over. Tourism (involving air travel) is a global growth sector, and in many populous countries it is still in its infancy. This pent-up demand for holiday trips, supported by rising incomes, will be a driver for the airplane as a means of transport for years to come. Thanks to inexpensive offers from so-called low-cost carriers (LCCs), relatively low-income households can also afford to travel by air. For the given reasons, routes to and from Asia as well as within Asia will post the highest rates of passenger growth (holiday and business travel) in future. This holds equally for the cargo segment, since in the years ahead Asia will continue to make advances both as a production location for industrial goods and as a consumer market. By contrast, the growth rates in traditional and relatively saturated markets such as North America or Western Europe will be more modest in future. Today, traffic within North America, over the North Atlantic and within Europe accounts for 46.5% of global RPKs. Nearly 30% of the passenger volumes carried in global scheduled airline traffic is generated in North America. In 2005, 18 of the worlds 30 biggest airports were in North America (17 of them in the US). Airbus says that a US citizen takes a flight 2.2 times per year on average. The readings for China and India are only 0.06 and 0.02, respectively.

North AmericaAsia 7.2 Europe- Within Asia Europe 8.2 11.0

North Atlantic 11.9 Within Asia 11.7 3

Source: IATA

Liberalisation of air transport provides growth stimuli

On the supply side, the main driver is the massive expansion of capacities that will be seen in the next few years both in terms of ground services infrastructure and aircraft. Nearly all of the worlds major airports have announced an expansion of their runway capacities over the next several years and have already entered the planning stages. And the international carriers have placed record orders for new passenger and cargo aircraft over the past few years. The modernisation and expansion of the infrastructure will result in efficiency gains which should keep up the strong pressure on ticket prices. This holds equally for the ongoing market penetration of the low-cost carriers, even though growth in this segment has slowed. According to the Association of European Airlines (AEA), they now claim a market share of around 30% of available seat-kilometres in Europe. McKinsey puts the passenger share of the low-cost carriers on intraEuropean routes at close to 20%. There are currently about 60 lowcost carriers offering their services in Europe. Many observers expect to see a round of consolidation in this market segment, but so far it has largely failed to materialise since the market entry barriers for newcomers are relatively low at present (e.g. favourable conditions for aircraft leasing, availability of staff). However, surplus capacities have been weighing on the entire aviation industry for years. The international air transport market is expected to undergo further deregulation over the next few years, and this will probably prove to be a further driver of sector growth. The host of bilateral agreements
August 18, 2006 3

Intracontinental traffic is dominant

Breakdown of passenger traffic by important markets, 2004 in % Within North America Others 29.2 24.3 North Atlantic 3.7 Within Asia 19.5

Within Europe 23.3 4

Source: IATA

Current Issues

regulating and restricting access to the air transport market today are likely to be gradually replaced by more open multilateral agreements in the next few years or abolished altogether. Rules linking an airlines traffic rights to the nationality of its owner and thus obstructing mergers in the industry will probably also be relaxed. US airlines have highest traffic volumes In the past, the normal result of liberalisation moves was lower ticket prices, higher frequencies on certain routes, a rising number of connections and a greater degree of choice for customers. Given a more liberal market environment the necessary consolidation of the industry would naturally also progress more quickly, especially if at the same time government subsidies for moribund airlines were cut 2 back and privatisation efforts were intensified.

Traffic volume (bn RPKs) of the world's 25 biggest airlines

American Airlines United Airlines Delta Air Lines Northwest Airlines Lufthansa Air France British Airways Continental Airlines JAL Southwest Singapore Airlines Qantas Airways Air Canada US Airways KLM Cathay Pacific ANA China Southern Airlines Thai Airways Emirates Air China Iberia Korean Air Lines Malaysia Airlines America West Airlines

External shocks hang like sword of Damocles over airline industry

Going forward, the airline industry will always face threats to its potential growth because of terrorist attacks, supraregional wars, internationally spreading diseases and other external shocks. These are events that cannot be influenced by market players, and they will continue to cloud the prospect of turbulence-free growth in the industry. Temporary sluggish phases as for instance after the second Gulf War at the beginning of the 1990s or in the wake of September 11, 2001 will remain typical of the sector. However, another typical feature is that the airline industry recovers relatively quickly after such external shocks and returns to the growth path. Price cuts and the fact that customers have a somewhat short 3 memory are a help. Experience shows that cargo traffic picks up before business and holiday travel because of the missing psychological component. A major issue of long-term significance for air transport is the development of the oil price and hence fuel costs. The high oil prices of recent years have seriously worsened the cost picture among the air carriers and made ticket prices more expensive, e.g. through surcharges for jet fuel. We believe that the days of permanently cheap oil are history. Our long-term forecast sees the oil price at USD 100 per barrel in 2020, which is largely attributable to the still surging demand for oil in China and India.
5

100

200

300

Source: IATA

For years to come, high and rising oil and jet fuel prices will tend to make the long-term growth forecasts put forward by Airbus and Boeing look overly optimistic rather than overly pessimistic. To add fuel to the fire, fiscal burdens on air transport (emissions trading, kerosene tax) cannot be ruled out on a 20-year horizon.

2. Hub-and-spoke strategy versus point-topoint traffic

There are two fundamentally competing business models in international air transport. With the hub-and-spoke system, traffic is bundled at major hubs and flight plans etc. are geared to optimise transfers for connecting passengers. This naturally gives rise to a

See Heymann, Eric (2004). Consolidation in air transport: in sight at last? Deutsche Bank Research. Current Issues. June 16, 2004. Frankfurt am Main. See Heymann, Eric (2003). Tourism in the shadow of terrorism and sluggish consumer spending. Deutsche Bank Research. Current Issues. September 12, 2003. Frankfurt am Main. August 18, 2006

The future of the hub strategy in the air transport industry

The world's 30 biggest airports in 2005

Passenger numbers (m)
Atlanta Chicago London (LHR) Tokyo (HND) Los Angeles Dallas Paris Frankfurt Las Vegas Amsterdam Denver Madrid Phoenix Beijing New York Hong Kong Houston Bangkok Minneapolis Detroit Orlando San Francisco Newark London (LGW) Singapore Tokyo (NRT) Philadelphia Miami Toronto Seattle

very high degree of complexity and higher costs in providing the 4 service. By contrast, the point-to-point system features direct flights between airports (also minor ones), largely without offers of onward connections with the same carrier. Traditional scheduled carriers and the strategic alliances that arose from cooperative ventures (Star Alliance, Sky Team, oneworld) dominate the hub-and-spoke business. The three alliances accounted for about 65% of the total revenue passenger-kilometres tallied up in scheduled services of IATA members in 2004 and the trend is rising. There are hardly any well-known, internationally operating airlines that have not yet joined one of these alliances. As the alliances grow, their degree of complexity logically also rises. The LCCs have pushed ahead and revolutionised point-to-point traffic in the recent past; they got the ball rolling in the US back in the 1970s. With this concept the most important aspect is to have the aircraft on the ground for as short a time as possible, which is why it is more difficult to bundle traffic. This is also why the LCCs usually deploy relatively small aircraft.

Customers accept both systems

When considering the question which concept is likely to have the edge going forward, bear in mind that the hub-and-spoke strategy of the strategic alliances and scheduled carriers is widely accepted by customers. The variety of connections offered by this system is a clear advantage for passengers. Of course, customers generally prefer direct connections without transfers (except perhaps on extremely long routes). In the past, though, they were not prepared to pay the higher prices charged in this case especially for intercontinental flights, or else there were simply no such offers to be had. In intercontinental traffic, tickets for flights with transfers/ stopovers are usually cheaper than direct connections if they exist in the first place. But since for most customers ticket prices are the key criterion when choosing a carrier, the development of the huband-spoke strategy is not only driven by cost aspects, i.e. supply5 side factors; it is also induced by corresponding demand. And naturally there is no denying that point-to-point traffic has gained significance over the past few years as the low-cost-carrier segment has succeeded in establishing itself. There has been some substitution for services offered by scheduled carriers. By and large, though, the LCCs generated additional demand for air travel via low ticket prices, which is a clear sign of their being accepted by customers. The companies focusing on this segment have occupied a market niche, bringing pressure to bear on charter airlines and scheduled carriers and forcing adjustments in ticket pricing.

Growth potential for both hub-and-spoke and point-topoint

0 50 100 6

Source: Airports Council International

From our point of view, the growth rates forecast for air transport offer sufficient upside potential for both concepts in the medium to long run. Arguments for the hub-and-spoke strategy continue to gain underpinning from the cost advantages derived from bundling traffic flows and in this context achieving better aircraft capacity utilisation

See Pompl, Wilhelm et al. (2006). Netzwerk-Carrier: Ein Geschftsmodell unter Druck. In Internationales Verkehrswesen, October 2006. Hamburg. Of course, the restrictive market access regulations in international air transport have also contributed to the formation of strategic alliances and thus favoured the hub-and-spoke system. 5

August 18, 2006

Current Issues

via code sharing. The economies of scale achieved through the deployment of large aircraft also play a role. The upcoming commissioning of the Airbus A380 will represent a quantum leap in efficiency. According to information from Airbus, the operating costs per seat will be 15-20% lower than those of the most modern comparable model offered by Boeing (B 747-400) at present. However, airports that will be served by the A380 will have to invest in their infrastructure, or have done so already. Massive investment at major hubs The respectable number of orders for this aircraft indicate that many of the worlds large, financially healthy airlines will continue to rely on the hub-and-spoke strategy in future. Further orders for the A380 are to be expected at the latest when the launch customers have successfully integrated the jet into their scheduled services. After years of sustained scepticism about the prospects for success of such superjumbos, Boeing has also announced the construction of a modernised jumbo jet (Boeing 747-8) with increased seating capacity. Further synergy effects related to the hub-and-spoke strategy pertain to the common use of ground staff and infrastructure. Announcements of massive investments in expansion at the worlds major airports or gigantic new projects as in Dubai are further supply-side signals in favour of the hub strategy.

Hub-and-spoke increases the customers options

On the demand side, the frequent flights and the large number of (final) destination airports provided by the hub-and-spoke system suggest that it will continue to find customer acceptance in future. The members of the Star Alliance alone fly to 842 cities in 152 countries via their hubs. In a pure-play point-to-point system it would not be economically feasible to offer customers such a com6 prehensive range of options. Business travellers in particular are not only interested in having a large number of destinations, but also a sufficient number of flights to choose from. For this reason, many companies whose staff members often have to travel on business like to locate their operations near major airports. Domestic or intraEuropean destinations that are served only once or twice a day are not very attractive for the business traveller. For intercontinental traffic, there has to be at least one connection per day. Since the local catchment areas of many business sub-centres are not large enough to sustain direct connections with such a high level of frequency in the long term, there will be no way to circumvent the hub-and-spoke concept going forward. Airline frequent-flyer programmes and joint service offers at airports have an equally positive effect on demand and customer loyalty.

Business travellers require high frequency

The major low-cost carriers in Europe

Share of available seat-kilometres %, 2005 Ryanair 31 Others 42

Expansion of low-cost carriers favours point-to-point traffic

The positive outlook for hub-and-spoke traffic does not rule out booming growth in point-to-point traffic on the contrary: with their focus on direct connections the LCCs are likely to continue whittling away at the hub-and-spoke strategy of the traditional scheduled carriers and gain market share on certain routes in the years ahead. Pure-play charter carriers will be the ones to feel the squeeze even
6

Easy Jet 27

Source: AEA

Nevertheless, the integration of an air carrier into a strategic alliance may result in a lessening of supply and competition on certain routes if the new partner has previously operated on the same route and such double operations are weeded out in the course of integration. Moreover, strategic alliances can lead to market access barriers at airports if the local infrastructure is mainly used by the members of one alliance in particular. August 18, 2006

The future of the hub strategy in the air transport industry

The biggest airports in Europe in 2004

Passenger numbers (m)
London (LHR) Frankfurt Paris (CDG) Amsterdam Madrid London (LGW) Rome (FCO) Munich Barcelona Paris (ORY) Milan (MXP) Manchester London (STN) Palma de Mallorca Copenhagen Zurich Dublin Stockholm Brussels Dsseldorf Oslo Vienna Athens Moscow Malaga Berlin (TXL) Helsinki Lisbon Hamburg Prague

more. The growth potential for passenger traffic at major hubs will then be curbed insofar as the LCCs start to offer direct connections between airports which hitherto were only to be reached by taking a connecting flight from a hub. In the process, the LCCs will target price-sensitive customers in both the holiday and the business travel segments. This way, the hubs may lose passengers needed for bundling traffic flows. The ongoing liberalisation of the air transport sector benefits the LCCs since it entails the elimination of market entry barriers; however, the EU market is already deregulated. It has to be borne in mind, though, that the LCCs have discontinued a number of point-to-point services in Europe of late since they failed to generate sufficient passenger volumes. Furthermore, the growth momentum in this segment has slowed steadily over the past few years. The biggest pure-play lowth cost carrier in Europe, Ryanair, ranked only 38 in terms of revenue passenger-kilometres in the list of the worlds biggest airlines in 2004. To assess the outlook for the two transport concepts it is a good idea to differentiate by region. Competition between the two is without doubt at its fiercest on domestic and intra-European flights (likewise on flights within the US). In future, the business models of scheduled carriers, low-cost carriers and charter airlines will 7 converge and overlap even more. In intercontinental traffic, traditional scheduled carriers and strategic alliances will be less vulnerable, though. The cost advantages of the LCCs play a much less significant role on these routes, partly because ground times are shorter in relation to flying times and therefore the turnaround time of the aircraft is less relevant. A further factor is that only a few cities in the world have a large enough local catchment area to generate sufficient passenger traffic to warrant direct connections; in Europe, London and Paris are likely the only ones. For example, the local catchment area and the economic strength concentrated in New York and London are sufficient to utilise the capacities of several daily flights between these cities without having to rely on feeder services. This certainly does not apply to traffic between e.g. Hamburg and Miami or Valencia and Boston. A detour via hub airports will also remain necessary in future.

Hubs: More important in Europe & Asia than in the US

In our estimation, the strategic alliances will continue to concentrate their traffic flows, especially intercontinental flights, on their major hubs. This holds particularly for Europe and Asia/Australia (i.e. for flights between these continents). Only a limited number of major airports will be available in these regions for the foreseeable future. Besides, the population and business centres of many countries in the two regions (e.g. UK, France, Australia) are concentrated in just a few cities. All the same, point-to-point traffic between Europe and/or Asia and the US could gain importance. A major factor in this regard is that the US is very polycentric. The US has a larger number of commercially (and touristically) important cities, whose airports thus have a large local catchment area and/or hub function. Going forward in Europe and Asia, though, these traffic flows are still likely to originate at one of the big hubs.

20

40

60

80 8

Source: Airports Council International Europe

See McKinsey (2005). Low Cost Carriers in Europe A Booming Industry at a Crossroads. Frankfurt am Main. 7

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Current Issues

Within Asia there will be sufficient growth potential in future for both point-to-point and hub-and-spoke traffic. One indication of this is given by the extensive orders placed by airlines from this region for both the Airbus A380 as well as the Boeing 787. Boeings 787, which is being designed to carry some 200 to 300 passengers, will have the edge particularly on long-haul flights. The 787 is currently in great demand and can be integrated in both air transport concepts.

Changes in the airport environment ahead

The developments forecast for air transport will have repercussions for the international airport environment. Disregarding small airports and airstrips, airports can generally be classified in three categories: Mega-hubs, through which the big, financially strong scheduled carriers and the strategic alliances organise their business. The capacities at these airports will be well utilised or scarce over the next few years despite upcoming investment in expansion. In Europe, these airports include London-Heathrow, Paris (CDG), Frankfurt am Main and, to a lesser extent, Amsterdam and Madrid. Given their large catchment area they are also attractive for pure-play point-to-point traffic (especially London and Paris), but are too expensive for many LCCs. Zurich is a classic secondary hub Secondary hubs, which have an attractive catchment area function both as feeder airports for mega-hubs as well as for small partners of a strategic alliance or else have a hub function for certain regions. Their not overly large size in comparison with mega-hubs raises the comfort and convenience factor for customers. In principle, the airports can be affected by the looming consolidation in air transport if smaller airlines hitherto using the airport as a hub are taken over by larger ones. The latter will probably not be exactly eager to serve these hubs as frequently as before (avoidance of service duplication, preference for hub function at home base). In such cases there is a threat of excess capacities weighing on the airports financial result. At the same time, though, the free capacities are linked with opportunities since new customers may be won (scheduled, LCC and charter carriers). The high volume of traffic generally enables profits to be earned in the non-aviation segment (retail, restaurants etc.). Some of the airports in Europe that fall into this category include, for example, Barcelona, Copenhagen, Lisbon, Manchester, Milan, Munich, Oslo, Rome, Stockholm, Vienna and Zurich. Secondary airports, which basically have an attractive catchment area, are important for feeding traffic into the big hubs and offer a certain number of direct scheduled connections, although intercontinental flights are the exception here. In principle, they are attractive also for the LCCs. The airports have no (or merely a rudimentary) hub function. Examples in Europe include: BerlinTegel, Bilbao, Birmingham, Cologne, Dusseldorf, Geneva, Hamburg, Lyon, Nice, Turin and Valencia. The Boston Consulting Group (BCG) published a study in 2004 with a similar classification (though note that BCG split the secondary airports as we define them into two categories between which, in our 8 opinion, the borders are largely blurred). However, we feel that the risks for secondary hubs detailed by BCG (potential excess

Secondary airports generally have no hub function

See Boston Consulting Group (2004). Airports Dawn of a New Era. Munich. August 18, 2006

The future of the hub strategy in the air transport industry

capacities, overinvestment) are not that serious. Many of the airports in this category tend to be labouring more today under capacity bottlenecks. These would not be automatically eliminated even with the loss of individual customers. Nevertheless, partly because of the government sponsorship of many airports there is the risk that economic aspects may be given too little attention during expansion planning and that investment may not be geared towards demand.

3. The future positioning of Zurich Airport

Zurich air traffic far from record highs
600 550 500 450 400 350 300 250 200 150 100 90 92 94 96 98 00 02 04 '000 flight movements, left '000 tonnes of air freight, left Passengers (m), right
Source: Unique (Flughafen Zrich AG)

30 25 20 15 10 5

Zurich Airport has gone through turbulent times. Surely the most significant event was the bankruptcy of its hitherto most important customer and the pride of the Swiss aviation industry, Swissair, in autumn 2001. Subsequently, passenger numbers plummeted. In 2003, they were down 25% or so on the record reading of the year 2000. Since then, the number of passengers using Zurich Airport has risen merely 5%, coming to 17.9 m in 2005. Zurich thus ranks th 17 on this score in the list of Europes biggest airports. All in all, Zurich Airport fits the description of a classic secondary hub.

Political restrictions on flight operations

Besides the turbulence on the business side, uncertainties and restrictions on flight operations related to (local) political issues are shaping the debate about Zurich Airports future prospects. A key issue at many airports is the acute and always very serious problem of aircraft noise. To sketch out the situation in brief: in the past, partly for topographical reasons, many flights approached Zurich via routes over southern German communities close to the border with Switzerland. In October 2003, Germany unilaterally announced an ordinance prohibiting overflying of these areas on weekdays from 6 am to 7 am as well as in the evening after 9 pm and also on weekends and holidays from 6 am to 9 am and in the evening after 8 pm. The German officials said the reason for this move, besides noise issues, was insufficient inclusion in decision-making processes at Zurich Airport, particularly as regards matters of flight 9 operations. Zurich Airport thus felt compelled to change its landing approach system so that during these times very heavily populated areas in Switzerland previously spared the burden of aircraft noise now had to be overflown more frequently (southerly approaches). The capacity of the runway for easterly approaches is restricted because it is not long enough to handle jumbo aircraft and because it is not equipped with an instrument landing system. By contrast, the previous approach areas north of the airport on both the Swiss and the German side are more sparsely populated. The upshot is that, as a result of the German ordinance, many more people are affected by aircraft noise now than before (greater negative externalities). The ordinance thus deviates from the generally common practice, also at German airports, of concentrating take-offs and landings on the most thinly populated areas possible.

Germany dominates flight plan in Zurich

Origin and destination of flights in Zurich by country in 2005, %

DE 22.6 Others 39.4

GB 8.6 IT 7.1

Domestic flights 4.5

AT 5.5

FR 5.8

ES 6.5

Source: Unique (Flughafen Zrich AG)

10

In 2005 nearly one-quarter of all aircraft movements in Zurich were attributable to connections with German airports. Thus, the aircraft noise problems in Zurich are not caused solely by Switerzland and third countries. On the one hand, this is of little comfort to the people on the German side affected by aircraft noise. On the other, Zurich Airport does also provide these same people with access to an excellent choice of flights to international destinations. 9

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Current Issues

Three airlines dominate Europe

Revenue passenger-kilometres of the 15 biggest airlines in Europe* Lufthansa Air France British Airways KLM Iberia Alitalia Virgin Atlantic SAS Swiss Austrian Airlines Turkish Airlines Finnair TAP Portugal Spanair Olympic Airlines 0 50 100 150 11 (bn RPKs)

The noise problems brought on by the ordinance triggered the formation in turn of local interest groups in Switzerland which, among other things, are calling for an absolute limit on flight movements to 250,000 per year and for a general ban on night flights for a minimum of nine hours. Of course, this is having a severe and destabilising impact on Zurich Airport and its customers. The situation calls for political action to address and reconcile the 10 different interests.

Fundamentally, Zurich Airport has growth potential

Disregarding these (local) political restrictions and looking separately at the positives and negatives for Zurich Airport, a number of positives attract the attention: greater Zurich boasts a large, well-to-do population that is very mobile not only because the city has a large proportion of foreign nationals (around 30%). Because Zurich Airport has excellent links with other means of transport (especially the railway network) and the other Swiss airports, it is the airport of choice for much of the travelling public also from other regions of Switzerland. This is reflected in Zurichs edge over Geneva and Basle in terms of passenger numbers. Switzerland and Zurich in particular are attractive business and financial centres, even though GDP growth has been slow by international standards in recent years. Furthermore, Switzerland has always been a popular holiday destination. Roughly one-third of the holidaymakers travel to Switzerland by air. On the demand side, the prerequisites for growth are obvious. And on the supply side, some events of the recent past have strengthened Zurich Airports position. Deutsche Lufthansas acquisition of the Swissair successor, Swiss International Airlines, will be of major significance in the long term. Zurich Airports key customer has been taken over by one of the biggest, most reputable and financially strong airlines anywhere. It is important in this context to note Lufthansas commitment to Zurich as a third hub (besides Frankfurt and Munich) and to the Swiss brand. Thanks to its recent integration into the worlds largest strategic airline alliance, the Star Alliance, Swiss can offer its customers additional services (more destinations, participation in frequent-flyer programmes, use of lounges etc.).

*Only AEA members. Source: AEA

Swiss: Chief customer of Zurich Airport

Breakdown of passenger volume by airline in Zurich in 2005, %

Others 35.7

Differentiated customer structure in Zurich

Besides Swiss and Lufthansa, Zurich Airport has a broadly structured customer base which includes scheduled carriers as well as LCCs and charter airlines. Swiss, which is the airports chief customer, accounted for around 48% of all its flight movements in 2005. Over half of all passengers in Zurich flew with Swiss. The market shares of the other carriers, in terms of RPKs, were all less than 5%. This puts Zurich Airport on a par with other major airports in Europe in terms of dependence on its chief customer. Last but not least, Zurich Airport also has attractive offers in the nonaviation segment. This holds not only for passengers but also for visitors and staff. In 2005, 40% of the airports income was generated in the non-aviation segment and the trend is rising.

Helvetic Airways 2.6 British Airways 2.7

Swiss 50.6 Air Berlin Luft3.9 hansa 4.5

Source: Unique (Flughafen Zrich AG)

12

10

The European Court of Justice is currently examining whether the German ordinance is compatible with the bilateral aviation agreement between the EU and Switzerland giving Switzerland the same rights as EU member states. August 18, 2006

10

The future of the hub strategy in the air transport industry

Lufthansa: Europe's leading freight carrier

Zurich Airports weaknesses

Zurich Airport has a natural disadvantage in its small domestic market, both in terms of population and geography. Domestic flights were responsible for less than 5% of all flight movements in Zurich in 2005 (for comparison, Frankfurt: 17%). The small domestic market thus hampers the hub function. For this reason, it comes as no surprise that the share of transfer passengers in Zurich, at 30%, is smaller than in Frankfurt for example (over 50%). The repercussions of the Swissair bankruptcy and Swisss current strategy are of course also responsible for the small share. A further weak point is Zurichs relatively minor significance in the internationally strong expansion of cargo business. It is of no little significance that, for Lufthansas operational planning, Zurich Airport ranks only third as a hub after Frankfurt and Munich. Multi-hubbing does not only have benefits. It also entails higher (transaction) costs for airlines that pursue such a concept. In point of fact, multi-hubbing does however provide Lufthansa with various options which improve its negotiating position vis--vis individual airports. At the latest when the expansion measures planned at Frankfurt Airport have reduced or eliminated its capacity bottlenecks, the options open to Lufthansa will increase even more, and the airlines dependence on Zurich (to the extent this is even the case) will decline accordingly. However, this will all be put into better perspective if Zurich remains the No. 1 hub for Lufthansa subsidiary Swiss in the long term, a not unlikely prospect as things stand today. To be able to flesh out the hub function, though, Lufthansa and Swiss will need corresponding access to the infrastructure in the long run. There is another important aspect in this context: the major significance of the chief customer, Swiss, as discussed above, results in a not insignificant risk, especially since the airline is no longer an independent company. On the hypothetical assumption that Lufthansa for whatever reason were to pursue a defensive business strategy in Zurich or else that Swiss were permanently unable to turn a profit, the consequence would be a negative economic impact on Zurich Airport. A (partial) withdrawal of these two airlines could not, in the long run, be entirely offset by other customers, even though some carriers today would most certainly prefer to have more slots during the attractive times of the day.

Cargo traffic of the 15 biggest airlines in Europe* Lufthansa Air France Cargolux British Airways KLM Alitalia Swiss Virgin Atlantic Iberia SAS Austrian Airlines Turkish Airlines Finnair TAP Portugal SN Brussels Airlines 0 5 10 13 bn tkm

*Only AEA members. Source: AEA

Exploitation of growth potential at risk

Hub function requires slots during early and late hours of the day From our point of view, the potentially growth-curbing effects of the given negative factors are far less serious than the politically motivated restrictions on flight operations in Zurich. An international hub in Europe requires a sufficient number of slots especially during the early and late hours of the day, since for example many aircraft from abroad arrive in the morning (Asia and North America) and depart in the evening (Asia). During these times there must also be scope for corresponding connecting flights and feeder traffic. Given restrictions on flight movements at these important times of the day brought about by, say, longer bans on night flights, Zurich cannot adequately fulfil the functions expected of a hub. An absolute limit on flight movements hinders future growth by definition. There is an increased risk that the affected airlines will seek alternatives, which will fundamentally be eased by the liberalisation of air

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transport. In this respect, Zurich competes directly with all of Central Europes (secondary) hubs X above all Munich, Vienna and Milan.

Conclusion
As things stand today, Zurich Airports position as a secondary hub in the heart of Europe and as an important hub for the Star Alliance is rock solid. From a strictly business point of view, the airport fulfils all the prerequisites to duly participate in the growth of air transport. But it is undeniable that political restrictions already jeopardise or are poised to jeopardise the airports growth potential. They could cause a steady loss of market share and a gradual decline to the status of secondary airport with far fewer direct connections to intercontinental destinations as a result. Additional value and jobs would then be created at other airports in Europe; depending on the scenario, a loss of jobs and a weakening of Zurich as a business region could not be ruled out. This would not happen from one day to the next. However, when authorities take a misguided approach to airport policy, it is subsequently very difficult to correct. Everyone knows that its dog eat dog in the airport segment. Indeed, a marketdriven, growth-oriented airport policy will help to shore up the attractiveness of the location in the long run. Naturally, political decisions are not always and never exclusively based on economic criteria. However, if economic aspects are overly neglected this may cause negative developments on a medium to long-term horizon, e.g. for the growth of business and the job market in the Zurich region. This message is directed at both sides in the debate, politicians and citizens alike, both in Switzerland and in Germany. Incentives needed to reduce aircraft noise It is to be hoped that a politically sound solution can be found in the coming months which will cater both for the business needs of Zurich Airport and for the legitimate interests on both sides of the border in lowering aircraft noise levels. Technological innovations and (monetary) incentive mechanisms to reduce aircraft noise and pollution should play a key role in this respect. Eric Heymann (+49 69 910-31730, eric.heymann@db.com)

Risk of gradual decline to status of secondary airport

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