Low-cost airlines: Stimulation effects wear off

Analysis of UK-Europe traffic shows that low-cost carriers (LCCs) will stimulate demand on new routes through lower fares for a few years. However, over time the new lower price/demand equilibrium point becomes established and organic growth rates return. In a mature market like the UK-Europe this means that high LCC growth rates cannot be maintained indefinitely.

The UK airline industry has been dominated in recent years by the rise of LCCs, and the market has grown significantly on the back of lower fares, increased competition, and more destinations to choose from. Barely a day would go by without Stelios or O’Leary appearing in the mainstream press, trumpeting the great growth story and the new world brought to the country through low-cost air travel.

So the following chart, showing passenger traffic between the UK and Europe between 1991 and 2013, is perhaps surprising. Expecting that the magic fairy dust of LCCs would shower perpetual growth on the market, instead the growth trend over the past 13 years has actually been downwards. Yes, there have been global crises during that time, from terrorism to volcanoes to financial crashes, but LCCs were taking over the continent, they were unstoppable.

UK-Europe passenger traffic, year-on-year growth 1991-2013

By the middle of the 1990s the market had recovered the fall in passengers during the 1990-91 recession. The real turning point in growth was 1996 with the first low-cost services to Europe from easyjet, with Ryanair arriving in force the following year.

From 1997 to 2000, growth averaged around 9% per year as LCCs added new flights to Europe, stimulating an array of unserved markets and significantly growing existing services. Not all the new passengers travelled on low-cost services, but their impact was significant. Between 1996 and 2001, low-cost passenger numbers grew by around 40% per year, while their full-service competition managed just 2%, albeit off a larger base.

September 11th put a temporary brake on growth in 2001, but the market bounced back by 2003, averaging 6% per year to the end of 2005. Despite a relatively healthy economy in the UK, growth from 2006 onwards began to fall, and the 2008 financial crash saw the market turn heavily negative, shedding passengers each year until positive growth returned in 2011. Despite modest growth in 2012 and 2013, the total market has still not regained the heady pre-crisis peaks of 2007, with traffic levels now on a par with 2006. So, despite the hype, the press coverage, strange new destinations and huge aircraft orders, the passenger market between the UK and Europe has effectively been stagnant for seven years. How can this be?

Stimulating markets with lower fares

Undoubtedly the financial crash of 2008 has had a significant effect on air travel in Europe, with many countries entering periods of recession as their economies went into reverse. But even before the crash, UK to Europe growth was already slowing, so without the recession the market was trending towards a growth rate of around 2%. Taking the recession out of the equation as a cause for the stagnant market, the explanation lies deeper in the way that the market has evolved since LCCs first took to the UK’s skies.

The LCC business model works best when passengers can be stimulated to travel by offering very low fares in the market. Passengers who wouldn’t previously have flown because of high fares are now stimulated to fly, thereby creating a new passenger market. The full stimulation effect of low fares in an existing market occurs when the fare differential is greatest; normally when the first LCC comes onto the route. If the existing average fare is, for example, £200, and the new average fare offered is £40, then the potential to stimulate a significant additional market is apparent. However, once the average base fare has been established at £40, then further discounting to £30 by a second new entrant LCC cannot stimulate the market with anything like the initial impact of the £160 reduction.

The floor in the average fare is the level below which services become uneconomical, where revenues don’t cover the costs even if the aircraft is full. In competitive situations, airlines might operate at below cost levels in the short-term to try and chase off the competition, but ultimately a route will only survive if it can be operated at a profit. In the example above, the second LCC in the market would have very little room for manoeuvre, as the margin between the average fare of £40 and the airline’s breakeven could be very small indeed. So although it may be possible to further stimulate the market and fill the aircraft at an average fare of £20 or £10, it would probably be uneconomical to do so.

Once low-fare stimulation has been fully played out, the competition becomes a battle for market share, a reversion to normal competitive conditions, albeit at lower fares. The driver for traffic growth passes from the airlines to the passengers: the state of the economy and the disposable wealth of the population become the engines for further growth; just as they were before the low-cost carriers arrived on the scene.

The step change in passenger numbers

This single route analogy can be scaled up to better understand the behaviour of larger markets, such as UK domestic services or services from the UK to Europe. The first movers with a low-cost model in Europe were Ryanair and easyJet, giving them a head start that they have exploited to the full. On launching their first European services in 1996/97, they were both able to bring that initial surge in passenger numbers delivered by significantly lower fares. Indeed, as every route the carriers opened in their early days was new to low fares, so the majority of markets saw a significant jump in passenger numbers through fare stimulation. This helps explain the healthy growth rates achieved between 1997 and 2000 in the UK to Europe market.

The following chart shows the annual passenger numbers from the whole London market to six of the first routes launched by easyJet in 1996/97 – Amsterdam, Athens, Barcelona, Madrid, Nice and Zurich. Between 1996 and 2000, the step change in passenger numbers is clear (an increase of over 60% since 1995), neatly coinciding with the launch and early years of easyjet’s Luton services.

easyJet UK-Europe launch routes, annual passenger traffic from all London airports

However, the routes struggled for growth after 2000, having to contend with both the September 11 attacks in 2001 and the financial crisis in 2008. In between these two events the UK economy was relatively robust, yet increasing prosperity couldn’t lift these six routes beyond low levels of growth.

The data suggests that the individual routes returned to what could be described as ‘mature’ levels of organic growth from three to seven years after low-cost services were introduced.

Ryanair expanded into mainland Europe from the UK in 1997, and by virtue of a different business model to that followed by easyjet entered into smaller markets, often using secondary airports as a gateway. Six of their first London routes were from Stansted to Malmo, Oslo (Torp), Pisa, Stockholm (Skavsta), Toulouse (Carcassonne) and Venice (Treviso).

Ryanair UK-Europe launch routes, annual passenger traffic from all London airports

In common with the easyjet experience above, the Ryanair markets also experienced a step change in passenger numbers with the introduction of low-cost services; from 1996 to 2000, the total passengers on these six routes grew by over 60%, coincidentally very close to the growth experienced on the initial easyjet services. Once again, growth cooled markedly after 2000, settling at a rate slightly higher than that achieved on the easyjet routes. In part this is down to smaller market sizes, but also the fact that with Ryanair operating into secondary airports at both ends of routes, there was scope for further growth between the primary airports operated by mainline or other low-cost carriers.

For Ryanair, the data suggests a slightly shorter period to post-low-cost maturity, varying from two to six years before growth resumes on a more normal trajectory.

Both of these charts illustrate well the theory that once a market has been stimulated by very low fares, the spectacular levels of growth cannot be maintained, and the markets return to the norm, albeit at a higher plateau. Indeed, the post low-cost growth in both charts doesn’t seem all that different from the level of growth experienced prior to the arrival of low-cost services. There is a new equilibrium reached at a different point in the relationship between demand and price.

Can UK-Europe keep on growing?

Yes it can, but not at the levels we have become accustomed to since the advent of low-cost services. These routes reached maturity within 6-7 years and normal organic growth rates now apply. Many trunk routes and sun routes from the UK into Europe have been served by low-cost carriers for nearly a decade. There are very few attractive routes left that have not already gone through the price stimulation-maturity cycle.

The chart below estimates the departing capacity of low-cost services from the UK to Europe since 2002. Growth was spectacular until 2007, after which it stopped. Since the market picked up following the financial crash and its aftermath, growth has averaged around 2% per year.

Departing seat capacity on LCCs from the UK to Europe 2002-2013

We have reached a new plateau in the UK-Europe market where spectacular market growth is a thing of the past. The ‘golden years’ of low-cost in the UK were probably between 1996 and 2006, with the routes launched during that period stimulating tens of millions of passengers to explore an ever-growing network of European destinations thanks to cheap fares. Low-cost is now the new normal.

By Richard Leigh Connect on LinkedIn

Richard Leigh