KLM, sustainable aviation fuel and market failure

KLM – Royal Dutch Airlines – has been found guilty in court of misleading advertising – information failure – claiming that the airline is moving to a more sustainable future. The court could not have been clearer – companies are not allowed to claim they are tackling dangerous climate change when in reality they are fueling the crisis.

The issue with KLM was the vagueness of their advertising and it did not explain how flying with them related to any environmental benefit. Also the court ruled that tree-planting, which was sold as a way to offset the emissions, only marginally reduce negative externalities (environmental aspects) and give the wrong impression that flying with KLM is sustainable. International Energy Agency stated that air transport has the potential to contribute to climate change as that the growth in aviation activity has historically outpaced improvements in efficiency

Sustainable Aviation Fuel
Aviation currently accounts for approximately 2 to 3% of global carbon emissions. Counting non-CO2 emissions, its overall contribution to climate change is significantly higher — and likely to rise as demand for air travel keeps increasing – air travel is projected to double by 2040. SAF is said to be a direct replacement for fossil fuels and reduces greenhouse gas emissions by up to 80% over the fuels life cycle compared to using fossil jet fuel. The issue with SAF is its price which recently has been up to 8 times more expensive than fossil fuel.

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Suez Canal / Panama Canal trade disruptions and diseconomies of scale

This year global trade has been disrupted by terrorist activities and drought. Terrorist attacks in the Red Sea has seen traffic in the Suez Canal reduce by 50% from 2023 and a drought in Panama has substantially reduced daily ship crossing by 32% in the same year.

The Suez Canal usually accounts for 15% of global trade whilst the Panama Canal equates to 5%.

The new favoured direction of trade is around the Cape of Good Hope which increases delivery times by 10 days or more on average. By the first half of February 2024, 586 container vessels had been rerouted, while container tonnage crossing the canal fell by 82%. See image – before and after Red Sea attacks and Daily Transit Volumes graph.

Climate change is impacting the Panama Canal with worryingly low water levels. The Panama Canal Authority has reduced daily transits from an average of 36 to 22, with plans for further reductions to 18 per day.

Impact on emissions
The rerouting of container ships means increasing speeds to cover longer distances. For example, accelerating from 14 to 16 knots increases fuel use per mile by 31%. Going the long way round via the Cape of Good Hope suggests a 70% increase in greenhouse gas emissions for a round trip from Singapore to Rotterdam.

Container freight rates on Asia–Pacific to Europe routes have risen sharply since November 2023. A record weekly spike of $500 was observed in the last week of December 2023. Average container shipping spot rates from Shanghai in early February 2024 more than doubled – up by 122% compared to early December 2023. The rates from Shanghai to Europe more than tripled, jumping by 256%. Source: UNCTAD

Shipping costs and diseconomies of scale
The rerouting of container ships will mean that some companies will have increasing costs and diseconomies of scale. As a company increases in size there are returns to scale which refers to the change in output achieved by the firm as a result of a proportionate change in all inputs – e.g. land, labour, capital and enterprise. This can be: 

• Increasing returns: where output increases at a proportionately faster rate than the increase in factor inputs. Economies of Scale
• Constant returns: where output increases at a the same rate as the increase in factor inputs. Constant Returns to Scale
• Decreasing returns: where output increases at a proportionately slower rate than the increase in factor inputs. Diseconomies of Scale

Diseconomies of scale becomes apparent when there are decreasing returns reflected in an increase in unit costs and the average cost.

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The Jevons Paradox and Tidy Street experiment

A colleague brought to my attention the Jevons Paradox. Named after English economist William Jevons who in the mid-19th century noticed that improved steam engine efficiency resulted in higher coal consumption rather than conservation. He argued that as the efficiency of steam engines increased, their usage expanded, offsetting any gains made in energy conservation. What examples are there today?

Vehicle transport – as the cost of driving per km decreases it makes driving more affordable and therefore increasing kms travelled. This offsets the energy conservation benefit of improved efficiency. According to Nissan EV drivers are yearly traveling over 370 miles further than petrol/diesel car users with 70% acknowledging EV range autonomy is better than expected.
LED lights – energy efficient lighting has led to greater demand for LED bulbs. Because of the reduced cost per light consumers have installed more lights hence the increase in outdoor lighting products.
Data centres – the benefits of the internet and electronic communication has led to the increasing demand for energy to power the server farms / data centres like those used for the Bitcoin market.

Tidy Street experiment
An experiment by Jon Bird looked at people’s behaviour regarding energy consumption on Tidy Street in Brighton, UK. 17 of the street’s 52 residents signed up and each household’s power bill was graphically represented on the street (see photos) and published through the media. Over the three weeks of the project average energy use dropped by 15% with some cutting usage by 30%.

“Each time their performance improved, they felt a little community pride. When they slipped back, the giant public display gave them a variation on the magic buzzer treatment.”

When the experiment ended Bird asked the households to individually continue. Without the public attention keeping them in check, participation dropped to 50% and then six months later to only 3 households, which only 2 keep their energy below city average.

“If you give people feedback on energy use, it does have the effect of reducing energy usage in the short-term,” Bird says. “What is trickier is, how do you get sustained sustainable behaviour? …There’s a difference between awareness and behaviour,” he continues “We’ve got the awareness, but haven’t quite got the motivation … Why is it that gyms have more membership than capacity? Most people don’t go. That’s human beings.”

Policy measures
Governments need to think long-term about efficiency and take into consideration the sustainability of resources. This can include carbon pricing, regulations enforcing energy standards and subsidies to encourage the use of sustainable / renewable energy resources. Furthermore consumption trends must also be considered so that particular resources can be allocated in sustainable ways.

Only by addressing the complex dynamics between efficiency and consumption can we effectively navigate the challenges of resource depletion and climate change in the years to come. It underscores the importance of considering the broader socio-economic factors influencing resource use and the need for comprehensive strategies to achieve sustainability goals. Jon Bird

Source: Didactic Discourse blog

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Cross price elasticity of demand and airline safety – how much should be invested?

You are no doubt aware of the two catastrophic accidents in 2018 involving Boeing 737 Max aircraft which led to the Federal Aviation Administration (FAA) to ground all 737 Max aircraft and make regulatory changes. The compliance costs incurred by the FFA were significant and can ultimately drive up fares and cause consumers to substitute higher-risk road travel for air travel – cross price elasticity of demand. See table below:

Before the 737 Max crashes the last major fatal US airline disaster was in 2009 when Colgan Air Flight 3407 crashed near Buffalo, NY, killing all 49 passengers aboard and one person on the ground. This contrasts sharply with the 36,560 fatalities on the nation’s roadways in 2018 alone, the most recent year for which data are available. The numbers show that US road fatalities are more than twice the number of lives lost in the two 737 Max crashes. Therefore if the cross price elasticity of demand of road travel with respect to air travel = 0.2, this means that a 10% increase in airfares would result in a 2% increase in the demand for road miles traveled – 2% / 10% = 0.2. Table 1 below estimates that a 10% increase in airfares an estimated 33 billion additional passenger-miles would be driven. This would have an expected increase in road fatalities of 240 – 70% of the 737 Max crashes.

Analysis of Automobile Travel Demand Elasticities with Respect to Travel Costs,” by Jing Dong, Diane Davidson, Frank Southworth, and Tim Reuscher. Prepared for the Federal Highway Administration, August 30, 2012. Table 27.
“Comparing the Fatality Risks in United States Transportation across Modes over Time,” by Ian Savage. Research in Transportation Economics 43: 9–22 (2013). Table 2.

The graph below shows the impact of an increase in airfares due to increased safety regulations. With the price rise the quantity demanded for air travel decreases and given that road and air are substitutes, the increase in the price of air travel shifts the demand curve for road travel.

The FAA’s mission is to provide the safest and most efficient air travel in the world. However the society’s optimal amount occurs when the marginal benefit of airline safety = to the marginal cost of airline safety – MB=MC. This theory does not say that society should invest in airline safety up to a point where the chance of a crash is zero, although an airline might have the resources to do so. As the investment in airline safety is subject to the law of diminishing returns, the cost increases are significant and the airline attempts to recover these through higher fares which, to a rational consumer, reduces demand.
The theoretical relationship between investment in airline safety and net lives saved is shown below.
I1 = more investment in airline safety will save more lives
I2 = less investment in airline safety will save more lives.
I* = the optimal amount of investment to save the most lives.

Of course, there are always opportunities to do better and Boeing and the FAA should avail themselves of all “efficient” opportunities to do so (i.e., those that save lives on net). Still, there is a real risk of reflexive over-regulation that costs more lives than it saves.

Source:

The Risk of Too Much Air Safety Regulation – Regulation Spring 2020

Market failure and infrastructure development in Mexico

This topic was mentioned last week on the Tutor2u blog and is very relevant to NCEA Level 3 and Cambridge A2 Economics courses.

The Maya Train is a 1,525-kilometre intercity railway in Mexico that traverses the Yucatán Peninsula. Construction began in June 2020 and the Campeche-Cancún section began operation on December 15, 2023, with the rest of the line to open later. The project aims to connect tourist destinations in the Caribbean with lesser-known sites inland, including historic Mayan sites from which it derives its name. Its construction is estimate to create 715,000 new jobs by 2030 in the 16 municipalities where the stations will be constructed. Economic growth will double around the route and the UN-Habitat predicts that poverty will contract by around 15% by 2030.

However, protestors have warned that the scheme will cause serious environmental damage, particularly along part of the route that runs though the Calakmul biosphere reserve, a Unesco world heritage site, where ancient pyramids erupt through the forest canopy. More than 100 species of mammal inhabit the forest, including the most important jaguar population in Mesoamerica, 398 species of birds and 84 reptiles, some at risk of extinction. Almost 3,000 households living along the route have been displaced.

• When there is a negative production externality, marginal social cost (MSC) exceeds marginal private cost (MPC), as in Figure 1.
• Firms take decisions on the basis of MPC, so the market settles at Q1, rather than at Q*.
• The shaded area represents the welfare loss for society in this position – i.e. the damage to the environment, species of mammals and the displacement of households. This is not reflected in the costs faced by the building of the railway.

Below is a video from the BBC on the project and its impact.

Source:

Wikipedia – Tren Maya

Top 50 airlines by revenue in last 12 months

The Airfinance Journal’s ‘The Airline Analyst,’ have selected 50 airlines with the highest recorded Latest Twelve Month (LTM) revenue ending between December 2022 and June 2023. Some points of note from the graph below:

• Emirates Airline have over 50% of the world’s active A380s – unsurprising that the ‘Average LTM Revenue Per Aircraft’ is so high’
• Contrast between Virgin Atlantic and Qatar being above the trend line as compared to Thai Airways and Cathay Pacific below the trend line. The focus of Virgin on the profitable North Atlantic route could be a reason for this and Qatar being a major hub into Europe and Africa.
• The level ‘Average LTM Revenue Per Aircraft’ could also be due to the time when countries ended their COVID-19 lockdown as well as how quick they were able to recover economically.
• Airlines that sit below the trend line have an operating fleet of predominately narrow body aircraft – the exception being Thai Airways and Cathay Pacific.
• Airlines that sit above the trend line have a high proportion of wide body aircraft.
• Four largest Chinese airlines sit furthest below the curve – illuminating the lack affordability in Chinese domestic markets and the stagnant growth in its economy

This data only refers to revenue and passengers and not the cost structures for each airline – this is due to be published next month in the Airfinance Journal. The questions that need to be addressed is:
– Do wide body aircraft have greater economies of scale than narrow body aircraft?
– Is the cost per passenger lower in wide body than narrow body aircraft?

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Airline fuel price hikes = opportunity to limit overcapacity.

At the start of 2022 the rise of jet fuel increased by approximately 90% and cost roughly 120% more than it did in 2021. This is particularly challenging as around 25% of an airlines operating cost is fuel and this ultimately increases the marginal cost of flying although this may foster greater capacity discipline.

Why has jet fuel increased
In June 2022 West Texas Intermediate (WTI) crude oil was up 135% at $111 from the previous year. Refined jet fuel prices rose even more with the price per gallon at $4 which was a 90% increase since the start of 2022 and 215% since January 2021. The cause of these increases are:

• Refining capacity dropped significantly post-COVID-19 as refineries, seeing less demand, had shifted capacity away from producing jet fuel towards other fuels.
• Ukraine war had meant lower crude and refined exports especially to Europe.
• Supply side constraints in meeting the sudden demand for aviation fuel after the ending of the lockdown

American Airlines reported that the price it paid per gallon of jet fuel had risen more than a third over 2022, from $1.48 in 2020 to $2.04 in 2021. At the time, it said that each sustained one-cent rise in the per-gallon price would increase its fuel expense for 2022 by about $40 million.

But there are positives for the airlines
McKinsey & Company identifies 3 reasons why high jet fuel prices might not be as bad for airlines as expected.

• Airlines can employ hedging strategies to protect themselves from rising oil prices. They can purchase large amounts of fuel contracts for future needs. This is at a price which they believe will be lower than in the future. They can also purchase a ‘call option’ which means buying the right to purchase fuel in the future at a price that is agreed today.
• Inelastic demand – airlines can pass on some the price increase to consumers as they have done in the past. Carriers typically pass on to consumers as much as 60% of a volatile rise in the price of fuel. However, the industry has been able to pass along costs more quickly, in large part because of high demand and a shift in consumer behaviour during the pandemic toward buying tickets closer to the date of travel – people need to travel after being locked up for two years. Analysis of previous years with high fuel prices suggest a positive correlation with unit revenue – see below:

• Higher fuel prices mean higher marginal costs (MC) of flying although the MC of operating a flight is low. Typically between 30-35% of an airlines cost is fully flight-variable – jet fuel, landing and passenger charges, air traffic control and food. This encourages carriers to add more capacity as the remainder of costs are predominately fixed – aircraft rental, flight crew salaries, and overheads so an additional flight does not lead to significantly higher cost.

In the past higher fuel prices has led to a more disciplined capacity deployment e.g.
2010 and 2012 – jet fuel prices 70% higher than 2003-2005 but operating margin much higher in 2010 to 2012 – see below.

With higher fuel prices, the marginal cost of operating increases, which in the past has led to more disciplined capacity deployment. Better discipline restores profitability.

Source: Why rising fuel prices might not be as bad for the airline sector as it seems. McKinsey and Company – 15th July 2022

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Transport economics – evolution of containerships and TEU capacity

The principle of economies of scale is fundamental to maritime transportation economics as the larger the ship, the lower the cost per unit transported. This trend has particularly been apparent in bulk and containerised shipping. Since the 1950’s the size and capacity of the containership increased from 500 to 25,000 TEU’s (Twenty-foot equivalent unit) – see table belo

The TEU is referred to as the container which has been the driver of intermodal transportation and its homogeneity means the easy handling of the container between shipping, rail and road. Marc Levinson in his book ‘The Box’ outlined its importance:
 
‘The value of this utilitarian object lies not in the what it is, but in how it is used. The container is at core of a highly automated system for  moving goods from anywhere, to anywhere, with a minimum cost and complication on the way’. 

The global containership fleet 2000 – 2021
 The trend over the last 20 years is to increase the TEU capacity by building larger ships. The total number of ships in 2000 was 2,606, with the average ship being able to transport 1749 TEU’s. By 2020 the global capacity number of ships increased to 5337 vessels with an average ship being able to transport 4352 TEU’s – see chart. Those containerships that have a capacity of over 2,000 TEU operate in the long-distance trade routes and account for over 89% of the world’s container fleet. Shorter containerships up to 2,000 TEUs made up the other 11% and they operate as feeder services and in short sea shipping.

Of late there has been significant growth in the size of containerships especially the large (ULCS) and mega large containerships (MGX-24) with an overall capacity of between 10,000 – 23,000 TEU.  This equates to 573 ships and accounts for 36% of the total capacity of the container fleet – see chart below.

Fleet Capacity Breakdown by TEU size range.

Source:
The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger 2nd Edition – (2016). By Marc Levinson

ALPHALINER – Monthly Monitor – January 2020

Why are airline prices so high? Supply and Demand

In the news of late has been the outcry from consumers of the increase in the price of domestic airline fares, in some case 300% higher than they were pre-pandmeic. So why have they gone up so much? It’s a simple matter of supply and demand.

Below is an interview with Air New Zealand CEO Greg Foran talking about what is driving up airfare prices. Pick the supply and demand causes.

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Global supply-side pressures starting to ease

At the heart of the rise in inflation over the past year has been supply-chain issues as well as the war in the Ukraine. However there are signs that this inflationary pressure is starting to subside with the cost of transportation coming down as well as improved delivery times for produce. The major concern was the COVID lockdown in China and now that restrictions have eased production and the transportation network have returned to some sort of normality. Oil and a number of other commodity prices have declined in recent months due to easing supply-side pressures and expectations of lower global demand, although prices remain elevated.

RBNZ – August Monetary Policy Statement

The Supply Chain explained

The supply chain has been stretched to the limit over the last two years and there have been a number of reasons for that. From a lack of containers to surges in global economy activity, as consumers shifting from buying services to buying goods, the freight time and cost have increased significantly.

From the IMF – good video explaining how the supply chain works and the problems faced after two years of lockdowns. Has the supply chain got too complicated?

Automotive industry hardest hit by supply-chain disruptions

Of the industries that have been most effected by the supply chain disruptions the car industry has taken the biggest hit with 52% of automotive supply-chain managers saying that disruption from COVID-19 to supply was very significant. The reasons for the automotive problems are:

Production stoppages – 48%
Trade restrictions – 24%
Access to raw materials – 12%

According to The Economist Intelligence Unit the problems associated with the shortage of semiconductors could have been avoided. Automotive producers cancelled orders of semiconductors at the start of the COVID-19 as they assumed that their spare capacity could meet the demand. Although the industry realised their mistake the allocation of semiconductors was mopped up very quickly by other sectors. The consumer electronics industries boomed as more people worked from home and spent income normally prioritised for leisure activities to other forms of entertainment. Access to raw materials was a major disrupter of other sectors – healthcare and food. With people in lockdown there was a considerable demand for food with eating out not a viable alternative.

East v West
It seems that more traditional supply chains (West) that have been developed over many years have been harder hit than more recent supply chains (East). Regionalisation has been the focus in North America and Europe but less so in Asia. Smaller companies are now localising their supply chains as COVID has been the catalyst to rethinking strategies with a renewed focus on flexibility.

Source: DISRUPTION, DIGITISATION, RESILIENCE: The future of Asia-Pacific supply chains. The Economist Intelligence Unit. 2021

Cost-Benefit Analysis of the Auckland Harbour cycle bridge

Reading Michael Cameron’s blog this morning I was intrigued to read that New Zealand’s Transport Minister Michael Wood did not provide the cost-benefit data when he announced the new $785m Auckland harbour cycle bridge earlier this month. However it has now been revealed the initial assessment by Waka Kotahi is only 0.4 to 0.6. That meant for every dollar spent on the bridge, there would effectively be a 40 to 60 cent loss. If a project is less than 1.0, the project’s costs outweigh the benefits, and it should not be considered.

You wonder about the rationale for this amount of expenditure when there is an opportunity cost – money that could be spent on the areas that seemed to be constantly deprived of government funds e.g. Health (especially with the vaccine rollout), Education etc.

Evaluation of Cost-Benefit Analysis
It is clearly more efficient for public spending to be subject to rigorous analysis, rather than based on the whims of politicians. However, there are a number of criticisms of CBA when projects are given the green light

1. It is often very costly to undertake, though usually this forms a very small proportion of total project spending.
2. Assessing the monetary value of external costs and benefits is often very difficult. What precisely is the value of the congestion that would be reduced if a new bi-pass were built around a busy town? How much extra tourist revenue will actually be gained from a new airport? How long will the building be used as a venue, as in the case of the Viaduct area in Auckland for the 2020/21 America’s Cup. One solution to this problem is shadow pricing, where analysts attempt to place a value on the costs and benefits of a decision or a project where an actual market price does not exist.
3. Changing circumstances can make initial projections appear grossly inaccurate. The Wembley Stadium project in London went considerably over-budget, and the majority Olympic Games are far more costly than originally estimated. For instance the Montreal Olympics in 1976 was eventually paid off in December 2006. Higher interest and inflation rates, and falling exchange rates can all dramatically affect costs.
4. Actual costs can also rise above planned costs as a result of moral hazard, where project managers go over budget because they expect that those who fund the project will make extra funds available, providing an insurance against their over-spending.
5. Ultimately, decisions to go ahead with projects are only guided by CBA, leaving politicians to make the final decision. Politicians are free, of course, to ignore the results of an appraisal. It looks like they have with the cycle bridge.

Mega ships and diseconomies of scale

The mega ship the Ever Given was a familiar name in the news recently with it getting stuck in the Suez canal and thus preventing any marine traffic in both directions. The Ever Given is operated by the Taiwan-based firm Evergreen and is a so called mega ship and was carrying over 18,000 containers.

Mega (container) ships have been built in increasingly larger sizes to take advantage of economies of scale and reduce expense as part of using multiple forms of transport without actually handling of the freight itself. The big container ships can carry up to 23,964 twenty foot equivalent unit (TEU) whilst the smaller capacity ships have a maximum capacity of 1,000 TEU.

Herd Mentality and Prisoner’s Dilemma
This being said there is some dispute over the extent that the mega ships achieve economies of scale. A follow the leader mentality in ordering bigger ships have been since the mid 1990’s with firms following Maersk in ordering bigger capacity ships. In most cases it only takes two years for other carriers to catch-up to Maersk and in some cases they can hold more TEU. This has led to operators facing prisoner’s dilemma. Operators are trying to outdo their rivals by building larger ships which help increase its market share through their reduced costs but are fully aware that what actually is needed is capacity rationalisation. This strategy has not only fuelled the never-ending competition for large ships but also led to mistrust among operators, entangling them in the prisoner’s dilemma. The ideal scenario is for operators to refrain from acquiring mega ships and let supply and demand prevail.

Infrastructure costs to cope with mega ships
The graph below shows the savings and costs increases from increasing the capacity of mega ships. There is a saving with carrying more TEU’s but terminals will incur significant capital expenditure to handle larger vessels and terminal yards areas will need to increase by 33% to avoid congestion, even with no growth in volume. There are negative externalities to consider that arise from upsizing as dredging deeper channels and expanding yard area will have environmental effects.

Source: Diminishing economies of scale from megaships? Marine Money Japan Ship Finance Forum, Tokyo 12th May, 2016

A lack of containers adds to shipping costs and inflation.

Covid-19 has severely impacted the global trade for a number of reasons:

• Container shortages as early as February 2020
• Port congestion caused by increased checks at ports
• Ship carriers cannot add more capacity as the entire global fleet is mobile.
• Slow down in container emptying has led to a backlog of containers at many ports

Major Chinese ports like Qingdao, Lianyungang, Ningbo, and Shanghai are experiencing severe container shortages. This means that ships are leaving Chinese ports without a full load. Containers filled with consumer goods from Asia are usually unloaded, then filled with exports of other commodities. Products like meat, pulp and coffee, crops and lumber are then shipped in containers back to China. But, without the containers landing in these ports, there is nothing to fill for the home journey. As you’d expect, this is leaving exporters frustrated and very stressed, especially with seasonal crops needing to be shipped. See chart below for the increase in shipping costs from three major shipping companies – Maersk, Cosco and Triton.

SOURCE: Bloomberg

Baltic Dry Exchange – what is it?
The Baltic Dry Index (BDI), is issued daily by the London-based Baltic Exchange. It is reported around the world as a proxy for dry bulk shipping stocks as well as a general shipping market number cruncher. Every working day, a panel of international shipbrokers submits their assessment of the current freight cost on various routes to the Baltic Exchange. The routes are meant to be representative, i.e. large enough in volume to matter for the overall market. See chart below.

The challenges for the oil market with COVID-19

Another good video from the FT this time on the future of the oil industry. There is a movement towards more cleaner fuels by major companies in Europe but the same can’t be said about the US. Oil producing countries have been hit by lower prices but some like Saudi Arabia have sufficient reserves to fall back whilst others like Nigeria and Venezuela are financially exposed. Below is a graphic from the video looking at supply and demand – useful for an introductory lesson on the market.

Source: FT

Covid-19 and impact on the airline industry

The global airline industry has been one of those that has been hardest by Covid-19. In the US passenger volume is down 96 %, whilst globally losses have topped US$314bn worldwide. Based on booking patterns Air New Zealand will lose over NZ$5bn in revenue per year and a loss of 3.500 jobs. What makes it even worse is that the latest Oxford Economics forecast shows that the loss in global output could be double that of the GFC. This has implications on the speed of the recovery in air travel in the second half of 2020. The table shows that Asia-Pacific takes a big hit financially and is second behind Middle East/Africa (51%) with a 50% loss in RPK.

Source: IATA Economics

RPK = Revenue Passenger Kilometres is an airline industry metric that shows the number of kilometres traveled by paying passengers

IATA estimate that RPKs will decline by 48% in year-on year terms and passenger revenues will be US$314 billion lower this year compared to 2019- see table below. IATA note that a typical airline has cash to cover around two months of revenue loss.

Below is a short video from PBS Newshour with Paul Solman looking at the airline industry.

Baltic Dry Index – the forgotten indicator

A lot of attention has been paid to the drop in oil prices to $28 per barrel as of today which is indicative of the increase in supply from US shale producers and the fall in global demand especially from China. However there is another indicator that shows the global economy is in pause mode and that is the Baltic Dry Index which measures the cost of shipping raw materials – iron ore, coal, metal etc.

In mid January this year the index fell below 400 (see graph) for the first time since records began in1985. In June 2015 the index was comfortably above the 1000 mark and in 2010 approximately 4000, therefore transport costs are at a very low level.

Why are shipping costs at such low levels?

It comes down to simple supply and demand. On the supply side shipping companies have increased their dry bulk capacity as the cost of borrowing money is at very low levels. On the demand side it was assumed that global trade would keep expanding but according to a World Bank report global trade has slowed down sharply in recent years to around 3% and it predicted to slow further.

Cost for ship owners

Owners of the largest container ships (known as capsize vessels) reckon it costs $8,000 per day for running costs. However in today’s market, users of these ships only pay around $5,000 in fees which makes it uneconomical for ship owners to offer their service. With this is mind shipping bankruptcies are bound to feature this year and unless China produces a new growth spurt the Baltic Dry Index will keep heading south.

Baltic Dry Index – Jan 2009- Jan 2016

Elasticity of Demand for Air Travel

At the most basic level, demand for air travel is stimulated by economic activity and economic and social linkages between countries and cities. Travel is also stimulated by economic linkages (i.e. international trade) and social linkages (i.e. international migration). In general, there will be greater demand for travel between countries that have larger economies and populations. In addition, destination attractiveness is a key driver of demand for leisure travel.
There are many other factors that affect demand for air travel. When the economy grows, greater economic activity stimulates business travel and leisure travel increases as people’s income increases.

• Demand is stimulated by lower prices, both airfares and the price of tourism expenditure (e.g. accommodation and food) ‘on the ground’ at a destination.
• Demand for travel to any particular destination also depends on the price of travel to alternative destinations. Other factors that affect demand include distance, safety, and other one-off events such as health and terrorism scares.

The concept of elasticity is very useful for understanding demand drivers. Elasticity measures the responsiveness of demand for air travel to changes in some other variable such as prices or income. A price elasticity of -0.5, for example, means that a 10% increase in price leads to a 5% reduction in the level of demand for travel. Or an income elasticity of 1.2, for example, means that a 10% increase in income leads to a 12% increase in the level of demand for travel.

Many studies have attempted to estimate various demand elasticities for air travel. In terms of price and income elasticities, a meta-study by Gillen et al (2008) summarised 254 different estimates from 21 published studies and found an overall median price elasticity of -1.1, indicating that demand for air travel is relatively sensitive to price changes.

As would be expected, the results also indicate that travel for business purposes is less price sensitive than travel for leisure purposes with business short/medium hail elasticities between -0.8 and -0.6 and long haul elasticities between -0.5 and -0.2, compared to -1.5 to -0.9 for short/medium haul and -1.7 to -0.5 for long haul leisure travel. Gillen et al also report a median income elasticity of 1.4, suggesting that demand for air travel is relatively sensitive to changes in income. The table below represents the median for each market segment – Source: Air Travel Demand Elasticities: Concepts, Issues and Measurement.

Given that someone has decided to travel, their choice of airline and airport, when such a choice exists, depends on a number of micro-level factors including purpose of travel, ease of access to the airport, flight frequency, expected delays, and departure/arrival times (Ishii et al, 2009). Thus the demand faced by a particular airline depends on macroeconomic factors as well as other factors more directly under its control.

Source: The New Zealand Aviation Operational Environment: A Guide for the Tourism Sector 2010

Quirky Economic Indicator – length of a ladder

Listening to “From Our Own Correspondent” on the BBC World Service I came across an interesting piece by Kate Adie on Global Trade. With the downturn in global trade the international transport industry has been very much affected. Those that have been associated with the distribution of goods get an early indication of the slowdown in global growth. The obvious indicators are: idle cranes, queues of merchant ships dwindle etc. But what about the speed of cargo ships and the length of ladders to climb aboard?

When the world economy was “steaming” ahead the captain of a merchant ship said that they cruised at 20 knots but when the economic crisis of 2008 arrived we slowed to 16 knots. A harbour pilot summed up the state of world trade by the length of the ladders that he climbs on the sides of ships.

A long climb up the ladder signifies that the ship is high in the water and exports are correspondingly low.

A short climb up the ladder signifies that the ship is low in the water and exports are correspondingly high.

The seafarers say that they take air to China before they load up with goods for the US.