Fuel Surcharge and Air Travel Demand
Fuel Surcharge
The purpose of this study is an evaluation of fuel surcharge and the extent to which they impact air travel demand. Whatever justification the airlines may have for levying this surcharge and howsoever they may like to stress the point that they have not increased the basic fare of air travel passengers view fuel surcharge differently from that of the airlines. The passenger regards any charge added on to the basic fare as an additional element of expenditure that increases his travel cost which in turn affects his purchase decision.
Curiously, while all airlines in India levy fuel surcharge there are many airlines outside India that do not charge fuel surcharge (for a list of airlines charging fuel surcharge see Annexure 1). Despite the fact that fuel prices have been rising unstoppably to record levels over the last four years, many airlines have remained profitable and have minimised the harmful impact of increasing fuel costs. Airlines have found an efficient management tool capable of ensuring more stable returns for shareholders and investors within this hostile environment. However, to be fair to the airlines in India it must be stated that techniques for improving fuel efficiency have already been exhausted and with fuel prices at the current high fuel hedging is a risky operation, therefore evidence indicates that fuel surcharges are the only short term measure capable of dealing with the volatility of fuel prices. Hence, to prevent being financially eroded, airlines have introduced fuel surcharges as a way forward to pass the burden of increasing fuel costs onto passengers.
Introduction of fuel surcharge in India had a precedence with developments in the US and European aviation industry. In the US concern about the price of fuel started in 1993 when the Government of the United States proposed the introduction of a fuel-tax. This preceded the recent consideration of fuel surcharges but initiated the anxiety within airlines about fuel related costs. The intention for the revenue from the fuel tax was to reduce the federal budget deficit. As concern grew and crude oil prices reached the highest levels since the Gulf conflict five years before, airlines were motivated into rapidly considering alternatives in order to offset damages from globally soaring fuel prices and fuel related taxes. The likely solution was imposing a fuel surcharge on ticket prices in order to pass this burden onto the passenger. Consequently, many US airlines attempted to impart the rise of oil prices onto customers, although the attempt was unsuccessful. However, as a consequence of a series of developments American airlines were allowed to impose fuel surcharge in 2004, the airlines, among others, included Northwest Airlines and American Airlines. In Europe and Asia too similar action followed, in the passenger sector, KLM was one of the first airlines to add a surcharge to passenger fares (November 1996), although it was firstly introduced in the cargo sector by other airlines such as Lufthansa, Swissair Cargo or KLM Cargo. By 2000, both passenger and cargo airlines had introduced fuel surcharges onto customers to share the burden of soaring jet fuel costs, with different approaches and outcomes being achieved. Not only that but some low cost carriers, which always seemed quite reluctant to implement fuel surcharges, could not postpone them any longer and had to add them. That was the case of Virgin Express and Germanwings. Hence, all carriers were taking action to compensate higher fuel costs to some extent, either through fuel surcharges as network carriers or yield management as the preferred option of low cost carriers. The immediate effect of the fuel-related surcharge was a worldwide increase on fares that consequently helped airlines improve their average passenger yield. Hence, airlines decided to keep this surcharge in place since the increase in revenue associated with this yield improvement enabled airlines to offset the high fuel price costs.
In India departing from the trend witnessed in other parts of the world the low cost airlines were the first to introduce fuel surcharge. First introduced by Deccan in March 2006 (and followed by other airlines in quick succession) at a modest Rs. 150 per ticket fuel surcharge was largely ignored by the passengers as an additional cost. The reaction of the passengers seemed to convey an impression of approval of the action taken by the airlines and an appreciation of the problems faced by airlines due to rising fuel prices. Perhaps encouraged by the public response airlines embraced fuel surcharge with great enthusiasm and revised it in fairly quick succession. It has now reached a stage where fuel surcharge in most instances outstrips basic and undiscounted fare by a fair margin. In 2006 fuel surcharge was revised six times, in 2007, five times and in 2008, once so far. Consumer resistance to fuel surcharge hike has started to manifest. Whereas earlier objection to fuel surcharge was generally confined to voicing displeasure at the perceived opacity between the advertised fare and the fare actually charged by the airlines but of late voices are being heard who are ready to question even the necessity of such a surcharge. The Indian consumer has been conditioned by years of soft handling of domestic petroleum prices (which are not revised as frequently as ATF) and hence the reluctance of airline passengers to accept frequent increase in fuel surcharge as a common trend although between March 2006 and March 2008 share of fuel in the cost of operation of an airline in India has gone up from 24% to almost 40%.
Fuel Surcharge | ||
| | Cumulative | |
| March ‘06 | 150 | 150 |
| May ‘06 | 150 | 300 |
| July ‘06 | 200 | 500 |
| August ‘06 | 150 | 650 |
| September ‘06 | 100 | 750 |
| November ‘06 | 150 | 900 |
| May ‘07 | 150 | 1050 |
| July ‘07 | 50 | 1100 |
| August ‘07 | 150 | 1250 |
| October ‘07 | 100 | 1350 |
| December ‘07 | 300 | 1650 |
| April ‘08 | 150 (Short haul) 350 (long Haul | 1800 - 2000 |
As the table alongside indicates, fuel surcharge has been revised practically every alternate month and mostly by Rs. 150. How the sum 150 was arrived at and why it has remained the preferred rate of revision is not known. In fact, questions have been raised about the scientific validity of quantum of fuel surcharge being charged by the airlines. The amount is identical irrespective of type of aircraft, the length of distance and type of class flown.
Fuel surcharge is linked to the price of ATF, which in turn is linked to the price of Indian Basket of crude oil. Price of both ATF and Indian Basket has remained very volatile over the past two years with upward peaks far outstripping the downward troughs. Between March 2006 and March 2008 price of Indian Basket of crude oil has gone up by 51% and that of ATF by 34%. Incidentally price of Indian crude is lower than Brent but higher than Dubai prices.
During the period March 2006 and April 2008, ATF price has been revised every month while fuel surcharge has been revised only thirteen times. However, the significant difference is that during this period there were seven occasions of downward revision of ATF price but fuel surcharge was not reduced even once. in all fairness to the airlines it must be added that they had all along resisted imposition of fuel surcharge and been absorbing the price rise. Even after
introduction of fuel surcharge airlines have not increased fuel surcharge on every occasion that ATF price has gone up, which perhaps indicate that airlines are absorbing a part of the fuel price hike even now.
We have already noted how initial passenger response to fuel surcharge was one of indifference that, as we shall later see in the paper, with progress in time has change to being frosty. The airlines by their action of presenting fuel surcharge as an item that was similar to tax and not to price (fare) to a great measure contributed to this transformation in public perception. To begin with it created confusion as to the real nature of the surcharge in the minds of the passenger and once this confusion was cleared by some quick clarification issued by the government it left them in two minds as to the extent they could rely on the claims of the airlines; an issue that has been particularly bothering their mind is whether the airlines have taken to complacency and they are passing on their cost inefficiencies on to the passengers in the garb of fuel surcharge. Existence of such a possibility cannot be denied. Mergers and acquisitions in the industry have reduced competition among airlines. Deccan and Sahara had been performing the role of price setter and their aggressive pricing strategy had kept fares low. The two airlines have now been neutralised by take over. Realignment of airlines ownership has to an extent restored the monopoly power of full service airlines and returned to them their role of price setter. This brings us to the question of what has been the impact fuel surcharge on passenger demand.
Air Travel Demand
Economic growth, business confidence, people's desire to travel and price are the key drivers of demand for air travel. In the Indian context price plays the most important role. In normal circumstances and under competitive conditions it is expected that a rise in price would lead to a fall in demand. However, the relationship between demand for a good and its price is a bit complex. It is not necessary that one rupee fall in price of a commodity should result in one rupee worth of rise in its demand. Demand being also a function of individual’s preference, the nature of the commodity and several quantifiable as well as non-quantifiable factors, a one to one correspondence between price of a product and the demand for it rarely exists. Even where price is the most important determinant of demand who is bearing the burden of payment becomes an important element in decision-making; in such cases personal preference and comfort play a more vital part than price. This is of particular relevance in the case of aviation where there are a large proportion of business travellers who generally do not have to bear their own travel cost. Thus low cost airlines are more likely to feel the impact of rise in fare on their passenger demand than full cost airlines. Another factor that influences relationship between price of a product and demand for it is the availability of a suitable substitute. Availability of alternate mode of transport, like rail and road have a direct bearing on the degree of impact that rise in fare would have on passenger demand. In general, impact on short haul route is relatively more than on long haul routes.
Both to measure as well as separate the impact of price and non-price factor on demand for a product, economics uses the concept of elasticity of demand. Elasticity measures the response or sensitivity of one economic variable to the change in another economic variable. Elasticities are a useful concept as they allow decision makers insight into the impact of different economic actions. A common elasticity concept is demand elasticity. This measures the change in quantify demanded of a particular good or service as result of changes to other economic variables, such as the price of the that good or service, the price of competing or complimentary goods/services, income levels, taxes, etc. There are three types of elasticity, price elasticity, income elasticity and cross price elasticity. In the present study we would use the concept of price elasticity.
Price elasticity is a measure economists use to capture consumers’ sensitivity to price changes for a particular good or service. The price elasticity is defined as:
% Change in Quantity Demanded
Price Elasticity =
% Change in Price
Since the quantity demanded generally decreases when the price increases, this ratio is usually expected to be negative. As an example, suppose a good has a price elasticity of -0.6; a 10% increase in the price will result in an 6% decline in the quantity demanded. For a good with a price elasticity of -1.2, a 10% increase in the price will result in a 12% decline in the quantity demanded.
Goods with elasticities less than one in absolute value are commonly referred to as having inelastic or price insensitive demand – the proportional change in quantity demanded will be less than the proportional change in price. In this situation, increasing the price will increase the revenue of the producer of the good, since the revenue lost by the relatively small decrease in quantity is less than the revenue gained from the higher price.
Goods with elasticities greater than one in absolute value are referred to as having elastic or price sensitive demand - the proportional change in quantity demanded will be greater than the proportional change in price. A price increase will result in a revenue decrease to the producer since the revenue lost from the resulting decrease in quantity sold is more than the revenue gained from the price increase.
Demand Elasticities in the Context of Air Transportation
In air transportation, as in many other sectors of the economy, the context in which the elasticities are considered can affect the value of the elasticities. In particular, the elasticity can vary depending on the availability of substitutes. Five different levels of aggregation are described below.
Pan-National Level: At the pan-national level a fare increase is imposed at some pan-national level; for example, the European Union imposing an aviation tax on all its member states. In this case, the options for avoiding the fare increase are even further reduced, so therefore the elasticity would be expected to be lower.
In recent years Indian aviation has seen very few instances of hike in basic fare, higher fare has mostly come from increase in fuel surcharge (the other surcharge, congestion surcharge, being currently levied by airlines has remained constant at Rs. 150 since its introduction). What effect fuel surcharge has had on air travel demand is brought out in the following chart. As expected, air travel demand is inversely related to fuel surcharge. An increase in fuel surcharge has after a lag invariably led to a fall in demand; conversely whenever fuel surcharge has fallen in percentage terms the growth in passenger demand too has improved.
The chart also brings out another aspect that aught to worry the airlines. The curve representing passenger carried is getting flatter, that is, the long-term rate of growth is slowing down. This is a disturbing trend emerging from fuel surcharge hikes particularly for the low cost airlines. When the market is growing everybody gains but when it starts to shrink it hurts the smaller, low cost airlines more because when airfare go up the leisure travellers, who form the bread and butter of budget carriers, are the first to drop out. Airlines like, Goair, Indigo, MDLR are likely to face hard time in the coming future. Also, further mergers and acquisition could be on the card; 2009 could witness another round of churning in Indian aviation.
| Month Year | Cumulative Surcharge | Price Elasticity |
| Dec-07 | 1650 | - 0.18 |
| Oct-07 | 1350 | - 1.07 |
| Aug-07 | 1250 | - 0.05 |
| Jul-07 | 1100 | - 0.85 |
| May-07 | 1050 | - 0.45 |
| Nov-06 | 900 | - 0.16 |
| Sep-06 | 750 | - 0.14 |
| Aug-06 | 650 | - 0.05 |
| Jul-06 | 500 | - 0.07 |
| May-06 | 300 | - 0.09 |
| Mar-06 | 150 | |
| | AIRLINES FUEL SURCHARGE CHART | |
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