Transatlantic Aviation: Effects of Easing Restrictions on	 
U.S.-European Markets (21-JUL-04, GAO-04-835).			 
                                                                 
Transatlantic airline operations between the United States and	 
European Union (EU) nations are currently governed by bilateral  
agreements that are specific to the United States and each EU	 
country. Since 1992, the United States has signed so-called "Open
Skies" agreements with 15 of the 25 EU countries. A "nationality 
clause" in each agreement allows only those airlines designated  
by the signatory countries to participate in their transatlantic 
markets. In November 2002, the European Court of Justice ruled	 
that existing Open Skies agreements were illegal under EU law, in
part because their nationality clauses discriminated against	 
airlines of other EU nations. The United States and the EU have  
been negotiating revisions to these agreements. Experts agree	 
that removing the nationality clause is central to any new	 
agreement. GAO was asked to report on (1) how prevalent Open	 
Skies agreements are and what their effects on airlines and	 
consumers are, (2) what the key ways that commercial aviation	 
between the United States and the EU could be changed by the	 
Court of Justice decision are, and (3) how the elimination of	 
nationality clause restrictions might affect airlines and	 
consumers. GAO's work included both analyzing data on		 
transatlantic air service and evaluating information from and	 
positions of industry officials, subject-matter experts, and	 
stakeholder groups. GAO is making no recommendations.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-835 					        
    ACCNO:   A11098						        
  TITLE:     Transatlantic Aviation: Effects of Easing Restrictions on
U.S.-European Markets						 
     DATE:   07/21/2004 
  SUBJECT:   Air transportation operations			 
	     Airline industry					 
	     Airline regulation 				 
	     Commercial aviation				 
	     Competition					 
	     Economic analysis					 
	     International agreements				 
	     International cooperation				 
	     International travel				 
	     International organizations			 
	     Open Skies Agreements				 

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GAO-04-835

Report to Congressional Requesters

July 2004

TRANSATLANTIC AVIATION

Effects of Easing Restrictions on U.S.-European Markets

Contents

Tables

Figures

July 21, 2004Letter

The Honorable John McCain Chairman The Honorable Ernest F. Hollings
Ranking Minority Member Committee on Commerce, Science, and Transportation
United States Senate

The Honorable Trent Lott Chairman The Honorable John Rockefeller Ranking
Minority Member Subcommittee on Aviation, Committee on Commerce, Science,
and Transportation United States Senate

Since the late 1970s, commercial aviation within the United States and the
nations that form the European Union (EU)1 has become substantially
deregulated, creating greater competition, lower fares, and significant
increases in passenger traffic. Commercial aviation between the United
States and the EU is not deregulated to the same degree. Since 1992,
however, the United States has signed what are called "Open Skies"
agreements with a number of EU nations. These bilateral agreements seek to
create a more deregulated transatlantic environment between the two
nations signing the agreement by reducing or eliminating operating
restrictions on the airlines of either nation. This means that any airline
licensed by either nation can offer service between the two nations. This
same relaxation of restrictions does not extend, however, to airlines
licensed by other nations. Under what is called the "nationality clause,"
the right to provide nonstop service between a point of origin in one
nation and a destination in a second nation is limited to airlines that
are owned and controlled by citizens of the two nations signing the
agreement, thereby effectively excluding other EU airlines from providing
competing service.2

In November 2002, the European Court of Justice, the EU body responsible
for interpreting European law, ruled that seven existing Open Skies
agreements and the bilateral agreement between the United States and the
United Kingdom violated EU law. In particular, the Court of Justice found
that the nationality clause illegally discriminated against airlines from
other EU nations because it excluded them from entering the transatlantic
aviation market between the two nations that had signed the agreement. In
June 2003, the European Council, composed of representatives from each
member state, issued a mandate to the European Commission to negotiate
with the United States on the creation of an Open Aviation Area, which
provides for the liberalization of the U.S.-EU market, including the
removal of restrictions on foreign investment in airlines between the EU
and the United States.

In October 2003, the United States and the EU opened negotiations.
Industry experts and stakeholders we spoke with agreed that resolving the
nationality clause was the key issue. However, in June 2004, the European
Council rejected a draft agreement being negotiated by the United States
and the EU Commission. The European Council stated that further efforts
should focus on "more balanced market access provisions" than were
included in the draft agreement. U.S. officials interpreted that as
referring to a desire by EU carriers to gain more direct access to the
U.S. domestic aviation market. Further contacts are being considered. U.S.
and EU officials stated that current agreements remain in effect. There is
no set time frame for when the matter must be settled.

Changing the agreements to remove the nationality clause restrictions
carries implications for U.S. and EU airlines, airline passengers, and
other stakeholders within the airline industry. These negotiations thus
represent an opportunity to examine the current agreements and their
effect on the U.S. airline industry, as well as the implications of
potential changes to those agreements. You asked us to report on the
potential implications of changes in these agreements. We examined the
following questions:

o How prevalent are Open Skies agreements between the United States and EU
nations, and what has been their effect on airlines and consumers?

o What are the key ways that commercial aviation between the United States
and the EU could be changed by the Court of Justice decision?

o How might the elimination of nationality clause restrictions in any new
U.S.-EU agreement affect airlines and consumers?

To examine the prevalence and effect of Open Skies agreements on airlines
and consumers, we reviewed prior research from a variety of organizations,
including the U.S. Department of Transportation (DOT), and we analyzed DOT
data on passenger traffic from 1990 through 2002. To determine the key
issues related to the European Court of Justice's decision, we interviewed
officials from five major U.S. and eight major EU airlines; DOT; the U.S.
Department of State (State); the European Commission Directorates General
for Competition, Employment, and Transport; U.S. and EU labor unions and
associations; and EU airports, as well as officials of EU aviation trade
associations. To determine how the absence of the nationality clause
restrictions might affect airlines and consumers, we interviewed industry
experts about the likely outcome of removing the nationality clause
restrictions, and used prior research to highlight any potential benefits
or barriers that airlines and consumers would face. We also analyzed
available data on capacity constraints at EU airports and the effect of
opening transatlantic markets on labor. We assessed the reliability of the
various data sets analyzed throughout the report and determined that they
were sufficiently reliable for our purposes.

We recognize that other important factors must be carefully examined when
analyzing international aviation. For example, issues relating to safety
and security regulatory oversight are obviously critical to any
comprehensive analysis of air transportation. Because of the magnitude of
these issues, however, we agreed with your staff at the outset that they
were beyond the scope of this report. In addition, while the EU mandate
called for the creation of a more open aviation market (including issues
such as foreign ownership restrictions and access to domestic markets),
both U.S. and EU officials acknowledged that addressing the Court of
Justice ruling and resolving the nationality clause issue were both
priorities, and we therefore focused our report on the issues linked to
the ruling only. We also agreed to exclude from this report several other
related issues - such as requirements that U.S. government employees and
others using U.S. government financed foreign air travel to use U.S.
airlines.3 For additional information on our objectives, scope, and
methodology, see appendix I. We conducted our work from October 2003
through July 2004 in accordance with generally accepted government
auditing standards.

Results in Brief

Starting in 1992 with the signing of the first of 15 Open Skies agreements
between the United States and EU nations, both consumers and airlines have
benefited from the removal of government restrictions on international
aviation. With one notable exception, the United States has Open Skies
agreements with the EU countries to which most transatlantic passenger
traffic flows. The exception is the nation that is the single largest
transatlantic market in terms of passengers and flights-the United Kingdom
(UK). Under the U.S.-UK agreement, only two U.S. airlines have access to
London's Heathrow airport, the major gateway to the United Kingdom and the
largest EU airport for transatlantic passengers. Available research
indicates that U.S. airlines profited from Open Skies agreements by
establishing more integrated alliances with EU airlines. Consumers
benefited from Open Skies agreements because they allowed airlines and
alliances to provide on-line service to more locations at cheaper fares.
Our analysis of scheduled service for May 2004 showed that the majority of
possible U.S.-EU markets were served with no worse than two-stop flights.
Moreover, travelers had a choice of competitors, with the majority of
markets being served by three or more airlines (or alliances).4

Addressing the findings of the Court of Justice decision could change
commercial aviation between the United States and the EU in at least four
key ways. They are as follows:

o Extension of U.S. airlines' Open Skies traffic rights to the entire EU.
If the rights available to both U.S. and EU airlines under the 15 current
Open Skies agreements were extended to the entire EU, U.S. airlines would
gain equal legal access to and between EU nations that still have
restrictive bilateral agreements. However, significant capacity
constraints and restrictions at a number of airports in these nations are
likely to limit the airlines' ability to make use of this new access, at
least in the near term. Some of those rights may have greater implications
for cargo carriers than passenger airlines. (Cargo issues are discussed in
greater detail in appendix III.)

o Extension of traffic rights for EU airlines. Removal of the nationality
clause restrictions would mean that the United States would recognize all
EU airlines as "European Community" airlines. With this recognition, all
EU airlines would gain the right to operate into the United States from EU
airports outside of their home countries. For example, Air France, which
currently can operate direct nonstop service only between U.S. and French
cities, could legally provide nonstop service to the United States from
any city within the EU.5 EU airlines from countries with restrictive
bilateral agreements, such as Spain, Greece and the United Kingdom, would
also gain further access to U.S. markets.

o Internationalization of airline operations within the EU. To the extent
that nationality-based restrictions would be removed, EU-based airlines
would be able to move their operations to other EU member states and still
provide service to the United States-for example, by merging with or
acquiring another airline, creating a subsidiary, or moving an existing
base of operations.

o Continued regulatory oversight. The possibility that EU airlines might
relocate into other EU nations raises issues about which nation's legal
and regulatory system would apply, particularly regarding safety,
security, and labor law. U.S. and EU labor groups have questioned whether
EU airlines, in attempting to reduce costs to improve their overall
competitiveness, would relocate operations to nations with lower wages or
labor standards.

Based on past experience with the U.S. aviation market, the opinion of
industry experts, and our analysis of available data, U.S. consumers and
airlines are likely to benefit if nationality clause restrictions are
eliminated between the United States and the EU, but the benefits may not
be realized for some years and will depend in part on the business
strategies that U.S. and EU airlines choose.

o U.S. airlines and consumers could gain additional access to London's
Heathrow Airport. Experts and officials expect that more U.S. airlines
would seek to provide nonstop service from their hub airports into
London's Heathrow Airport. Both consumers and "new entrant" airlines
(those that would gain access to the airport) could benefit from the new
service. Access to Heathrow by other U.S. airlines would provide consumers
with greater choice, service from more U.S. destinations, and possible
competitive pressures on price. New entrant airlines would benefit from
being able to carry passengers into a valued destination. However, because
of capacity constraints at Heathrow, it may be some time before these
potential benefits for U.S. airlines and passengers emerge.

o EU airlines could launch competitive transatlantic service from an
airport now dominated by another EU airline. For example, Lufthansa
Airlines might decide to initiate nonstop passenger service between Paris
and Miami-a market now generally divided between Air France (with its
alliance partner Delta Air Lines) and American Airlines. Airline officials
said that they would be unlikely to establish a significant presence at
another airline's hub, however, because of operating and marketing
barriers to establishing competitive service there.

o Consolidation within the EU aviation industry could increase. Ending
nationality clause restrictions would remove a barrier to consolidation of
the EU aviation industry, because airlines would no longer have to be
concerned about whether a merger would jeopardize traffic rights that are
granted under current agreements. Mergers could potentially affect U.S.
consumers in a positive way if such consolidation would create an
additional competitor or provide access to new "on-line" service. However,
mergers can also have negative effects if, by combining into one airline,
the number of competitors in a market falls. Although industry experts and
officials anticipate that EU airlines will merge, they did not agree on
the timing and nature of any additional consolidation.

o EU airlines could relocate to other EU nations with lower wage costs.
While increased competition is likely to force airlines to become more
cost-efficient, we did not find substantial evidence to indicate that
airlines would consider such relocations in the near term. Airlines would
still need to locate operations based on where passenger demand exists,
rather than on where the lowest wages could be paid. However, the 10
newest EU nations, which joined the EU in May 2004, have an average gross
domestic product that is 40 percent of the average for the 15 other EU
countries, so the possibility for such actions cannot be dismissed.6
Because transnational unions do not currently exist within the EU,
organized labor has raised concerns about how employee rights could be
protected were companies to relocate to or form subsidiary operations in
other EU countries.

Background

U.S. and EU Domestic Airline Markets Are Largely Deregulated

A dominant theme of the commercial airline industry in the United States
and the EU in the past 2 decades has been one of decreased government
economic regulation. This development began in the United States with
passage of the Airline Deregulation Act of 1978, phasing out federal
regulation of rates, routes, and services for domestic airlines. EU
aviation deregulation began in 1987 and led to the creation of a single
European aviation market.7 In 1993, the EU efforts mirrored U.S.
deregulation by removing all government restrictions on routes, fares, and
capacity, as well as barriers to cross-border investment of European
airlines. By 1997, the EU removed the final operating restriction by
allowing cabotage within the EU. Deregulation has allowed substantial
growth in both U.S. and EU airline operations and passenger traffic, with
consumers on both sides of the Atlantic benefiting from decreased fares
and increased service. As airline operations and passenger traffic grew,
U.S. and EU aviation industry employment increased as well (see table 1).

Table 1: Changes in Domestic U.S. and EU Aviation Markets and Employment

                                                      U.S. since     EU since 
Type of change                                   deregulation deregulation 
                                                     (1978-2002)              
                                                                  (1993-2002) 
Annual average percentage change in revenue              3.3%        6.1%a 
passengers enplaned                                           
Annual average percentage change in number of            3.9%        3.7%b 
pilots                                                        
Annual average percentage change in pilot                3.4%        3.1%b 
compensation/expensesc                                        
Annual average percentage change in real (or            -2.7%         N/Ae 
inflation adjusted) airline yieldsd                           

Source: GAO analysis of data from DOT, Air Transportation Association, and
Association of European Airlines.

aBased on data from 25 Association of European Airline members.

bBased on data from 15 Association of European Airline members.

cPilot compensation percentage changes do not reflect possible changes in
negotiated work rules. According to Air Inc.'s 2004 U.S. Airlines Salary
Survey, work rules include, among other things, the maximum number of
hours worked per month, payment for hours above the maximum, and number of
vacation days.

dYield is an industry term denoting the price (in cents) a revenue
passenger pays to fly one mile. Yield does not include aviation taxes,
which are remitted directly to the taxing authority and never recorded in
carrier financial statements.

eComprehensive yield data for all EU carriers is not available.

Open Skies Agreements Extend Partial Deregulation to Transatlantic Routes

For many decades, international air service has been governed by aviation
agreements that are based on the principle that nations have sovereignty
over their airspace. This sovereignty is defined by nine "freedoms of the
air" that have developed over time to outline possible aviation rights
between countries.8 During a 1944 international civil aviation convention
in Chicago, the participating countries decided that international
aviation would be governed by negotiated bilateral aviation agreements
that specify "traffic rights," such as the number of airlines that can
operate between markets, the airports from and to which they operate, the
number of flights that can be provided, and the fares that airlines could
charge. These aviation rights, including the right to prevent foreign
airlines from cabotage operations, have been the basis for international
aviation.

Under traditional bilateral agreements, air services can only be offered
by airlines that are licensed and designated by the two countries that
sign the agreement. To be licensed to provide commercial air services, an
airline must meet various legal and regulatory requirements. Among these
requirements are citizenship and control tests, which require that an
airline be majority-owned and effectively controlled by citizens of the
licensing country.9 In the United States, the airline must also meet
economic fitness and safety requirements. EU law establishes a framework
for the granting of airline licenses and air operators certificates,10 but
all Community airlines licensed by EU member states in accordance with EU
law are permitted to provide transport throughout the EU. The process by
which countries indicate which airlines are authorized to provides service
under the agreements is called "designation." Designation has
traditionally indicated that the country making the designations will
ensure appropriate regulatory oversight. This responsibility extends to
ensuring that the airline complies with international civil aviation
safety and maintenance standards.11

Open Skies agreements are a particular kind of bilateral agreement. They
remove the vast majority of restrictions on how airlines of the two
countries signing the agreement (signatory countries) may operate between
their respective territories. For example, they remove prohibitions on the
routes that airlines of the signatory countries can fly, or the number of
airlines that can fly them.12 These expanded operational rights represent
significant alterations to the traditionally more restrictive bilateral
agreements that specified service frequency, capacity, routing, and
pricing.

While they granted more rights to airlines of the signatory countries,
Open Skies agreements, through the nationality clause, allow the U.S.
government to block airlines of other countries from these rights. For
example, while both Germany and France have Open Skies agreements with the
United States, the German-based carrier Lufthansa is not permitted by
either France or the United States to operate flights between France and
the United States, without it being a continuation of a flight that
originates in Germany.13 Yet according to DOT officials, if it is deemed
"not inimical" to U.S. interests, DOT can waive the ownership and control
requirements. For example, DOT officials stated that, under the
multilateral Open Skies agreement signed with Brunei, Chile, New Zealand,
and Singapore, it applied a more flexible definition of the nationality
clause for nations covered by the agreement and focused on ensuring that
the airlines covered by that agreement are "effectively controlled" by
nations that signed the agreement.14 Table 2 summarizes some of the key
differences between traditional bilateral agreements and Open Skies
agreements.

Table 2: Summary of Key Differences between Traditional Bilateral
Agreements and Open Skies Agreements

Type of     Service       Service frequencya   Fares        Extended       
agreement   capacity                                        traffic rights 
               Restrictions  Restrictions on what              Restrictions   
Traditional on which      markets airlines may Restrictions on operations  
bilateral   airlines can  serve and the number on pricing   to and from    
agreements  operate       of flights that can               additional     
                             be flown                          countries      
               No                                                             
               restrictions                                                   
               on the number                                                  
               of airlines                                                    
               that may                                        Allowance for  
Open Skies  operate                            No           open rights to
agreements                No restrictions      restrictions and from
               No                                 on pricing   additional
               restrictions                                    countries
               on what                                         
               markets                                         
               airlines may                                    
               serve                                           

Source: GAO analysis of U.S. Department of State and U.S. Department of
Transportation data.

aGovernments are allowed to restrict operations at airports due to
environmental regulations. For example, 44 EU airports reported having
night flight restrictions.

The U.S.-EU market grew from 28 million annual passengers in 1990 to over
51 million passengers by 2000, representing the most important
international market for U.S. airlines. British Airways is the largest
carrier in the U.S.-EU market, followed by American, Delta, and United
Airlines (see fig. 1). Neither U.S. nor EU low-cost carriers currently
offer transatlantic services.15

Figure 1: Largest U.S. and EU Airlines Based on Percentage of Total U.S. -
EU Traffic Carried, 2002

Open Skies Agreements Have Benefited Consumers and Airlines by Removing
Restrictions on International Air Service

Consumers and airlines have benefited from Open Skies agreements that the
United States has signed with 15 individual EU member nations. The number
of such agreements has grown over time, although 10 EU member nations,
including the largest U.S. aviation partner, the United Kingdom, still
have more restrictive bilateral agreements or no agreement at all. Open
Skies facilitated the formation of more integrated international alliances
between U.S. and EU airlines, which allowed the airlines to expand their
networks and provide competitive service for more passengers to more
locations at cheaper fares. As a result, U.S. passengers have been able to
pay less to reach most EU destinations, significantly increasing passenger
traffic.

The United States Has Open Skies Agreements with the Majority of EU
Nations

Since signing the first Open Skies agreement with the Netherlands in 1992,
the United States has entered into agreements with 15 of the 25 EU nations
(see fig. 2). The United States signed nine of these agreements by 1996.
Since then, the United States has signed Open Skies agreements with six EU
member states: Italy, Malta, Poland, Slovakia, Portugal, and France.16

Figure 2: EU Member States with Open Skies Agreements

While the majority of EU member states have signed Open Skies agreements,
10 EU member states maintain bilateral agreements that are more
restrictive than Open Skies agreements or have no aviation agreement with
the United States. The United States does not have any aviation agreement
with Cyprus, Estonia, Latvia, Lithuania, and Slovenia. EU member states
that have traditional bilateral agreements include Greece, Ireland, Spain,
Hungary, and the United Kingdom. For the five countries with bilateral
agreements but without Open Skies, the types of restrictions vary from
agreement to agreement. For example:

o The U.S.-Spain agreement does not permit U.S. airlines to code-share17
with any of their EU partners from intermediate points elsewhere in
Europe. For example, United Airlines cannot place its code on any
Lufthansa flight from Germany to Spain. The resulting "interline" service
tends to be both more expensive and more inconvenient than code-shared
routes, placing them at a competitive disadvantage.18

o The agreement with the United Kingdom, commonly referred to as Bermuda
2, restricts service between the United States and London's Heathrow
airport to two airlines from each country-at present, American and United
from the United States, and British Airways and Virgin Atlantic from the
United Kingdom. In addition, the agreement limits nonstop service into
Heathrow by U.S. airlines to 12 specified U.S. cities. UK airlines can
operate from Heathrow to 11 specific cities, plus other cities where there
is no U.S. airline competitor. Despite these restrictions, London's
Heathrow airport (Heathrow) accounted for the highest percentage (over 20
percent) of U.S.-EU passengers of any European airport between 1990 and
2002.

Open Skies Agreements Enhanced Creation of Airline Alliances and
Subsequent Expansion of Airline Networks

Open Skies agreements greatly changed how U.S. and EU airlines provide
international service. The change centers on the alliances that various
U.S. and EU airlines have formed with each other.19 Operating in an
alliance allows an airline to greatly expand its service network, without
having to increase the number of routes it flies using its own aircraft.
In the simplest case, an international code-sharing alliance links the
route network of one airline with the route network of another, forming an
end-to-end alliance with little overlap (see fig. 3). In this way,
alliances have allowed airlines to expand the number of markets that
received "on-line" service between the U.S. and EU.20 Airline passengers
prefer this type of "seamless" service, compared to interline service,
because it allows the convenience of single ticketing and check-in, among
other things.

Figure 3: Illustration of How Alliance Networks Link Markets

Alliances greatly increase the number of markets that can be served
on-line because they connect locations that were otherwise served only by
one of the alliance airlines. This concept, illustrated in figure 3,
allows networks to serve "behind-and-beyond" markets. Transatlantic flight
occurs between what are called "gateway" airports, such as Atlanta and
Paris. A "behind" point is a location that feeds passenger traffic into
the gateway airport on one side of the Atlantic, while "beyond" points are
those destinations that can be reached once a passenger has traveled to
the gateway airport on the other side of the Atlantic. For example, Kansas
City, Missouri, and Berlin, Germany, constitute a "behind-and-beyond"
market. Neither city has nonstop transatlantic service, so passengers from
either destination must first fly to a gateway airport. A passenger
originating a trip in Kansas City would have to take a flight into a
gateway airport (such as Atlanta), connect to a transatlantic flight to an
EU gateway (such as Paris), and then connect onto a flight to Berlin.

Most major U.S. airlines that provide transatlantic service (American,
Delta, United, Northwest, US Airways, and Continental) belong to
international alliances with other airlines, including many from the EU.
To more closely integrate scheduling and pricing, alliance partners may
request that they be given immunity from national antitrust laws, which
would otherwise prohibit potential competitors (i.e., the alliance
partners) from coordinating pricing and services.21 DOT has granted
antitrust immunity to most of the alliances that U.S. airlines have with
EU airlines. Beginning with Northwest and KLM Royal Dutch Airline (KLM) in
1993, DOT approved antitrust immunity for U.S. airlines with 18
international alliance partners. Yet not all alliances have received
antitrust immunity. U.S. policy stipulates that only airlines from
countries that have signed Open Skies agreements with the United States
can receive antitrust immunity.22 The efforts to obtain antitrust immunity
for an alliance between American and British Airways has twice failed, in
part because the United States was unable to obtain an Open Skies
agreement with the United Kingdom and the airlines were not willing to
cede Heathrow slots as required by competition authorities. American and
British Airways are limited in the number of markets in which they can
code-share, and are not permitted to coordinate market scheduling and
pricing in the same way as other airlines that do have antitrust immunity.
(See appendix IV for summary information of the major international
alliances.)

Consumer Benefits Have Resulted from Expanded Alliances and Networks

Various studies have found that the alliances and expanded networks
created since the first Open Skies agreements have produced significant
benefits for consumers. Two studies conducted by DOT found that the
development of alliances in transatlantic markets led to consumer benefits
in the form of more competitive service and more extensive networks.23

We found that international network airlines serve the majority of U.S.-EU
city-pair markets with no worse than double-connection (i.e., two-stop)
on-line service. Based on scheduled flights for May 2004, 83 percent of
the possible U.S.-EU markets (5,165 of 6,210) were scheduled to receive
on-line service with nonstop, single-connection or double-connection
service.24 More than half of those markets were served by nonstop or
single-connection flights. Table 3 summarizes the connectivity of major
U.S.-EU markets. (Additional markets may also have received on-line
service, but the service would have required more than two connections and
would thus be excluded from our analysis.)

Table 3: U.S.-EU Markets Served with Nonstop, Single-Connection or
Double-Connection Flights

Best level of Number of Percentage of                                      
service         markets       markets  Example of market served
scheduled                              
Nonstop             174          3.4%  New York-London (Heathrow)          
Single            2,640          51.1  Kansas City-Atlanta-Paris           
connection                             
Double            2,351          45.5  Oklahoma City -Chicago -            
connection                             Copenhagen-Helsinki                 
Total             5,165        100.0%  

Source: GAO analysis of Sabre, Inc., May 2004 airline schedule data.

aWe categorized markets based on the best level of service, which
generally refers to the fastest possible service (i.e., having the least
number of connections). Markets were placed in a single category. For
example, although several airlines offer connecting service between
Chicago and London, because other airlines serve that market with nonstop
flights, we categorize it as a nonstop market.

In addition, consumers in most U.S.-EU markets have a choice of service
from more than one competing airline or alliance. Figure 4 illustrates
that consumers flying between Kansas City and Berlin have four different
competitive alternatives. In the 174 nonstop markets, 71 percent have at
least three airlines providing either nonstop service or competitive
single-stop service.25 In markets where the best level of service is
one-stop or on-line single connections, over 85 percent have at least
three competitors, and in markets where the best level of service involves
two connections, 60 percent have three or more competitors (see fig. 5).

Figure 4: Customers in the Kansas City to Berlin Market Have Multiple Trip
Options

Figure 5: Most U.S.-EU Markets Served by Three or More Competitors

Between 1996 and 1999, according to DOT, within Open Skies countries,
fares dropped an average of 20 percent, compared to a 10 percent fare
decrease in non-Open Skies markets (see table 4). These differences are
consistent across the various categories of markets, such as
gateway-to-gateway markets and behind-beyond markets. Much of the decrease
has been attributed to the incentive for alliances to offer lower-priced
on-line service rather than the higher-priced interline

connecting service.26 DOT officials noted, however, that little if any
analysis of changes in airfares and service has been completed that would
examine any changes in the market since September 2001.

Table 4: Changes in Average Fares in Transatlantic Markets, 1996 versus
1999

                                                                         Average 
 Type of  Behind-beyond Behind-gateway Gateway-beyond Gateway-gateway    for all 
 market         markets        markets        markets         markets     market 
                                                                      categories 
 Open                                                                            
 Skies           -23.9%         -19.9%         -24.8%          -17.0%     -20.1%
 markets                                                              
 Non-Open                                                                        
 Skies           -13.2%         -14.6%         -15.8%           -5.1%     -10.3%
 markets                                                              

Source: DOT.

Note: Fares are not adjusted for inflation.

Addressing the European Court of Justice Decision Will Affect Commercial
Aviation in Four Key Ways

Industry and government officials with whom we spoke generally said that
the Court of Justice decision-particularly as it relates to likely changes
in the existing nationality clause in the Open Skies agreements and the
bilateral agreement with the United Kingdom-will affect commercial
aviation in at least four key ways, depending on the eventual outcome of
negotiations between the United States and EU.27 These experts agree that
complying with the Court of Justice decision will require that
nationality-based restrictions be eliminated. The four key areas raised by
potential changes to the nationality clause are closely intertwined and
are as follows:

o A new U.S.-EU agreement that would address the nationality clause issue
would likely supersede the five existing restricted bilateral agreements
and also would become effective in the five EU nations where no agreement
currently exists. It would thus provide U.S. airlines with expanded legal
traffic rights (i.e., rights to operate between two destinations) into
what are now restricted markets. However, capacity limitations at certain
key airports might restrict U.S. airlines' ability to exercise this new
right.

o Eliminating the nationality clause restrictions means that the United
States would recognize all EU airlines as "European Community" airlines.
These airlines, which currently can provide transatlantic passenger
service only between the United States and airports in their own country,
would have the ability to provide service between the United States and
any EU country.

o Because nationality-based restrictions would no longer apply, one major
barrier to European transnational mergers would no longer exist. EU-based
airlines could more freely consolidate, create subsidiary operations, or
relocate their businesses to any location within the EU without
jeopardizing their rights to fly to the United States.

o The increased operating flexibility that EU airlines would receive
raises questions as to which EU member state's regulatory oversight and
labor laws should apply in particular situations. If an EU airline moved
its operations to (or established a subsidiary carrier in) another EU
country-perhaps to take advantage of lower wages or other cost
savings-questions are likely to arise as to which member state's
regulatory framework and labor laws would apply.

U.S. and EU officials agree that both sides must eventually reach some
agreement on resolving the nationality clause issue in order to comply
with EU law. However, there is no set time frame for when the matter must
be settled. In November 2002, the EU called for member nations to renounce
their Open Skies agreements with the United States, but did not pursue the
request in response to receiving a negotiating mandate. It is uncertain
how a prolonged inability to remedy the nationality clause issue might
affect U.S. and EU commercial aviation, in part because such issues have
never arisen before.

Extension of Open Skies Model Would Provide U.S. Airlines with Additional
Traffic Rights

U.S. airlines would gain expanded legal traffic rights under a new U.S.-EU
agreement. According to U.S. and EU industry and government officials, a
new agreement would supersede and be binding on all EU member states,
thereby removing most remaining traffic right restrictions.28 Because the
Open Skies agreements between United States and 15 member states have
already effectively eliminated traffic restrictions in those markets,
there would be no significant gains in traffic rights for U.S. airlines,
although EU airlines would gain expanded traffic rights or operations to
and from those countries. However, U.S. airlines would gain rights to
serve markets, from which they had been previously restricted, with the
other 10 EU countries.

Extending the Open Skies framework and rights to all EU member states
would be necessary in order to prevent a critical imbalance of economic
rights from developing that would place U.S. airlines at a potential
competitive disadvantage. Unless Open Skies rights were extended to all EU
nations, any country with which the United States now has a more
restrictive bilateral agreement would be able to benefit from rights
negotiated by other countries without itself having to negotiate for those
rights. In other words, those countries (and their passengers and
airlines) would benefit from the actions of others without "paying" for
them-an outcome known as "free riding." A free-rider scenario would occur
between the United States and EU if an airline from a non-Open Skies
country were able to operate from an Open Skies country to circumvent
restrictions in the home country's bilateral agreement. For example, a UK
airline could originate a flight in France with a commuter aircraft,
change to a wide body aircraft at London's Heathrow airport, and then
continue on to the United States to a point not designated under Bermuda 2
with hundreds of additional passengers. This would put U.S. airlines at a
competitive disadvantage because the current bilateral agreement with the
United Kingdom prevents any U.S. airline from flying similar routes.

U.S. Airlines Would Gain Access to Restricted Markets

One key operational right that U.S. airlines would gain is full legal
nonstop access to all markets in the 10 countries with which the United
States still has more restrictive bilateral agreements or no agreements.
The most noteworthy of these 10 is the United Kingdom, because of the
amount and value of passenger traffic that moves between the two
countries. Bermuda 2's limits on competition disproportionately affect
U.S. airlines because the United Kingdom successfully negotiated for
additional traffic rights in the early 1990s. Partly as a result, between
1992 and 1996, the UK airlines' share of the U.S.-UK market rose from 49
percent to 59 percent.29 Today, UK airlines still provide more service in
the U.S.-UK market, especially into Heathrow. As of May 2004, British
Airways and Virgin Atlantic scheduled a total of 43 daily nonstops from
Heathrow to the United States, compared to 28 daily nonstops offered by
American and United.

While a new U.S.-EU agreement could eliminate the legal restrictions on
the number of U.S. airlines permitted to operate into Heathrow, capacity
limitations would affect the extent to which U.S. airlines would be able
to operate there. Heathrow is essentially operating at full capacity,
especially at times that are commercially viable for transatlantic
operations. According to airline and industry officials, the
commercially-preferred times for transatlantic arrivals into Heathrow are
between 6 a.m. and 10 a.m., and the commercially-preferred times for
transatlantic departures from Heathrow are between 10 a.m. and 2 p.m.
These times are based on airlines being able to coordinate their
transatlantic flights with feeder flights from their spoke airports.
However, as figure 6 shows, the demand for arrival (and departure) slots
during these times generally exceeded the available supply.  30

Figure 6: Comparison of Total Runway Capacity and Demand at Heathrow,
Summer 2004 Demand for Arrivals

Note: The demand for slots is calculated from requests from individual
airlines for the right to operate at particular times. Demand is
calculated as a 7-day average. Capacity and demand for departures are
similar to capacity and demand for arrivals.

U.S. Airlines Would Gain Fifth Freedom Rights

If the U.S. Open Skies framework were extended to all EU countries
following the removal of the nationality clause restrictions, U.S.
airlines would gain full "fifth freedom rights," including to and from EU
member states with restrictive bilateral agreements. These fifth freedom
rights would allow U.S. airlines to operate flights from the United States
to any EU country and then beyond to another EU country. However, traffic
rights to countries beyond the EU would be limited to those the United
States already has under its Open Skies agreements; the EU has no current
mandate to grant new "beyond rights." Open Skies agreements, by
definition, grant airlines the unrestricted right to operate fifth freedom
flights, which are otherwise limited under the more restrictive bilateral
agreements, such as the agreement with the United Kingdom.

Airline officials and industry experts maintain that over time, however,
fifth freedom rights available from countries that have Open Skies
agreements have proven to be of limited commercial value to passenger
airlines. (Cargo airlines, on the other hand, greatly value fifth freedom
rights. See appendix III for additional information on cargo carriers.)
United, for example, attempted to exercise fifth freedom rights for
operations with Open Skies countries in Europe, but abandoned those
operations after determining that they were not profitable. United
officials explained that, with the development of alliances, it is more
cost efficient to use alliance partners to provide connecting service into
"beyond" markets. Of the U.S. passenger airlines that have fifth freedom
rights with EU countries, only two airlines exercise these rights.
Northwest operates fifth freedom flights from Minneapolis that stop in
Amsterdam and continue to Bombay, India. Delta flies from Atlanta to
Bombay using fifth freedom rights over Paris.31

U.S. Airlines Would Gain Code-Sharing Rights

Under the terms of the more restrictive bilateral agreements with Spain
and Greece, U.S. airlines are prohibited from serving those markets by way
of code-share flights. This effectively prohibits, for example, passengers
using a United ticket from traveling from Albuquerque to Madrid by
connecting at Frankfurt, Germany, to a United code-share flight operated
by its Star alliance partner Lufthansa. If the Open Skies framework were
extended throughout the EU, such prohibitions would be eliminated.
Airlines would be able to offer new routings to passengers, and passengers
would be free to choose among new options for travel into those countries.

EU Airlines Would Be Able to Establish Transatlantic Routes between the
United States and Other EU Countries

Like U.S. airlines, EU airlines would have greater access to international
markets. Eliminating nationality clause restrictions included in existing
agreements effectively means that, in any new agreement, the United States
could recognize the concept of a "European Community" airline.32 This
could mean, for example, that rights originally restricted to designated
airlines of the signatory countries would be available to all European
Community airlines. In other words, Lufthansa, British Airways, and LOT
Polish Airlines would be European Community airlines in addition to being
German, British, and Polish airlines. If the United States recognized a
European Community airline, it would have the right to operate
transatlantic flights directly to and from more EU destinations. Under
current Open Skies agreements, the right to establish transatlantic routes
between destinations in the signing countries is limited to airlines
licensed in and designated by those two countries and is under the
ownership and control of the country's citizens. For example, Air
France-an airline licensed and designated by France-is not allowed under
existing Open Skies agreements to provide nonstop transatlantic service
between cities in the United States and Italy; it can fly only between
U.S. and French cities.33 Under an Open Skies agreement that included an
EU nationality clause, Air France would have the right to fly between any
EU city and any city in the United States. In theory, Air France could
also decide to establish a mini-hub in a city outside of France, where it
could potentially begin providing nonstop service into additional U.S.
cities. This same flexibility would extend to all EU airlines and to all
U.S.-EU markets. In this way, EU airlines, regardless of the EU country in
which they were licensed, would have the ability to provide flights into
the United States from throughout the EU (see fig. 7).

Figure 7: Potential Effect on Transatlantic Service of the Removal of the
Nationality Clause Restrictions

EU Airlines Will Have Greater Ability To Restructure and Operate
Transatlantic Service

Eliminating nationality-based restrictions would remove a major barrier
that has prevented EU airlines from restructuring their operations by
merging with another airline or creating significant commercial operations
in locations outside their home countries, without sacrificing traffic
rights across the north Atlantic. Because international traffic rights are
granted by two signatory nations and are tied to national ownership and
control, an airline operating an international service cannot merge with a
carrier from another EU member state without risking the loss of these
U.S. traffic rights. Similarly, because the traffic rights are tied by
designation and nationality clause to airlines from particular countries,
airlines also cannot move operations into another country and exercise
those rights.

Eliminating nationality-based restrictions would allow citizens of any EU
nation to exercise what is called the "right of establishment." Under the
Treaty of Rome, any EU citizen has the right to establish a business in
another EU state. Removing nationality-based restrictions would allow EU
airlines to restructure operations, such as merging with another EU
airline or relocating in another EU member state, to gain economic
efficiencies without losing traffic rights into the United States.34 For
example, EU airlines could relocate operations to or establish
subsidiaries in EU member states that have lower average wages and (from a
business perspective) more lenient labor laws. Controlling costs
associated with labor (i.e., "social costs," which include wages,
benefits, and pensions, and which also define the number of hours in the
work week) is important to an airline's ability to compete with lower-cost
or more efficient airlines, because those costs can represent a major
portion of an airline's operating costs.

Under an agreement in which the United States would recognize a European
Community airline, EU airlines could take the following actions.

o Acquisitions or mergers-EU airlines could engage in cross-border airline
mergers and acquisitions without jeopardizing traffic rights to the United
States.35 Some observers of EU aviation have long believed that the large
number of relatively small state-supported airlines created a fragmented,
inefficient system burdened with excess capacity. The suggested remedy was
consolidation of the European industry.

o Moving operations to another country-EU airlines could move some or all
of their operations to other EU countries without risking the loss of
traffic rights. For example, an existing airline, such as Austrian
Airlines, hypothetically would be able to move its operations into and
establish itself in Poland and still be able to provide service into the
United States from anywhere in the EU.

o Creating subsidiary operations-EU airlines could set up subsidiary
operations outside of their home countries that could provide
transatlantic service.36 Because these subsidiaries could be established
anywhere in the EU, they could potentially take advantage of lower costs
that might be available in some EU countries.

o Establishing new entrant airlines--EU citizens in one country could
establish an airline in another country and provide service into the
United States, provided they met licensing and certification requirements.
Citizens from Spain, for example, could establish a new airline in Poland
and provide service from anywhere in the EU to the United States.37

Moving Airlines or Operations between EU Countries Raises the Issue of
Which Country Would Have Regulatory Authority

While eliminating the nationality clause restrictions may mean that
traffic rights are no longer limited, the concept of an airline's being
licensed by a particular EU country remains important for regulatory
oversight. For issues concerning safety and security oversight of
airlines, all governments maintain an interest in having assurance as to
which other government remains responsible for assuring the safe and
secure operation of airlines that may fly to or from any given location.

While operating a safe, secure carrier is of course important for
maintaining consumer confidence in the carrier, ensuring the safe and
secure operation of commercial aviation is a fundamental responsibility
that is shared by governments and airlines. Under the existing EU
framework, this oversight responsibility resides with each country,
subject to a framework of European level cooperation and legislation.
Thus, one issue that will need to be resolved, if airlines are permitted
to shift their operations from one EU country to another, is which country
exercises the oversight responsibility.  38

A number of criteria have been suggested for determining which country's
legal and regulatory system should apply. Traditionally, the country that
issued the airline's operating license has been responsible. However,
ensuring safety and security would become problematic if an airline
relocated its major hub activities to a location possibly hundreds of
miles outside the licensing state's borders. Another possible criteria
proposed to determine which state's systems apply is based on the location
of the carrier's "principal place of business." But in an industry in
which the assets and employees are mobile, what constitutes an airline's
principal place of business is uncertain. While not providing a definition
per se, the ICAO Air Transport Regulation Panel and the Organization for
Economic Co-operation and Development have suggested a set of guidelines
that governments could use in determining an airline's "principal place of
business."39 These guidelines propose that a "principal place of business"
means the country in which an air carrier does the following:

o maintains its primary corporate headquarters;

o regularly provides air transportation service;

o maintains substantial capital investment in physical facilities;

o pays income tax and registers its aircraft; and

o employs a significant number of nationals in managerial, technical, and
operational positions.

However, questions arise regarding how to measure the extent to which an
airline might meet each of these criteria (e.g., defining and measuring
"substantial capital investment").

Officials with major airline unions generally support these criteria. The
concern of labor groups is that, unless a relatively stringent standard is
applied, airlines will move operations to countries specifically to take
advantage of lower costs of doing business (particularly with regard to
wage rates and labor laws). Doing so is sometimes referred to as adopting
a "flag of convenience," a pejorative term adopted from the maritime
industry.

The question of which member state's labor law should apply to a situation
is the subject of a current legal challenge brought by employees of the EU
low-fare carrier Ryanair at the Charleroi Airport in Belgium. Ryanair is
headquartered in Ireland and has bases located in Stansted, United
Kingdom; Frankfurt/Hahn, Germany; Stockholm, Sweden; and Charleroi,
Belgium. It employs nonunionized pilots. All of Ryanair's pilots,
regardless of where they are based, are employed under Irish labor law and
pay Irish taxes. In May 2002, Ryanair did not retain three employees after
these employees had completed Ryanair's 1-year probationary period. The
employees at Charleroi charge they were wrongfully terminated under
Belgian law. The question for the EU courts is whether Ireland or
Belgium's labor laws would apply in this instance.

U.S. Consumers, Airlines, and Labor Groups May All Benefit from Changes in
Agreements, Although Extent of Benefits Is Uncertain and Gains May Not Be
Realized Immediately

Eliminating the nationality clause restrictions from the new U.S.-EU
agreement would likely provide new benefits to consumers, airlines, and
labor groups. By eliminating the nationality clause restrictions, a new
agreement would in effect extend the Open Skies framework to the 10 EU
member countries without Open Skies agreements. This could potentially
provide the same benefits that consumers, airlines, and labor groups
realized after the signing of the current Open Skies agreements. However,
because of mitigating circumstances, these benefits will take some time to
develop, and they will be contingent on resolving a number of related
issues (e.g., de facto access to restricted airports). Experts and
industry officials with whom we spoke generally agreed that eliminating
the nationality clause restrictions would mainly increase the potential
for the following:

o More U.S. airlines might attempt to provide nonstop service from their
hub airports into London's Heathrow Airport.

o EU airlines might use their new ability to establish transatlantic
routes between U.S. cities and EU destinations outside of their homeland.

o More transnational mergers might occur between EU airlines.

o An EU airline might attempt to establish a "flag of convenience"
operation-that is, the airline might move some or all of its operations to
another EU country with lower wage or other costs.

Each of these actions would allow airlines to more freely respond to
market forces and consumer demand. As in other instances where government
removed restrictions on airlines, such as domestic deregulation and Open
Skies agreements, consumers could potentially benefit from increased
competition and therefore better service and lower fares.

New Entry by U.S. Airlines Into Restricted Markets Would Benefit
Consumers, but Access to London's Heathrow Airport May Be Limited by
Current Slot Allocation Process

Officials at some U.S. airlines said a major potential benefit of a new
agreement would be the opportunity for access to markets restricted by the
existing bilateral agreements. Similar to the experience of current Open
Skies agreements, U.S. consumers and airlines would benefit from gaining
access to the 10 restricted markets, such as the United Kingdom, Spain,
Ireland, and Greece. The likely source of the greatest benefit would be
London's Heathrow Airport, since it is the largest destination for U.S.
travelers (see fig. 8). If a new agreement extended the U.S. Open Skies
framework to all EU member states, it would remove the restrictions of the
Bermuda 2 agreement. U.S. airlines with no current access to Heathrow
would gain the right to operate there. For example, Continental Airlines,
which currently has no Heathrow access with its own aircraft, would be
able to begin service into Heathrow from any U.S. airport, including its
hubs at Newark, Houston, and Cleveland. (Continental now operates flights
from those hubs into London's Gatwick Airport and code-shares with Virgin
Atlantic into Heathrow.) Because Heathrow is the major U.S.-EU gateway,
many U.S. airlines view the opportunity to gain access to this market as a
positive benefit.

Figure 8: Top EU Markets Based on Total Percentage of U.S.- EU Passenger
Traffic from 1990-2002

Access to Heathrow by additional U.S. airlines represents potentially
positive benefits to consumers and airlines. Consumers would benefit from
gaining greater choice of airlines, service from more U.S. destinations,
and possible competitive pressures on price. For example, if all U.S.
airlines now serving London by flying into Gatwick switched their
operations to Heathrow, London-bound consumers would benefit because
access to central London is faster and easier from Heathrow. In addition,
consumers in Denver and Detroit, who now have flights into Heathrow only
on British Airways, would likely benefit from the additional competitive
presence on those particular routes. Airlines that do not now have access
to Heathrow would benefit from being able to carry passengers into a
valued destination. Even though these airlines operate to London's Gatwick
Airport, they have reported losing high-yield business passengers and
corporate accounts to competitors because of their inability to provide
service to Heathrow.

For consumers and airlines to realize such benefits, however, airlines
would first need to gain de facto access to airport slots, gates, and
terminal space. Because Heathrow is already operating essentially at full
capacity, a new entrant airline would have to gain access through the
existing slot allocation process, which provides limited opportunities for
new entrants--airlines with no more than four slots per day (the
equivalent of two daily takeoffs and landings). Each year, the number of
slots that become available through the normal slot allocation process is
equivalent to about five daily takeoffs and landings.40 Existing EU slot
allocation regulation requires the slot coordinator41 to set aside 50
percent of any slots that become available for distribution to new
entrants.42 Before those slots are made available, however, incumbent
airlines have limited rights to acquire any open slot and substitute
another they already hold. Incumbent airlines can use this process to
"trade up" slots they hold at less desirable times for newly available
slots that might be for more commercially advantageous times. This
effectively relegates the slots available to new entrants to commercially
less desirable times. However, once a new entrant does obtain slots, it
can gain slots at more commercially viable times through a grey market,
which is used by airlines to trade slots. These trades are allowed during
any point of the year and are often done so for payment. The EU does not
officially condone this grey market, although a 1999 decision by a UK
court found this system to be acceptable within European law.43 The EU has
recently initiated proceedings against this system.

While some officials have pointed out that the slot allocation process
does give priority to allocating slots to new entrant airlines, there is
disagreement regarding the effectiveness of this process in assisting new
entrants. Once a new entrant airline acquires five or more daily slots, it
is no longer considered a new entrant and then must compete for any
available slot as an incumbent airline. To gain additional slots for
transatlantic operations, a new incumbent airline with five slots would
have to compete against British Airways, with over 500 daily slots, and
Virgin Atlantic, with just over 30 daily slots (in the Summer 2004
scheduling season).

Another option for U.S. airlines to gain slots is based on the
reallocation of slot resources between alliance partner airlines. Some
airline officials said that, once the legal restrictions are removed,
international alliances with substantial numbers of Heathrow slots could
reallocate these slots between alliance members, thereby providing U.S.
airlines with some access to Heathrow slots. Some European airlines have
stated that this option would be discussed within the alliance; others
maintained that alliance partners would be hesitant to trade or sell slots
to other alliance members, because the Heathrow operations likely add
considerable revenue to their own network. Alliance partners may also be
hesitant to trade or sell slots because, although the alliances are
established through legal contracts, past experience has shown that
airlines can and do move out of alliances. Thus, a slot sold or traded
might be permanently lost or used against the airline in the future.
Finally, even if an alliance partner may have a slot that theoretically
could be put to more productive commercial use by trading or selling it to
another alliance partner, other capacity constraints at Heathrow could
prevent its use for transatlantic operations. For example, a slot (with
its associated Jetway and terminal facilities) used for 40-passenger
turboprop operations could not readily be transformed for use by a 400
passenger Boeing 747.

Given the limits imposed by these slot allocation options, it may be some
time before the potential benefits for U.S. airlines and passengers
emerge. Some European airline officials have pointed out that gaining
access to slots, gates, and terminal space at Heathrow can be done over
time. They cite Virgin Atlantic as an example of an airline that
originally obtained slots at less preferable times and, over time,
acquired additional slots and traded them with other airlines. Through
trading, Virgin Atlantic gained a number of slots at prime times. In
Virgin Atlantic's case, it applied for and obtained six daily slots once
the UK government designated it as one of the two British airlines allowed
to provide transatlantic service from Heathrow in 1991.44 By 1996, it had
obtained approximately 15 daily slots, which rose to 28 daily slots by
2001. Airline officials reported that between 1996 and 2001, the airline
gained an additional five pairs of daily slots to the United States. As of
the 2004 summer schedule, Virgin Atlantic will have just over 30 daily
slots. That total includes four pairs of slots that Virgin Atlantic was
able to acquire this year for about 20 million British pounds
(approximately $36 million).

Airlines may also gain access if capacity at Heathrow expands. Heathrow's
capacity may increase over time through capital improvements and changes
in operations.

o The first phase of a new terminal at Heathrow, Terminal 5, is expected
to be operational in 2008 and could ease terminal and aircraft parking
capacity constraints related to passenger holding areas and aircraft
gates. With the completion of the second phase in 2011/2012, this new
terminal is expected to handle 30 million annual passengers and will
include 45 aircraft parking stands.45 British Airways is expected to be
the principal tenant at the new terminal, and its relocation there will
allow other airlines (possibly new entrants) to gain access to facilities
in other terminals. However, the new terminal will have no direct impact
on the number of available runway slots.

o BAA, plc,46 is examining the potential to implement a "mixed mode"
runway operation, which would allow both runways to be used for landings
and takeoffs rather than assigning one runway for landings only and one
runway for takeoffs only.  47 The examination will need to take account of
potential noise and air quality implications. There are no official
estimates of the impact on runway capacity of a change to "mixed mode,"
but BAA, plc, has suggested that this change could increase slot capacity
by 10 per hour. However, it is unclear if the UK government will approve
this change due to opposition by local communities related to the expected
increase in noise.

o The UK government's 2003 report on the future of air transport supported
further development of Heathrow, including a new runway and additional
terminal capacity, but only after a new runway at London's Stansted
Airport was finished and only if stringent environmental limits could be
met.48 The report indicated that any additional future enhancements to
Heathrow's capacity would be completed within the 2015-2020 period.

A report commissioned by the EU on the effects of different slot
allocation approaches concluded that current EU slot regulation provides
incumbent airlines an advantage and makes it difficult for new airlines to
obtain slots to introduce new or more frequent service.49 It also
concluded that if the EU adopted various market mechanisms (such as
secondary trading, increased slot prices, or slot auctions), higher
passenger volumes would occur. The report did not recommend that the EU
commission require divestiture of slots as a condition of airline mergers.
However, in its approval of the Air France-KLM merger, to ensure that new
entrant airlines could provide new competitive service on certain markets,
the EU commission sought the surrender of 94 daily slots from Air France
and KLM.50 Generally, incumbent airlines object to such events, arguing
that

they own the slots and would have to be compensated for them.51 BAA, plc,
officials also voiced the concern that forcing incumbents to surrender
slots each time a new entrant wanted to gain access to the airport was not
permitted in the EU slot regulation and would create an undesirable
precedent, in part because of the instability it would create for
incumbent airlines' operations.

While a new U.S.-EU agreement would provide U.S. airlines with legal
access to markets that are now restricted, airline officials stated that,
without actual physical access, these new legal rights would be
meaningless. This is especially true for access to Heathrow. The current
slot allocation process at Heathrow gives incumbent airlines an advantage
to help maintain and improve their position, making it difficult for new
entrants to gain effective commercial access. Therefore, it may take an
indeterminate amount of time before consumers and airlines derive
significant benefits from a more open Heathrow.

EU Airlines' New Ability to Provide Service in More Markets Could Increase
Competition, but Entry May Be Limited

Absent the nationality clause restrictions, EU and U.S. airlines could
begin offering new transatlantic service between more cities. New
competition has the potential for generating various benefits for
consumers: transatlantic service to and from more cities, increased
choices-and possibly pressure on prices-on existing routes, and pressure
on airlines to provide higher quality service. Some officials said that
increased consumer demand for nonstop point-to-point service could spur
airlines to develop new city-pair markets. For example, a carrier could
start nonstop service from Berlin to Kansas City, neither of which, as of
May 2004, had direct transatlantic service.

The Boeing Company expects that consumer preference for nonstop flights,
congestion at major airports, and new technology will push airlines to
develop new nonstop city pairs. According to Boeing officials, between
1980 and August 2001, as the transatlantic market has developed, the total
number of city pairs served with nonstop flights more than doubled, in
part because airlines were able to connect those markets using aircraft
with smaller capacities (see fig. 9). Boeing projects that, between the
United States and EU, an additional 114 city pairs could support nonstop
service with 250-seat aircraft. It cites San Francisco-Milan,
Houston-Madrid, and Seattle-Frankfurt as possible examples.

Figure 9: Change in Nonstop City Pairs and Average Aircraft Capacity
across the North Atlantic

Note: Data were drawn for the month of August in each year.

The development of new nonstop service or new competition in existing
markets would offer consumer benefits. Clearly, consumers would benefit
from having nonstop service on new city-pair markets rather than
connecting service. If airlines chose to compete on other airlines'
existing routes, the presence of additional airlines on a route could not
only provide consumers with more choices of flight times during the day,
but also could act as a competitive force on service quality and price. In
the United States, consumers at dominated airports experience higher
average airfares than do those at more competitive airports.52

Although removal of the nationality clause restrictions would
theoretically open the door for new competition in various markets,
airlines will likely face significant operating barriers in those markets,
particularly at dominated hub airports. In the past, we reported that new
competition at key domestic airports was inhibited by a lack of access to
slots and airport facilities.53 In 2004, an EU report noted that
competition at certain key airports continued to be inhibited by lack of
available slots at attractive times. The report listed Heathrow,
Frankfurt, Madrid, and Paris's Charles de Gaulle airports as having more
demand for slots than available capacity, either throughout the day or at
peak times of the day.

As in the United States, major European gateway airports also tend to be
dominated by a single carrier or alliance.54 As table 6 shows, each of the
EU's major airports has one airline that controls a much larger percentage
of scheduled seat capacity than its next largest competitor. Transatlantic
flights to and from these airports are generally dominated by one
alliance. For example, Delta and Air France, both members of the Sky Team
Alliance, fly 100 percent of the nonstop flights between Atlanta and
Paris's Charles De Gaulle airport. United and Lufthansa, both part of the
Star Alliance, operate 100 percent of the nonstop flights between
Frankfurt and Washington Dulles and 73 percent of the nonstop flights
between Frankfurt and Chicago.

Table 5: Comparison of Dominant Carrier's Scheduled Seat Capacity with
That of Next Largest Airline at Major EU Airports

                                         Dominant airline's     Percentage of 
                                           percentage total    scheduled seat 
EU airport         Dominant airline       scheduled seat capacity for next 
                                       capacity for airport   largest carrier 
                                                     (2002)            (2002) 
Madrid, Spain      Iberia                          59.3%              9.3% 
Frankfurt          Lufthansa                        58.8               2.6 
Paris Charles De   Air France                       57.2               4.1 
Gaulle                                                   
Barcelona          Iberia                           52.7               7.7 
Amsterdam          KLM                              52.5               5.6 
London Gatwick     British Airways                  51.3               8.6 
Munich, Germany    Lufthansa                        49.4               8.8 
Rome Fiumicino     Alitalia                         46.8               8.9 
London Heathrow    British Airways                  40.5               9.6 
Manchester, United British Airways                  35.5              10.7 
Kingdom                                                  

Source: Citigroup Smith Barney, 2003 Hub Factbook.

Sales and marketing practices-which include frequent flier programs and
corporate incentive programs-may also impede competition. They do so by
reinforcing market dominance at hubs and impeding successful entry by new
carriers and existing carriers into new markets. Practices such as
frequent flier programs encourage travelers to choose one airline over
another on the basis of factors other than obtaining the best fare.

Such factors have a tempering effect on the extent to which EU airlines
may seek to launch competitive transatlantic service at these EU gateways.
EU airline officials with whom we spoke said they have no plans to
establish a significant presence in the hub airports of other airlines.
Officials said it would be difficult to successfully compete in a hub
against an incumbent airline because of the inherent advantages airlines
maintain in their own hub airport. More recent experience has shown
however that it is precisely the existence of high premium routes that
have attracted low-cost carriers to introduce new competition at or near
those high-fare markets, although they often use secondary airports.
Experience in both the United States and Europe has shown that low-cost
carriers have increased their presence in major hub airports or secondary
airports in major hub markets (i.e., Southwest and ATA at Chicago's Midway
airport and easyJet at Gatwick).

Consolidation among EU Airlines Could Affect Consumers Both Positively and
Negatively

Consolidation among EU airlines may be more likely if nationality clause
restrictions were eliminated, and could lead to a more efficient EU
industry structure. Generally, removal of regulatory barriers to industry
structure, when accompanied by appropriate competition-preserving
antitrust policies, is expected to improve operating efficiencies and
promote innovation. The U.S. Department of Justice's Horizontal Merger
Guidelines55 recognize that competition usually encourages firms to become
more efficient. Mergers can also generate significant efficiencies by
permitting a better utilization of existing assets, enabling the combined
firm to achieve lower costs than either firm could have achieved without
the merger. In turn, that may result in lower prices, improved quality,
enhanced service, or new products. At the same time, however, because the
motivation behind mergers is the prospect of financial gain, mergers are
restricted under both U.S. and EU antitrust laws in their ability to
create or enhance market power or to facilitate its exercise. Market power
in this instance is the ability of a firm to profitably maintain prices
above competitive levels for a significant period of time. Thus, while
consolidation in an industry through mergers can produce efficiencies and
potential consumer benefits, it remains important for antitrust or
competition authorities to guard against market abuses.

Analyses we have previously conducted of actual or proposed mergers in the
U.S. domestic market suggest that mergers often have both positive and
negative effects.56 Mergers have the potential for creating positive
benefits to consumers in such ways as the following:

o In markets where each of the merging airlines had a relatively limited
presence, combining their limited shares can create an additional
effective competitor.

o Consumers in some markets would benefit from having access to new
"on-line" service. For example, when the European Commission recently
approved the merger of Air France and KLM, it reported that KLM consumers
would gain access to more than 90 new destinations and Air France
customers would be offered 40 new routes.

o Members of the frequent-flyer programs of the merged airlines would be
able to use their miles to reach an expanded number of destinations.

Some industry officials and experts said a U.S.-EU agreement removing
nationality restrictions would facilitate the opportunity for more
cross-border mergers in the EU aviation industry, because EU airlines
would not lose important traffic routes into the United States as a result
of merger. However, other officials said that restrictive bilateral
agreements still held with three other major aviation nations would limit
the extent to which airlines would seek to consolidate. The three nations
most frequently mentioned were Japan (because of the size and value of the
existing market), China (because of the size and value of the potential
market), and Russia (because of the implications of overflight rights).
For example, Russia and Germany currently have a bilateral agreement that
restricts routes and overflight rights to Russian and German airlines. If
Lufthansa Airlines were to merge with another EU carrier, it is not clear
that Russia would extend these rights to the merged airline. If an EU
carrier did not have overflight rights from Russia, its flight times and
costs for operations to other Asian countries would increase
significantly. These officials said airlines that had received traffic
rights and other operating considerations through such agreements might be
unwilling to risk losing them through a merger.

A merger can have negative effects on consumers in those markets where the
merger reduces the number of effective competitors. This negative effect
is increased if the two airlines that merge have significant overlapping
markets or if the merger creates an airline that dominates a particular
market. Industry experts generally agree that, with dominance in a market,
airlines can wield market power and make entry into those markets by
would-be competitors more difficult. Therefore, an airline that can wield
this market power has the ability to raise fares when unconstrained by
competition. Consolidation also raises the possibility that competition in
key markets will be reduced, thereby potentially affecting fares and
service. The current merger between Air France and KLM illustrates this
point. The European Commission noted that the merger would also eliminate
or significantly reduce competition on 14 routes, including 3
transatlantic routes (Amsterdam-New York, Amsterdam-Atlanta, and
Paris-Detroit). Air France and KLM have agreed to surrender slots at
Amsterdam and Paris, but it is unclear if other airlines will provide
effective competition in those markets.

In the absence of specific merger proposals, it is not possible to project
the extent to which such positive and negative effects would be present.
Some aviation experts maintain that the likely outcome of consolidation is
the solidification of three "mega" alliances. These "mega" alliances would
provide the vast majority of international aviation service and would be
solidified around the Star, SkyTeam, and oneworld alliances, with the
major U.S. and EU airlines providing the vast majority of transatlantic
service. Some experts question the long-term viability of the existing
structure of smaller EU national airlines, such as Austrian Airlines or
TAP Airlines. These experts project that such smaller airlines may become
regional or niche airlines serving limited markets.

Major Obstacles Likely Would Limit EU Airlines from Moving Operations to
Other  Countries, at Least in the Near Term

While labor groups and some other stakeholders are concerned that EU
airlines may attempt to achieve lower costs by relocating operations or
establishing subsidiaries in EU member states that have lower social costs
and labor standards, a number of major obstacles could limit airlines from
establishing such "flag of convenience" operations. Increased competitive
pressure resulting from any new U.S.-EU agreement may lead airlines to
seek reductions in operating costs. Because labor represents the single
largest portion of these costs, labor groups have expressed concern that
EU airlines might consider relocating to EU countries with-from an
operating standpoint-more favorable labor laws.

Differences in labor costs and labor law among EU member states certainly
exist. According to a 2003 EU study, the newest 10 member states had an
average gross domestic product that is 40 percent of the average for the
15 other member states.57 The EU has adopted a common set of rules with
regard to certain labor policies, such as gender equality,
nondiscrimination, and health and safety. Even so, specific regulations
and enforcement authority remain with the member states. Additionally, EU
member states still maintain their own national labor laws, some of which
may provide airlines with more favorable labor environments. Differences
remain, for example, in how EU member states regulate collective
bargaining. For instance, an EU report stated that the new EU member
nations had generally very weak collective bargaining regulations when
compared to the other EU member nations.

According to labor representatives, the ability of airlines to relocate to
or establish subsidiary operations in other member states would enable
airline management to replace the existing workforce with lower-wage
workers. Additionally, EU officials stated that there is no EU law
regulating the representation, in collective bargaining, by a single
employee organization. As a result, workers in the same "craft" (i.e.,
pilots or flight attendants) employed by a single company but located in
different EU member states cannot be represented by a single employee
organization. There are, however, common rules concerning the right to
information and consultation of employees in Community-scale undertakings
and Community-scale groups of undertakings. According to labor
representatives, employee representation rights are critical to preventing
downward pressure on wages. These rights include single representation for
all members of an employee group, including those of subsidiaries and
holding companies; the ability to negotiate an agreement; and effective
enforcement of a negotiated agreement. Unless labor gains some of those
rights, airlines will be able to establish subsidiaries and then
substitute lower-wage labor for the existing workforce. A study prepared
for the European Cockpit Association, the association of each member
state's pilots unions, argues, that with the increase in inter-company and
cross-national alliances, trade unions and employee associations based in
single countries and without inter-union networks could be left without an
effective voice in the future restructuring of the industry, such as
determining where work will be located and under what conditions.

While many aspects of this issue remain unsettled, we did not find
substantial evidence to indicate that airlines would relocate operations
or establish "flag of convenience" subsidiaries in lower-wage EU
countries, at least in the short term.

o None of the EU airline officials we interviewed indicated a desire to
relocate to a low-wage country, citing company branding and markets as
being more important in driving business decisions than low-wage labor.
Airline officials said that commercial aviation differs from other
industries because the product (air travel) must be produced close to the
customer base (population and economic centers). Consequently, airlines
need to maintain their major operations at key economic centers, none of
which are located within the lower-cost countries. Another example that
suggests factors other than low-wage labor drive an airline's business
decisions is that EU regional airlines, not bound by international
bilateral agreements, have not pursued movement to countries with lower
wages and social costs over the last 11 years, despite the fact that such
movements were possible after the creation of a single European aviation
market.

o Despite the fact that pilots and flight attendants are inherently mobile
and could theoretically travel from lower-cost areas to do their work,
airlines said it was preferable to locate flight personnel close to the
base of operations. Therefore, airlines will have to provide a
competitive, market-based compensation package to retain qualified
employees. For example, an airline that chose to have a major base of
operations in Paris would need to hire employees paid at "market"
salaries. To run its daily operation from Paris to Hong Kong, Cathay
Pacific Airways, for example, employs 70 French citizens at its Paris
offices and Charles De Gaulle Airport. To compete in the labor market for
qualified employees, Cathay officials said that it must offer a
compensation package that is competitive with that offered by other
airlines.58

o If an airline decided to move its operations to another EU country or
import low-wage labor from there, it appears unlikely they would have
access to a sufficient supply of appropriately trained personnel. For
example, according to EU and airline officials, the number of pilots
available in these countries who are trained on aircraft used by the
airlines is relatively small.

o Finally, airline and government officials noted that both U.S. and EU
pilots have negotiated scope clauses59 that limit the airline's ability to
substitute workers from lower-wage subsidiaries for its current workforce
(i.e., engage in "labor substitution"). Moreover, available evidence
suggests that the creation of the EU's single market has not led to labor
substitution.60 A report by the UK Civil Aviation Authority stated that,
since EU aviation deregulation and the creation of a single market, the
United Kingdom had not had any airlines reflagging to a more lax
regulatory regime or workers displaced by cheaper workers from other
countries in the EU, nor had any UK airlines lost any market share to
airlines from lower-wage EU countries, despite the fact that the United
Kingdom is one of the higher-wage EU countries.

While there currently appears to be little evidence of serious
consideration of relocation or establishment of subsidiaries for access to
low-wage labor, the removal of the nationality clause restrictions and the
accession of 10 lower-wage member states into the EU does change the
market dynamic. EU labor groups said that the benefits of relocating
business operations among the 15 countries that comprised the EU prior to
May 2004 were limited, since there was not a large wage and social cost
disparity between them. Now, the disparities are greater. In addition, one
U.S. labor representative said that, while there initially may be little
economic incentive for established transatlantic EU airlines to move their
operations to countries with lower costs and labor standards, new entrants
could use the change in regulatory structure to gain a competitive
advantage. Furthermore, over time, there may be economic incentives for
established EU airlines to move their principal places of business or to
establish subsidiaries in countries with lower labor standards. Some
airline officials cite low-cost carrier Ryanair as an example of a carrier
that is taking advantage of the fact that the EU's single market is still
governed by individual member states' labor laws, and that pay and working
conditions are not subject to collective labor agreements at the European
level.

Because of this concern, U.S. labor representatives have proposed that
certain protections be included in any draft U.S.-EU agreement that would
reduce the incentive for airlines to take advantage of "flags of
convenience." One proposal would be to include a definition of "principal
place of business" in the draft to help clarify which set of laws would be
applied to a given carrier. Including this definition would make it harder
for major EU airlines to establish subsidiaries in lower labor standard
countries and have those laws applied to them. Setting this standard would
also clarify which country would be responsible for overseeing and
enforcing safety and security requirements for the airlines.

The success of low-cost carriers like Ryanair and Southwest raises the
question of whether existing low-cost carriers could successfully compete
in the transatlantic market. Typically, low-cost carriers have succeeded
in the domestic market by providing point-to-point service, often at less
congested airports. These airlines achieve their comparative cost
advantages through lower operational costs (often gained through using a
single aircraft type), and greater productivity. Recently, low-cost
carriers have begun to compete with network airlines by offering long-haul
(transcontinental) service. Under current Open Skies agreements, both U.S.
and EU low-cost carriers can provide nonstop flights between the U.S. and
the home countries of the EU low-cost airlines. However, it is unclear how
low-cost carriers would compete on transatlantic routes. Key aspects of
the low-cost carrier business model, notably the higher relative
productivity of labor and aircraft and the use of a single fleet type, are
more difficult to achieve on transatlantic routes.

Concluding Observations

A new aviation agreement without nationality-based restrictions between
the United States and the EU could create additional benefits for
consumers and airlines, but would require oversight from antitrust
authorities to ensure that the benefits of more open markets in the EU
accrue to the traveling public. The existing bilateral aviation agreements
between the United States and individual EU countries would need to be
modified to resolve legal concerns within the EU, namely the nationality
clause. Depending on the outcome of negotiations between the United States
and the EU, the changes could be relatively minor or could result in a
comprehensive opening of the U.S. and EU markets. With a new agreement
that removed the nationality clause restrictions and expanded the Open
Skies framework, U.S. consumers and airlines could benefit from increased
access to new destinations within the EU, lower fares from more efficient
route networks, and potentially more competitive routes. As discussed in
this report, such benefits may be limited because the current alliance
structure and bilateral agreements already provide many benefits, and
because congestion and limited access to key airports may mitigate or
delay the potential benefits. Resolving the EU legal concern over the
nationality clause could lead to continued consolidation among airlines
within the EU and potentially stronger ties between U.S. and EU airlines.
However, mergers such as that between Air France and KLM raise questions
about their impact on U.S. consumers because of their antitrust-immune
alliance partnerships with U.S. airlines. For example, how might the Air
France-KLM merger affect the international operations of their U.S.
partners, Delta, Continental and Northwest? In evaluating the potential
effects of such a scenario, how would regulators separate the effects or
influences of airlines' international operations from their domestic
operations? Since other major U.S. airlines participate in alliances with
EU airlines, further European industry consolidation would continue to
raise such questions.

In the absence of any significant competitive pressure from low-cost
carriers flying between the United States and the EU, there is a risk that
beneficial elements of potential restructuring could be offset by a
reduction in competition between alliances. Antitrust authorities in the
United States and EU will need to be vigilant to safeguard the benefits
that could accrue from the changing market structure.

The net effect on airlines and consumers will depend on (1) when and to
what extent U.S. airlines might gain access to markets that are now
restricted, and (2) the business strategies that U.S. and EU airlines
adopt. Obviously, the outcomes of any of these developments cannot be
predicted. For example, low-cost airlines-which have often been a source
of innovation-may find ways to alter their traditional business plans in
ways that would make them a competitive alternative to major network
carriers in transatlantic service. Past experience has shown that removing
government restrictions on aviation (e.g., through domestic deregulation
or Open Skies agreements) provided benefits to consumers, airlines, and
the industry's workforce. Because those significant benefits have already
been realized, the benefits associated with additional liberalization of
the U.S.-EU markets should be similar in nature but incremental in scope.
It appears that the greatest source of likely benefits to both U.S.
airlines and consumers lies in gaining de facto access to London's
Heathrow Airport. How the benefits from access to such restricted markets
may compare to those already realized from the other 15 Open Skies
agreements ultimately depends on the extent of the increase in competition
and changes in airline operations and passenger traffic.

Agency Comments and Our Evaluation

We provided a draft of this report to DOT and State for their review and
comment. Neither DOT nor State offered written comments, but did provide
technical corrections, which we incorporated as appropriate. In oral
comments, DOT's Deputy Assistant Secretary, Office of the Assistant
Secretary for Aviation and International Affairs, noted that concluding a
new agreement with the EU that would further liberalize transatlantic
aviation would provide significant benefits to consumers, airlines,
communities, and labor interests on both sides of the Atlantic. DOT
believes that establishing a regional air transport agreement between the
United States and the 25 members of the EU would establish a template for
a more competitive aviation regime on a worldwide basis. Finally, DOT
noted that it remains committed to achieving that goal and securing the
benefits that it could bring. We also provided selected portions of a
draft of this report to the European Commission; airlines; BAA, plc; the
Airline Pilots Association; and other groups cited to verify the
presentation of factual material. We incorporated their technical
clarifications as appropriate.

Unless you publicly announce the contents of this report earlier, we plan
no further distribution of this report until 30 days from the date of this
letter. At that time, we will provide copies to relevant congressional
committees; the Honorable Norman Y. Mineta, Secretary of Transportation;
the Honorable Colin L. Powell, Secretary of State; and other interested
parties, and will make copies available to others upon request. In
addition, this report will be available at no charge on the GAO Web site
at

http://www.gao.gov. If you have any questions about this report, please
contact me or Steve Martin at 202-512-2834. Other major contributors are
listed in appendix VI.

JayEtta Z. Hecker Director, Physical Infrastructure Issues

Scope and MethodologyAppendix I

At the request of the Chairman and Ranking Minority Member of the Senate
Committee on Commerce, Science, and Transportation, and the Chairman and
Ranking Minority Member of that Committee's Subcommittee on Aviation, we
examined three issues relating to potential changes to existing Open Skies
aviation agreements with European Union member states. Specifically, our
objectives were to answer the following questions: (1) how prevalent are
Open Skies agreements between the United States and EU nations, and what
has been their effect on airlines and consumers; (2) what are the key ways
that commercial aviation between the United States and EU could be changed
by the Court of Justice decision; and (3) how might the elimination of
nationality clause restrictions in any new U.S.-EU agreement affect
airlines and consumers?

To determine how prevalent Open Skies agreements are and what their effect
on airlines and consumers has been, we reviewed prior research from
Department of Transportation (DOT), the UK Civil Aviation Authority, the
EU Directorate General Transport and Energy (DG TREN), and other aviation
research organizations. We reviewed documents from the Department of State
(State) to identify the EU member nations with Open Skies agreements and
reviewed the five bilateral agreements the United States has with 5 of the
10 non-Open Skies EU member nations. (The United States does not have any
relevant aviation agreements with Cyprus, Slovenia, Estonia, Latvia, or
Lithuania.) We interviewed officials from these agencies to confirm that
the information in these documents and reports were correct.

To determine the effect of Open Skies, we looked at the growth of
transatlantic passenger and freight traffic, and we analyzed historical
data on airline passenger and freight traffic. We used DOT's T-100
on-flight data to determine the total number of passengers and the total
weight of freight and mail volumes that flew between the United States and
the EU from 1990 to 2002. U.S. and foreign airlines are required to report
all nonstop segments in which at least one point is in a U.S. state or
territory.  1 To facilitate analysis of the T-100 data, we contracted with
BACK Aviation Solutions (BACK), an aviation-consulting firm. BACK obtains
the DOT data and makes certain adjustments to these data, such as
correcting recognized deficiencies in the airlines' data submissions, when
these submissions have not met DOT's standard of 95-percent accuracy.

To determine the reliability of DOT's T-100 data and BACK's product, we
(1) reviewed existing documentation from DOT and BACK about the data and
the systems that produced them, (2) interviewed knowledgeable agency and
company officials, and (3) performed electronic tests of the data. We
concluded that the data were sufficiently reliable for the purposes of
this report.

To determine the amount of nonstop or connecting service available between
selected U.S.-EU markets,2 we analyzed airline flight schedule information
submitted to Innovata by U.S. and EU airlines for May 2004. Innovata,
whose clients include all major North American airlines, maintains
comprehensive airline schedule data files based on information they
collect, verify, and aggregate from the airlines. We purchased and
accessed Innovata data through Sabre's FlightBase airline scheduling
software. To determine the reliability of the Innovata data and Sabre's
product, we (1) reviewed existing documentation from Innovata and Sabre
about the data and the systems that produced them, (2) interviewed
knowledgeable company officials, and (3) performed electronic tests of the
data. We concluded that the data were sufficiently reliable for the
purposes of this report.

When analyzing the scheduled service in markets, we selected the largest
U.S. and EU airports in terms of passenger traffic, based on airport
categorization by the Federal Aviation Administration (FAA) and the
Airports Council International.3 While this does not include all airports
within the United States or EU, the U.S. airports selected accounted for
96.6 percent of the total U.S. passenger traffic in 2002, and EU airport
officials stated the EU airports selected comprised the major European
airports. We also used the May 2004 schedule data to examine the number of
competitors within a given airline market. DOT has in the past defined a
"competitor" as an airline or alliance that has a market share of at least
10 percent of available flights. As in prior reports on the effects of
changes in competition of proposed mergers or alliances, we adopted that
10 percent threshold. To determine the number of competitors within each
market, we identified the best level of service provided and the
competitive alternative.4 For example, if a market has nonstop service,
that would be considered the best level of service. However, one
stop/single on-line connecting service may be a valid competitive
alternative to nonstop in some markets (e.g., among the subset of
passengers who are not time-sensitive or may be more sensitive to
prices).5 Therefore, when the best level of service is nonstop, to
determine the number of competitors, we counted all airlines that provided
either nonstop service or one stop/on-line single connecting service. For
markets where the best level of service is one stop/on-line single
connecting service, we counted airlines that provided two stop/on-line
double connecting service as additional competitors.

To determine what the key ways are that commercial aviation between the
United States and EU could be changed by the Court of Justice decision, we
interviewed officials from DOT, State, DG TREN, the European Union
Directorate General for Competition (DG COMP), France, Germany, the
Netherlands, and the United Kingdom, as well as from U.S. and EU airlines,
EU airports, and EU aviation trade associations. We discussed the
implications for European airlines of changes to the nationality clause in
existing Open Skies agreements. We also discussed congested airport
facility access and environmental regulations to better understand carrier
access to EU airports. We reviewed reports recommended by aviation
authorities from the European Commission, Germany, Britain and the
Netherlands. Finally, we also discussed with EU officials the EU process
for airline certification, establishment, and operations.

To analyze the potential effect of removing the nationality clause
restrictions on consumers and airlines, we interviewed officials from DOT,
State, DG TREN, DG COMP, France, Germany, the Netherlands, and the United
Kingdom, as well as from U.S. and EU airlines, U.S. and EU airports, and
EU aviation trade associations. We also conducted a review of existing
research and analyzed airport capacity and demand data from Airport
Coordination Limited. These data contain the number of slots available at
London's Heathrow airport and the demand for these slots by airlines.
Based on logical tests for obvious errors of completeness and accuracy, we
determined that the data were sufficiently reliable for our purposes. To
analyze the potential labor effects, we interviewed officials from major
U.S. and EU airlines, U.S. and EU labor unions, the EU Directorate General
for Employment, labor research organizations, and U.S. and EU agencies.

We also conducted a review of existing research and analyzed data from
DOT's "Form 41" database. This database contains financial information
that large air carriers are required by regulation to submit to DOT (see
49 C.F.R. Sec. 241). Airlines submit financial data monthly, quarterly,
semiannually, and annually to DOT with financial and operating statistics.
To facilitate analysis of these data, we contracted with BACK, an
aviation-consulting firm. BACK obtains the DOT data and makes any
necessary adjustments to these data to improve their accuracy. To
determine the reliability of DOT's Form 41 data and BACK, we (1) reviewed
existing documentation from DOT and BACK about the data and the systems
that produced them, (2) interviewed knowledgeable agency and company
officials, and (3) performed electronic tests of the data. We concluded
that the data were sufficiently reliable for the purposes of this report.

We also reviewed an industry survey of pilot contracts that included wages
and benefits for pilots and pilots of different seniority levels, by
airline. The Association of European Airlines (AEA) provided employment
information for 15 member airlines. Based on interviews with knowledgeable
AEA officials and logical tests for obvious errors of completeness and
accuracy, we determined that the data were sufficiently reliable for our
purposes.

We conducted our work from October 2003 through July 2004 in accordance
with generally accepted government auditing standards.

Air FreedomsAppendix II

Cargo CarriersAppendix III

While U.S. cargo carriers have also benefited from the 15 Open Skies
agreements the United States has signed with EU member nations, the
European Court of Justice ruling also affects these carriers. Since 1990,
U.S. cargo carriers have experienced a significant increase in volume and
operations with the development of a large hub-and-spoke network. With a
new agreement that extended the Open Skies framework, U.S. cargo carriers
would also likely gain additional traffic rights into markets that are
currently restricted. There are unique cargo carrier issues that are not
directly linked to the nationality clause, however, and these issues do
present concerns to U.S. cargo carriers. Because U.S. cargo carriers rely
heavily on night operations, attempts by local communities in EU member
states to impose additional restrictions on night flight operations could
have an effect on U.S. cargo carriers.

U.S. Cargo Carriers Have Increased Their North Atlantic Operations Since
Open Skies

Similar to the increase in passenger service, cargo service also
experienced a significant increase in volume and operations since the
inception of Open Skies agreements. Freighter operations for all carriers
flying between the United States and EU increased more then 75 percent
from 1990 levels to over 20,000 flights in 2002 (see fig. 12).1 Using
"fifth freedom" rights provided by Open Skies, FedEx and United Parcel
Service (UPS)-the largest U.S. all-cargo carriers-expanded operations
through hub-and-spoke networks in Paris and Cologne. FedEx currently
operates three daily flights from the United States to Paris, one to
Frankfurt, and one to London (Stanstead Airport); UPS operates five daily
flights from the United States into its European hubs (Cologne, Germany;
East Midland, United Kingdom; and Paris, France). These increased
freighter operations carried more than double the 1990 freight and mail
volumes, so that by 2002 freighters carried over 2.5 billion pounds
between the United States and the EU.

Figure 10: Freighter Operations for All Carriers Flying between the United
States and the EU, 1990-2002

Fifth Freedom Rights

With the removal of the nationality clause restrictions, U.S. airlines
would gain "fifth freedom rights" (i.e., the right to operate flights from
the United States to an EU country and then beyond to another country) in
EU member states with restrictive bilateral agreements. For example, under
"fifth freedom rights," FedEx is able to transport cargo from Memphis to
Paris, deposit some or all of it in Paris, and then pick up new cargo and
fly it to Frankfurt. While all U.S. cargo carriers have fifth freedom
rights under current Open Skies agreements, under the more restrictive
bilateral agreements, such as the agreement with the United Kingdom, these
rights are limited.

UPS and FedEx make extensive use of fifth freedom rights in many of the EU
countries where they have such rights. Under the Bermuda 2 agreement, when
U.S. cargo carriers operate a flight from the United States that stops
both in the United Kingdom and an airport in continental Europe, that
flight is restricted from using some fifth freedom rights to pick up cargo
in the United Kingdom and transport it on to the continental destination.
For example, FedEx schedules a daily flight from its hub in Newark to its
hub in the United Kingdom, and this flight then continues on to Paris.
Under the current agreement, FedEx is allowed to drop off cargo in the
United Kingdom, but it is not allowed to pick up cargo in the United
Kingdom and transport it to Paris. Instead, the plane must travel to
France only partly loaded (that is, with the Paris-bound cargo that
originated in the United States). Cargo that FedEx receives in the United
Kingdom for shipment to Europe must be shipped using a separate charter
service. This increases FedEx's operating costs. A new agreement would
remove these restrictions and allow FedEx to utilize its network more
efficiently.

Lack of EU Enforcement Ability on Noise Regulations May Affect U.S. Cargo
Carriers

Increased restrictions on night flight operations could potentially
adversely affect the ability of U.S. cargo carriers to operate. At a
number of EU airports, local communities are seeking, for environmental
reasons, to restrict the extent of night operations. At Frankfurt, for
example, German officials are in the process of attempting to ban all
nighttime operations at the Frankfurt airport and have cargo carriers move
their operations to the Hahn airport-about 80 miles away. Restrictions on
these nighttime operations would compromise U.S. cargo carriers'
operations.

If cargo carriers need to limit their nighttime operations or move them to
other locations, the impact on U.S. cargo carriers could be significant,
since they have invested substantial financial resources to develop their
distribution networks and airport facilities. For example, FedEx has
invested over $200 million to develop its operations at the Charles de
Gaulle, Stansted, and Frankfurt airports. UPS also has invested
significant sums in its facilities at Cologne, Germany. Therefore, changes
in night flight regulations could effectively devalue these investments by
reducing the ability of these companies to fully utilize their networks
and facilities. In particular, if FedEx were forced to relocate its
Frankfurt operations to Hahn, the value of its Frankfurt facilities would
be diminished. FedEx officials indicated that if a night ban was enacted,
it would limit them with regards to expanding future operations. In
addition, if an airport restricted aircraft from landing after midnight,
it would force U.S. cargo carriers to eliminate either late pickups or
early deliveries. Both FedEx and UPS highlighted this as a huge
competitive disadvantage.

The EU has little direct influence in local attempts to invoke such
restrictions, as such actions remain a local- and country-specific matter.
Although the EU issued a directive in 2002 on the establishment of rules
and procedures with regard to noise-related operational restrictions at EU
airports, all actual regulations are established and implemented by the
individual member states.2 The EU directive supports the ICAO "balanced
approach," which outlines a standard set of procedures for establishing
aircraft noise regulations.3 This approach and the EU directive attempt to
harmonize the procedures used by individual member states. However, since
the pressure to restrict night operations usually originates with local
communities surrounding airports, local governments have enacted night
flight restrictions in compliance with local citizen demands or local
government regulations. Therefore, noise restrictions can greatly vary
between member states. If aviation stakeholders feel that member states
have not followed the procedures established under the ICAO "balanced
approach," they can appeal to the EU. If the EU rules in favor of the
aviation stakeholder, the member state is required to amend the
regulation. However, according to EU officials, under EU law, during the
infringement proceedings, there is no requirement for the EU member states
to stop or delay these noise regulations. Officials stated that, while the
EU does not have any enforcement mechanisms and the infringement procedure
is more of a political pressure tool, the EU treaty does provide for
accelerated procedures once the procedure is placed on the Court of
Justice agenda.

Current International Airline AlliancesAppendix IV

Source: U.S. Department of Transportation, U.S. Department of State,
oneworld alliance, Star alliance, Northwest Airlines, and SkyTeam
alliance.

Air France-KLM MergerAppendix V

A major consolidation event-the recently approved Air France-KLM merger-is
already occurring within the framework of existing Open Skies agreements.
This merger involves two airlines owned and controlled by national
citizens from countries that had both signed Open Skies agreements with
the United States. It has been structured in such a way as to protect the
traffic rights granted under bilateral agreement for each airline.1 This
meant that the merger needed to include a series of corporate governance
and ownership adjustments not normally found in a traditional merger. For
example, the actual merger includes a 3-year transitional shareholding
structure that will ensure that majority ownership of Air France is with
French citizens and that the majority ownership of KLM is under Dutch
citizens. The basic structure attempts to preserve the brands and identity
of each airline by establishing a French holding company, Air France-KLM,
which will own 100 percent of the economic rights for both Air France and
KLM.2 To protect KLM's traffic rights, Air France-KLM will only control 49
percent of the voting rights, with 51 percent being held by Dutch
foundations and the Dutch government. After 3 years, the Air France-KLM
holding company will own 100 percent of both airlines. European officials
believe that the EU's February 2004 approval of the Air France-KLM merger
signals the start of consolidation of the European aviation industry. If a
new U.S.-EU agreement eliminates the nationality clause restrictions, the
need to structure mergers to protect traffic rights across the north
Atlantic will likely be eliminated.

Mergers among major European airlines will inevitably raise questions
about how existing global alliances will be affected. Because of the
alliance with U.S. partners, mergers will exert effects on U.S. airlines
and consumers. Air France and KLM are in separate alliances with different
major U.S. airlines (Delta and Northwest, respectively), and DOT has
granted antitrust immunity to both of these alliances. In addition, Delta,
Northwest, and Continental agreed to a major domestic code-sharing
partnership in 2002, which was permitted with certain conditions by DOT.

GAO Contacts and Staff AcknowledgmentsAppendix VI

GAO Contacts

JayEtta Z. Hecker (202) 512-2834 Steven C. Martin (202) 512-2834

Acknowledgments

In addition to those named above, Amy Anderson, David Hooper, Jason Kelly,
Joseph Kile, Grant Mallie, Sara Ann Moessbauer, Tim Schindler, Stan
Stenersen, John Trubey, and Matt Zisman made key contributions to this
report.

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