InterVISTAS’ analysis on the United Kingdom’s referendum and majority decision to leave the European Union
Vol. I
Executive Summary
Following the majority decision to leave the European Union in the UK’s referendum on June 24th, the watchword has been uncertainty. There remains great uncertainty around both the economic and political outcomes of this vote, much of which will remain for months, possibly even years. As yet, nothing has changed – only once the UK government triggers Article 50 of the Lisbon Treaty will the process of leaving the EU formally begin (a process expected to take up to two years). Until that time, the UK remains a member of the EU and is bound by EU laws and regulations.
Despite the uncertainty, we can consider some of the issues that will face the aviation industry as a result of Brexit.
Key Points Discussed in this Issue
The largest impact on the UK aviation sector will be from the economy – most forecasts predict lower economic growth following Brexit, which will have a negative impact on air traffic.
While the lower UK Pound may stimulate more inbound traffic, this will likely be offset by the higher cost of travel for outbound UK residents – 67% of the UK’s traffic is outbound.
Initial forecasts suggest that UK traffic will be 3-5% lower by 2020, than would have been the case without Brexit – negative but not catastrophic.
The UK will need to determine its future access to the EU Single European Aviation Market. The most obvious route would be to obtain the sort of equal access that Norway, and Iceland were able to obtain.
The UK may need to renegotiate its bilateral arrangement with third party countries (e.g., the U.S., and Canada), or choose to remain a part of the EU bloc in such negotiations.
The approach to security and borders are likely to be modified but largely unchanged, as the UK was never part of the Schengen (single-border) Agreement.
Brexit may see the return of intra-EU duty free at UK airports.
For more information please contact:
Marcus Balmforth
Managing Director
InterVISTAS Consulting
2 Abbey Gardens, Great College Street
Westminster | London SW1P 3 NL UK
Tel: + 44-203-451-8576
Mobile: + 44-7786-381635
E-mail: marcus.balmforth@intervistas.com
Economic Impacts to the UK and EU
Financial markets across the globe have reacted negatively to the success of the Leave vote, tumbling on uncertainties about the economic future of the world’s fifth largest economy, and its relationship with the European Union.
The difference between the FTSE 100 and FTSE 250 is that the former has a large component of global companies where the fall in sterling share price was offset by the appreciation of currencies where their profits originate. The FTSE 250 represents more domestic UK companies. The fall of sterling was complicated by a flight to safety in currency markets, with the US Dollar and Japanese Yen appreciating against other major currencies.
Note that these headline figures may somewhat exaggerate the medium and long term impact of Brexit. The quoted falls include the reversal of sharp gains earlier in the week as traders made the (erroneous and no-doubt costly) assumption that the UK would vote to remain in the EU.
Unsurprisingly, the UK Pound has declined in the days following the referendum. On Monday, June 27th, it reached just above US$1.30, down from around US$1.50 prior to the vote. This is the lowest exchange rate since the mid-1980s, and it is below levels during the depths of the Financial Crisis in 2009. While this 10%+ change is large, it is not such a monumental change that would induce a significant structural readjustment in the British economy (as experienced during past currency crisis in South America, and Asia).
Finally, the recent upward trend in global oil prices lost momentum as both Brent and WTI crude prices slipped again after declining earlier in the week on jitters over the referendum. However, the change in the price of oil was relatively minor with Brent spot prices dropping 5%, well within typical daily volatility in recent months. The nominal cost of oil in Sterling has, however, risen as the currency depreciation outweighed the dollar-denominated fall in crude prices.
Looking further ahead, the ‘Leave’ victory is expected by most experts to have negative consequences on the UK’s macroeconomic outlook. Forecasts will inevitably be revised downwards as many Brexit scenarios predicted a drop in economic activity and growth. Some estimates suggest that the UK’s economic growth over the coming two years could be cut in half compared to previous forecasts, suggesting growth in the 0.75-1.25% range per annum. Increased market volatility will likely play some role, but declining consumer confidence over job losses, slackening business investment, and trade uncertainty are likely to be the primary mechanism through which the UK’s output is reduced.
Goldman Sachs are forecasting that the UK’s GDP growth will be 1.5% in 2016, down from 2.0% predicted before the referendum, and that GDP growth in 2017 will be 0.2%, down from 2.0%. For longer term implications, we have to refer to forecasts produced prior to the referendum forecasting the cumulative impact of Brexit.
As shown in the table below, the UK’s GDP was forecast to be as much as 10% lower in 2030 than would have been the case without Brexit (i.e., not 10% lower than today’s GDP but rather the projected non-Brexit GDP in 2030). The scale of the impact is dependent on the assumptions made about how the UK’s membership is unwound and the economy’s response to that. Regardless of the scale, virtually all the mainstream forecasts predict a negative impact on economic growth.
(For currency rates refers to close of the London Stock Exchange.)
Of course, these forecasts are speculative, and no doubt new economic forecasts will emerge as events develop.
Implications for the Aviation Industry
The United Kingdom’s eventual departure from the European Union will undoubtedly have an impact on the aviation industry, both locally in the UK, and wider ranging through the EU, and across the world. The UK aviation industry is expected to be impacted by economic factors as well as regulatory and policy issues.
Slower Economic Growth Will Impact Traffic Growth
Indeed, a slower growing (or even recessionary) UK economy will result in slower traffic growth. The long term relationship between GDP growth, and traffic growth is well established and well documented.
IATA released a statement on the 24th June projecting the impact of Brexit on the UK’s traffic development. This projection considered two key impacts:
Lower GDP growth leading to lower traffic growth. GDP elasticities were applied to post-Brexit GDP forecasts produced by the UK Treasure, OECD and others.
The fall of the UK pound on outbound and inbound travel. The fall of the Pound would make travel to the UK cheaper for overseas visitors but more expensive for UK travellers. IATA notes that travel to/from UK is 67% outbound, but that the net impact would depend on the sensitivity of inbound and outbound travellers to exchange rate changes.
On this basis, IATA projects that UK air traffic in 2020 will be 3-5% lower than would have been the case without Brexit. Of course, exchange rates can fluctuate considerably, and the GDP impacts are equally uncertain, so the ultimate impacts may differ considerably. The conclusion from this is that the impact, while negative, is not catastrophic – the UK is an important air market that carriers will still want to serve.
While the overall impact may be relatively small, the impacts on individual airports could differ significantly. Regional airports that depend on outbound leisure traffic may be significantly impacted in the short to medium term by exchange rate changes. Airports with exposure to the financial sector, such as Edinburgh, and London City, may see impacts as the financial sector assesses and manages the impact of Brexit.
Investors are Negative on British Airline Stocks
The expectation of lower traffic and the general uncertainty has impacted airline share prices. Both the stock of EasyJet, and International Airlines Group (IAG – which includes British Airways) opened lower at the start of trading on Monday, after falls on Friday. The carriers’ stocks rebounded at points, but both carriers are down 20-25% as of 1 CET on June 27th. Note that although Ryanair’s largest base is at Stansted, it is an Irish company and will retain the regulatory privileges of an EU airline. Nevertheless, its high exposure to the UK has resulted in a 20% decline in its share price.
As Heathrow is Europe’s largest hub for transatlantic traffic (some 22% of European traffic to/from North America is via Heathrow), the share price of U.S. carriers with a heavy presence at Heathrow have also been impacted – both American Airlines and United Airlines are down around 15% (American is also a codeshare and Oneworld partner with IAG).
These share price fluctuations should be treated with caution as they are likely caught up in the general negative sentiment around Brexit – it is unlikely that the future earnings of these carriers will decline to such a degree that warrants the share price drop, especially on the back of the 3-5% traffic declines that IATA forecasts.
UK Needs to Determine its Future in the Single European Aviation Market
The UK’s EU membership enabled its access to the continent’s Single European Aviation Market where its airlines, and travellers enjoyed the benefits of a fully liberalised air transport market. The development of the single market was a boon to the UK’s aviation industry and was a major driver behind the rise of low-cost carriers in Europe such as Ryanair, EasyJet, and Norwegian, all of which have major bases in the UK. The UK’s departure from the EU will put the nation’s air carriers’ ability to operate unfettered, in the single market, into question.
Arguably, the most likely outcome of the UK’s exit from the EU would be the negotiation of UK entry into the European Common Aviation Area Agreement (ECAA). Non-EU nations, such as Iceland and Norway, enjoy access to and the privileges of the single aviation market, but paradoxically, require acceptance of EU aviation laws and regulations. As the UK’s aviation laws and regulations already conform to EU standards, it is reasonable to believe that they will continue to do so in the future, along with their membership in EUROCONTROL.
Alternatively, the UK could take the Swiss solution and negotiate a bilateral agreement with the EU and its Member States. This would require a similar level of conformity to general EU’s laws and regulations as is currently in place as an EU member.
Should the UK not re-join the EU’s single aviation market, British (and EU) airlines will suffer as single market operations will be unavailable. Analysts at HSBC indicate that up to 30% of EasyJet and Ryanair’s operations, and 25% of Wizz Air’s, could be impacted should the UK not be able to re-join the ECAA. As the proliferation of low cost carriers in Europe has largely been driven by the liberalisation of operational restrictions enabled through the common aviation market, these carriers would likely be the most affected. While carriers could get around restrictions by seeking air operating certificates in both the UK and the EU, doing so would add overhead costs and reduce operational flexibility which have been at the core of LCC business models.
Bilateral Renegotiation with Third Party Countries – Open Skies Turn Cloudy?
Beyond the European market, a non-EU UK will be faced with renegotiating its air service bilaterals with countries outside the EU. Bilateral renegotiation would be impacted on two fronts: market access of EU carriers, and the applicability of bilaterals negotiated with the EU as a bloc.
Under the EU, bilateral agreements between any Member State and a third state must then apply to any Member State (or member of the ECAA should they be included in the negotiations). A critical component for the UK going forward is the Community Carrier clause, whereby any carrier domiciled in an ECAA state has equal access to the terms of the agreement with the third state. This has implications not only for UK carriers accessing third states, but also to ECAA carriers operating from the UK. A clear example is the case of Norwegian operating services between the UK, and the US under the US-EU Open Skies Agreement. There is a potential that the renegotiation process will change the nature of EU carriers access to third states via the UK – a potential that is muddled by any requirements the EU puts in place for a new UK-EU agreement for joining the ECAA.
(We note that British Airports Authority (now Heathrow Airports Holdings),
is a private company, and is no longer traded on the stock exchanges.)
A second component will be the process of updating bilateral agreements to which the UK was a party to as a member of the EU, often called horizontal agreements. Depending on the terms of the UK’s exit, these horizontal agreements would cease to exist, and any bilaterals, such as the US-EU Open Skies Agreement, would need to be rebuilt. While the UK may decide to go it alone and pursue individual agreements, we see a solution that the UK may re-enter existing bilaterals through further horizontal agreements with the EU and the third states. Going forward, and especially if the UK maintains its integration in the single aviation market, the UK and EU may continue to pursue a policy of horizontal agreements in a similar fashion to the EU-bloc bilaterals in place today.
It is possible that the UK will choose a different path and use the exit from the EU as an opportunity to redefine the terms of their air service agreements with non-European states. However, continued integration into the single aviation market, and a radically different approach to non-European state bilaterals are not compatible – the UK will have to choose one or the other. We believe it is unlikely that the UK would significantly change the nature of their bilateral agreements in the future, especially as they have substantially reduced their bargaining power down from a market of a half billion potential travellers to just 65 million.
Other, more minor issues will also need to be resolved – for example, the anti-trust immunity that the EU has provided to members of the three alliances (oneworld, Star and SkyTeam) allowing carriers like British Airways and American Airlines to codeshare.
Our general expectation is that the impact of Brexit on air service bilaterals will likely be more of a diplomatic exercise than a significant structural shift in the nature of international air services in the UK and the EU. Nevertheless, there will need to considerable renegotiations in the two years after Article 50 is triggered, and it is possible that more than two years will be required to deal with all of the regulatory issues.
Borders and Aviation Security Facilitation Largely Unchanged
Unlike potential impacts to air carriers and the UK’s bilateral relationships, border and security facilitation issues are not expected to be significantly impacted in the short or medium term. As the UK was never part of Schengen (single-border) Agreement, border control, and border security enforcement will remain largely unchanged. Combined with the local provisions for the Common Travel Area between the UK and Ireland, is it not expected that the departure from the EU will substantially change border security policies or requirements. It is expected that the UK government will continue to cooperate with EU agencies to maintain border control, security standards, and policies that are in line with its EU neighbours.
On the aviation security front, the UK’s departure from the EU is expected to have some negative impacts. Cooperation on aviation security programs and policies between the EU, the US, Canada and Australia had previously seen the UK following suit as an EU member despite their requirement to apply their own rules domestically. With the UK’s exit, agreements and cooperation that were previously multilateral will now require additional bilateral cooperation to include the UK along with the EU.
This shift will add some complexity to the nature of the agreements in place and how airports and air carriers are regulated, but it is not expected to meaningfully detract from aviation security in the UK or the EU.
Duty Free is Back?
Duty free sales for travel between EU nations ended in 1999. Brexit could see the return of duty free sales at UK (and EU) airports for travel between the UK, and EU offering a significant boost in retail sales that may partially offset the impact of slower growth traffic volumes. Airport retail has moved on considerably since 1999, and the range of goods that could now be offered, duty free, is considerable.