Premium #213 – The US Scope Clause – Aberration and Annoyance

"Scope Clauses" are collectively bargained contractual terms in pilot union agreements with US major carriers that place restrictions on how many and what size of aircraft regional airlines may operate. Typically, these restrict regionals to aircraft under 86,000 pounds and no more than 76 seats. Their goal is to protect union jobs at the major airline from being eliminated by regional airlines operating larger aircraft. Here is a summary of the current scope clauses with the three major legacy carriers in the United States. It is notable that the details are quite precise. These have been the subject of difficult negotiations, and while they have changed and grown somewhat over time, as aircraft have changed, any changes must be negotiated at the expiration of a contract, which typically run for multiple years. Back in March we wrote about the impact on fleets that the scope clauses forces. It is, frankly, a market aberration. Anything that prevents a company from optimizing its business is an artificial economic barrier. The case for scope clauses protects mainline pilots from lower cost regional airlines that have lower pay scales. We now have a US airline market that is an oligopoly. News of the pending merger between Virgin America and Alaska serves to tighten the grip of a few big airlines in a major air travel market. To think the consumer will win from this action is extremely naive. Wall Street will like it and so will senior executives at the airlines because their shareholders will benefit most. Regional airlines have brands that few outside the industry have ever heard of. This is because the regionals brand their fleets to match the majors they serve. The major airlines arrangements with regional airlines called "capacity purchase agreements" - which means the regionals provide the aircraft and fly the aircraft typically between hubs and smaller communities, on routes the major airline designates. This was great when regionals were flying small turboprops. But technology evolution never slows. Aircraft OEMs developed the regional jet - a small jet that seated 50 and could fly as fast as any jet and much further than the existing turboprops. And so began the fear among major (mainline) pilots as these small jets started flying everywhere. Major airlines could use these aircraft and their regional partners to disrupt their own business. Why fly a large jet in a marginal competitive market, when you can deploy a small and lower cost aircraft that better matches supply and demand? It is far more economically efficient, after all. It is easy to see why pilots at the big airlines, in all honestly, freaked out. Their job security was threatened. These small jets could connect all sorts of markets that would avoid hubs. It was, in essence, operating a parallel airline with the same brand. Major airlines could deploy regionals as a way to drive down their own production costs. Given the vagaries of running an airline, it was perfectly logical that airline managers would see this gap and exploit it. Perhaps the ones most exploited, however, are regional airline pilots. After finding a way to accumulate the 1,500 flight hours that are required to land a right seat job at a regional, a newly hired pilot today earns a meager annual income under $23,000 per year. Compare that with the incomes at a major airline, and you can see why the unions require these clauses – particularly when you realize that with pay cuts of 50% over the last two decades and inflation, they now earn net about a quarter of the real income as in the “good old days.” The scope clauses in their collective bargaining agreements (CBA) rigorously define and delineate what work is undertaken by airline employees covered under the CBA and what work, if any, is outsourced. Regional airlines are considered as outsourced work. Historically, when regional jets were first introduced, the pilot unions did not foresee what the smaller regional jets would do to their profession. A series of charts from the US Regional Airlines Association depicts the disruption these jets helped accomplish. Along with the rapid growth in regional carriers, major US airlines also had to face the rise of the Low Cost Carriers and cut costs to economically match that threat. Today, three of the largest regional airlines, Envoy, ExpressJet and SkyWest are now defined as major airlines in their own right as they each generate over a billion dollars of annual revenue. A squeeze was coming and something had to give. It is important to understand how major airlines continue to control the industry: Majors use their Capacity Purchase Agreements to buy the seats on the regional aircraft but perform the marketing, ticketing, and crucially, control the revenue. A regional airline in essence wet leases the aircraft and crew to the major. With a fixed revenue agreement with the major, the regional airline can increase profits only by cutting costs to the bone. Ask any passenger about a regional flight in the US and they can explain what that feels like. Why do people work for regionals? They do so because it is seen as the way to apprentice for a job at a major, a hopefully short stepping-stone in their career. This is part of the reason we are seeing a shortage of commercial pilots in the US. Pay is awful and prospective pilots cannot easily attain the recently increased number of hours they need to meet the FAA's requirements for airline operations (which were increased five fold without a logical transition plan.) This brings us back to airline economics. Regional airlines need bigger aircraft. They have fewer available crews to meet existing demand, so optimizing costs and making a profit requires moving more people on fewer flights. But the hurdle they run into is the scope clause forced on them by pilots at the majors. As a result, they cannot fly those larger aircraft today. What is the state of play on these deals? Scope clauses vary between airlines. The deals are constraining airline economics to protect mainline pilots. The major airlines are all trying to get rid of 50-seaters as fast as they can. (Some airlines are bringing back 50-seaters and there is no 50 seat replacement) They want larger aircraft doing the work at regionals. It means they can then drive down their costs again. As the last column in the chart above illustrates, appropriate aircraft to fit in the segment for larger regional aircraft are held back. In the following chart we can see that, in terms of pilots being open to revisiting scope clauses, timing varies. Pilot unions being what they are, what one deal accomplishes often becomes the floor for any future deal. In fairness to pilots, they have seen pay scales change and benefits dramatically shrink. It has been a tough profession and one with exacting standards and skill requirements. From a mainline pilot point of view, these scope clauses are rational. Scope clauses are necessary to maintain wages, because pilots have been harshly treated the last two decades by what can be described as frequently incompetent and arrogant airline management. Their once lucrative career is now just another job – with little security and low pay for the responsibilities the job requires. Without scope clauses, we would likely only see widebody operations by majors, and increasing outsourcing of all single aisle operations. Airlines expect perfection from their pilots but do not necessarily (in the US) treat them equally to what is demanded from them. This is why many pilots have left the US to fly for fast growing airlines overseas, especially Asian and the ME3 airlines. Being a commercial pilot enables an individual to find jobs worldwide, The difficulty is that wherever a pilot goes, they have to slot into a "seniority" system at the new airline. This can be very annoying for a pilot with 20 years experience and starting fresh at, say, Qatar, as routes and duty are seniority-based. As the chart illustrates popular aircraft like Embraer's E175 may fit within current scope but its improved E2 version does not. Similarly, the Mitsubishi MRJ90 - the most ordered model - also falls outside current scope. At Bombardier, the CRJ900 fits within scope but the CRJ1000 does not. Is there a way out of this weird arrangement? The consolidated US airlines do not want any more unhappy employees - especially pilots. They are making money hand over fist. Anything that rocks that boat will annoy shareholders, managers and employees. Delta's pilots already have their hands out for a 40% pay increase. What are the airlines and their managers going to do? As we heard from Allied Pilots Association (the collective bargaining agent for American Airlines pilots), "There is no appetite whatsoever at American, United or Delta for a deep change in 76 seat/86,000 MTOW change." Pilots don't want to touch scope. Any changes would likely be minimal, perhaps to enable a new aircraft type of similar size, like the E2-175 or MRJ90. But that is going to be a big fight. We expect absolutely nothing to disturb the juicy revenue stream for the majors. The majors will end up paying their union employees more - maybe not the 40% they would like - but much better because they can now afford it. With market power from consolidation, the majors have kept fares high even as fuel costs have fallen over 60%. This also means Wall Street is happy, as airlines are now worthy of "investment grade" ratings, allowing the brokers to market securities. The rising tide will not be disturbed. We think a fight with pilots over scope will be avoided, despite new more capable aircraft. So what happens to new aircraft with better economics? The OEMs offering them will have to market those bigger and better aircraft outside the US. The huge US regional airline market will be constrained from these new and larger aircraft because scope is unlikely to move soon. This means Embraer will keep building and selling its E-175 (as they have told us) even though the E2 is a much better aircraft. Mitsubishi will struggle with over 75% of its MRJ orders going to two US-based regionals. And Bombardier will continue to offer its CRJ900 that fits within scope clauses even though the slightly larger CRJ1000 is 5.5% more efficient. Of course, regional airlines will continue to squeeze employees and cost structures to stay in business. What does this mean for the future of the OEMs in the regional space? It is clear that if scope clauses do not move, the new aircraft models will not be able to operate in the U.S. This will block the largest market in the world for the E2 and the MRJ. Will this mean that the status quo will remain? It very well could mean that the aircraft that are on offer today may continue until negotiating scope once again becomes interesting. Over the last few decades, we’ve seen growth in regional aircraft from 19 seat turboprops to 30 seat turboprops, to 50 seat jets, and now 70-100 seat jets configured for 76 passengers in multi-class configurations. But will the growth stop, and where is the line drawn? New aircraft from Bombardier and Embraer can fit 135 and 132 seats respectively, capacities that were clearly in the mainstream and operated by aircraft from Airbus and Boeing. But new orders from those manufacturers have move to 150 and 162 seat and larger aircraft. While aircraft are increasing in size, the line between a regional and major is artificially fixed in place. There are great new regional aircraft becoming available today, from the MRJ90 to CSeries to E2Jets, but US regionals won’t be able to take advantage of them because of unyielding scope clauses. It all comes down to who should operate these airplanes, low cost flight crews from regionals or high cost flight crews from majors? The biggest loser will be the US airline consumer, paying top dollar for flights operated by regionals using smaller aircraft, which translates to an even worse travel experience. Welcome to the stupidity of scope clauses, which along with all other artificial market constraints should be trashed.

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