40
1 First Draft. Please do not quote without permission. Comments are most welcome. Hybrids within Hybrids: A Challenging Organizational Arrangement in the Airline Industry Claude Ménard and Gézia Damergy Centre d’Economie de la Sorbonne, Université de Paris (Panthéon-Sorbonne) EMNET CONFERENCE, AGadir (Morocco), November 21-23 2013

Hybrids within Hybrids: A Challenging Organizational Arrangement in the … · 2014. 1. 28. · 2 Hybrids within Hybrids: A Challenging Organizational Arrangement in the Airline Industry

  • Upload
    others

  • View
    17

  • Download
    0

Embed Size (px)

Citation preview

  • 1

    First Draft. Please do not quote without permission.

    Comments are most welcome.

    Hybrids within Hybrids:

    A Challenging Organizational Arrangement in

    the Airline Industry

    Claude Ménard and Gézia Damergy

    Centre d’Economie de la Sorbonne,

    Université de Paris (Panthéon-Sorbonne)

    EMNET CONFERENCE, AGadir (Morocco),

    November 21-23 2013

  • 2

    Hybrids within Hybrids:

    A Challenging Organizational Arrangement in the Airline

    Industry

    Claude Ménard and Gézia Damergy

    Centre d’Economie de la Sorbonne,

    Université de Paris (Panthéon-Sorbonne)

    1. Introduction.

    Strategic alliances on international markets are now a dominant feature in the airline

    industry. Restrictions on cross border mergers, fed by national pride embedded in tight

    regulation, and the need to offer a seamless service “from anywhere to anywhere” with

    efficient worldwide connections have pushed major airlines to take advantage of the

    deregulation movement of the 1980s-1990s to build networks in order to achieve significant

    economies of scope and density. The three international global alliances nowadays provide

    about 60 % of air transport capacities.

    In what follows, we refer to these alliances as “hybrid” modes of organization, in line with

    recent developments in organization theory inspired by Williamson (1996).1 By hybrids, we

    mean organizational arrangements between two or more economic entities that put

    together significant decision rights and, in numerous cases property rights, while remaining

    legally and economically distinct, each entity keeping control over key assets in last resort.

    The intensity of shared rights largely determines the type of hybrid at stake and the

    modalities of governance chosen. Although there is already an abundant literature available

    on airline alliances, not much is available on these issues of allocation of rights and the

    associated problems of internal organization and governance

    1 For a detailed review and discussion of this literature, see Ménard (2012).

  • 3

    Recent evolution in the airline industry has made the picture of these hybrid arrangements

    with their overlapping rights even more complex. Indeed, subsets of members within the

    same alliance are now developing specific agreements, with much tighter coordination and

    the acceptance of a complex set of rules to pilot the venture. The agreement between Air

    France-KLM/Alitalia/Delta implemented over the recent period provides a vivid illustration.

    As a result we have hybrid forms blooming within existing hybrids, with distinctive

    characteristics that make them apart from the global alliance of which they are nevertheless

    central players.

    These layers of intricate arrangements raise important problems with respect to the stability

    of the alliance and the governance of the new structure. Our paper focuses on two key

    issues in that respect. First, these “hybrids within hybrids” are getting close to full

    integration when it comes to strategic decision rights although parties to the arrangement

    remain almost entirely separate when it comes to property rights. Why is it so? Are

    institutional constraints the only explanation or are there also issues of performance that

    would favor these arrangements? Second, what mode of governance can overcome the

    tensions resulting from the sharp distinction between strategic decision rights that are

    pooled while control over key assets remain in the hands of the different entities?

    Our paper develops elements of answers to these complex questions. Section 2 reviews part

    of the literature on strategic alliances, particularly in the airline industry, in relation to the

    literature on hybrids, thus providing the basis of our theoretical framework. Section 3

    examines the different steps in the development of hybrid arrangements in the airline

    industry, from tactic alliances to strategic alliances to the more recent organizational

    ventures, and the associated differences in the allocation of rights. Section 4 explores more

    systematically the core properties of the ‘hybrid within hybrid’ mode of organization though

    a review of the pioneering venture developed by Air France/KLM/Alitalia/Delta since 2008.

    Section 5 discusses more specifically the complex governance structure implemented to

    monitor this venture and draws some lessons about the issues at stake, particularly the

    sustainability of such arrangements. Section 6 concludes with lessons for organization theory

    drawn from this analysis.

    2. Strategic alliances as hybrids: where do we stand?

  • 4

    Economists were initially reluctant to take into account strategic alliances and other

    ‘hybrids’, perceived as non-standard modes of organization that did not fit well in their

    “production function” approach to the firm.

    Consequently, most early contributions came from managerial sciences and sociology or

    from economists working on the frontier of these disciplines. Strategic alliances were

    perceived as specific forms of inter-firm arrangements. For example, Parkhe (1991: 581)

    defined alliances as « a relatively enduring inter-firm cooperative arrangement, involving

    flows and linkages that utilize resources and/or governance structures from autonomous

    organizations, for the joint accomplishment of individual goals». Similarly, two early surveys

    looked at strategic alliances as one form among the more general network arrangements

    (Grandori and Soda, 1995) and as arrangements that escaped well-established theories and

    that were approximated through messy analytical frameworks (Oliver and Ebers, 1998). One

    of the very first books that looked at strategic alliances as a class of their own deserving

    specific analysis was provided by Nooteboom (1999), who also devoted an entire chapter to

    governance issues.

    2.1: Theoretical background.

    Progressively, three leading approaches emerged that still dominate the landscape with

    respect to alliances. A pioneering perspective was offered by the so-called ‘resource-based

    view’, initiated by Wernerfelt (1984), which developed a distinction between resources,

    which are tradable and non specific to the firm so that they can be acquired through markets

    or inter-firm arrangements; and capabilities, which are specific to a firm so that to trade or

    share them would challenge the firm’s identity and even its survival (Amit and Schoemaker,

    1993). However, the main focus of Resources Based View is about how a firm secures its

    capabilities and creates barriers to imitation rather than providing an explanation to

    strategic alliances and other cooperative agreements that would go beyond means to

    circumvent scarcity of resources.

    More influential among economists trying to understand the nature of alliances has been

    agency theory. Indeed, when confronted to problems of controlling and monitoring some of

    their resources, firms may have an incentive to outsource to partners while securing the

    provisions of goods or services at stake through credible contractual agreements (Lafontaine

  • 5

    and Slade, 2012: 962 sq.). However, the emphasis in that perspective is less on the existence

    of strategic alliances or other alternative modes of organization than on the incentive for

    firms to deal with partners to overcome internal problems. Hence, the theory focuses on the

    firm, not on alternative arrangements.

    In that respect, it is the transaction costs perspective inspired by Williamson (1991) that has

    prevailed in the development of a positive analysis of inter-firm agreements such as

    alliances, franchise, joint ventures, and so forth.2 A recent contribution (Baker, Gibbons and

    Murphy, 2009) proposes a distinction between different forms of alliances based on the

    allocation of rights and outcome, complementing Transaction Cost Economics with the

    introduction in the analysis of alliances of a fruitful distinction between property rights and

    decision rights. Our theoretical framework largely builds on these contributions.

    2.2 : A short review of the literature on air alliances.

    Before turning to our model, it is important to take note of several contributions more

    specifically focused on airline alliances, a topic of intensive research over the last decade or

    so.

    Several authors paid special attention to the concept of strategic alliances. Li (2000) made an

    important contribution to the identification of different forms of strategic alliances and the

    evolution of their modes of cooperation analyzed from an industrial organization

    perspective. Morrish and Hamilton (2002, p. 401) qualified these modes of organization as

    “any collaborative arrangement between two or more carriers involving joint operations

    with the declared intention of improving competitiveness and thereby enhancing overall

    performance”.

    In their effort to circumvent the concept, authors also exhibited factors that could motivate

    this choice. Button et al. (1998) emphasized that alliances generate synergies by combining

    resources and expertise, opening the door to functional complementarities (the most

    illustrative being code sharing and frequent flyer programs that gave way to the so-called

    ‘dog-bone’ networks), while allowing members to have easier access to important financial

    2 For a survey of the dominance of the TCE approach to franchise systems, see Lafontaine and Slade (2007); and

    Ménard (2012) for the more general hybrid arrangements.

  • 6

    resources. Thanks to these arrangements, firms otherwise rivals learned to share goals in

    order to improve performance and reach higher level of profitability. Other arguments focus

    on uncertainty and complexity. According to Luo (2007) alliances are an effective way for

    members to reduce costs but also uncertainty by sharing risks. “From a self-selection

    perspective, joint ventures are more likely to be chosen than other entry modes in situations

    with high uncertainty, meaning that environmental volatility plays a role on the selection of

    the joint venture mode” (Luo, 2007, p. 40). Globalization is also viewed as an important force

    having pushed towards alliances. According to Ireland, Hitt and Vaidyanath (2002), in a

    globalized environment no single firm has all resources needed to gain and sustain a

    competitive advantage on the long run. Bilotkach and Huschelrath (2012) substantiate the

    point, emphasizing that in a global market, the level of demand on most city-pair markets is

    not sufficient to sustain regular non-stop services, so that forming international global

    alliances is an important way for airlines to facilitate inter-connections for consumers. This is

    close to the argument made by Nielsen who pointed out that as market complexity increases

    “inter-firm collaboration becomes a crucial component in building a competitive advantage”

    (Nielsen, 2010: 682).

    However, the underlying element to all these views is that alliances improve performance. Is

    it so obvious? Porter (1990) submitted that alliances are a tool for extending or reinforcing

    competitive advantage, but rarely a sustainable means for creating it. Morrish and Hamilton

    (2002) went a step further. In an extensive review of alliances that developed in the period

    1986-2000, they suggested that despite the increase of load factors and productivity, there

    is no convincing evidence that alliances have had a positive impact on the competitive

    position and profitability of members, the increased frequency of flights having been

    counter-balanced by decreasing fares. At about the same time, Oum et al. (2000) published

    one of the most important empirical analyses of the impact of alliances on airlines’

    performance. Airline alliances are portrayed as a strategic management choice, designed to

    enhance competitive capabilities in business rivalry. The authors identified two main

    advantages in joining an alliance: improved operational productivity and improved

    competitive position through market power. Other important contributions are from Barla

    and Constantatos (2006), who showed that profits might be greater under strategic alliance

    than under full merger; and from Brueckner and Whalen (2000) and Bilotkach (2005) who

  • 7

    examined the impact of alliances on airfares as well as the effect of competition among

    alliances, and concluded that alliances benefit passengers, thanks to the complementary

    nature of the products and the removal of double marginalization. More recently, Brueckner

    and Picard (2012) showed how antitrust immunity limits the potential anti-competitive

    effects of cooperation in alliances by reducing incentives to collude among international

    alliances.

    However, notwithstanding their richness, most analyses fall short so far of looking at the

    governance issue that is so central to the sustainability of alliances. It is so, with a few

    exception (see De Man, Roijakkers and De Graauw, 2010) because these analyses rely so

    much on a standard industrial organization approach, with inter-firm agreements explored

    essentially through their impact on market structures.

    2.3 Our Analytical Framework.

    Without ignoring the significance of the issues raised in this market-oriented literature, we

    would like to propose a theoretical framework that we derive from transaction cost

    economics, enriched by the relational contract approach (Baker et al., 2008). This framework

    intends to make room for the problems of governance on which so much of the success or

    failure of the redistribution of rights among parties to an alliance depends. In the context of

    alliances, we understand governance as the process through which rights and assets are

    allocated and transactions are established, implemented, and monitored through specifically

    designed mechanisms. In line with the concept developed by Williamson (1996: chap. 4),

    strategic alliances can be understood as forms of hybrid arrangements, in which two or more

    partners pool strategic decision rights as well as some property rights, while simultaneously

    keeping distinct ownership over key assets, so that there is the need for specific devices to

    coordinate their joint activities and arbitrate the allocation of payoffs.

    Let us consider a simplified case with only two firms, 1 and 2, and four assets {A,a; B,b}. A

    and B are assets essential to the core activity of 1 and 2, respectively, and remain operated

    within their respective boundaries, while a and b are assets valuable if and only if used

    jointly. Each firm holds full decision rights DA and DB, while rights da and db require

    coordinated decision making since linked to the joint usage of a and b. The resulting payoffs,

    associated to property rights at hands, are therefore ПA, ПB, πa, and πb, with the last two

  • 8

    generated if and only if the corresponding assets are jointly used (profits are zero

    otherwise). The basic hypothesis underlying our analysis of hybrids is that in order to benefit

    from the joint usage of a and b, the partners have to develop specific devices to coordinate

    actions related to these assets, while they often remain competitors on other sets of action.

    As discussed below, the nature of these devices and the extension of their power depend on

    the type of decisions, and possibly assets, that are shared.

    Figure 1 synthesizes the complex allocation of rights and assets that characterize hybrids:

    black arrows suggest the assets and rights that rely on joint coordination, while the

    horizontal arrow suggests the possibility that partners simultaneously compete. However,

    the figure does not provide indications on the exact nature of the coordinating devices

    implemented by partners, an issue to be discussed below.

    FIGURE 1: THE COMPLEX ALLOCATION OF RIGHTS AND ASSETS IN HYBRIDS

    Source: Ménard 2009

    Important problems of coordination and implementation of decisions immediately arise

    from such arrangements. The nature and magnitude of these problems precisely determine

    the choice of governance mechanisms … and the possibility of their misalignment with tasks

    to be done. Indeed, a key issue in strategic alliances (as in other forms of hybrids) relates to

    FIRM 1 A D

    A

    ПA

    FIRM 2 Β DΒ

    ПB

    STRATEGIC COORDINATION

    => {a, b, d

    a, d

    b, π

    a, π

    b}

  • 9

    the matching between the transactional hazards that partners are facing and the allocation

    and monitoring of rights among them.

    There are several sources of transactional hazards that can open room for opportunistic

    behavior, threatening the stability or even the existence of such alliances. First, we assumed

    above that part of the decision to go hybrid comes from the fact that some assets have no

    value (or a negligible one) if they are not exploited jointly. It means that bilateral

    dependence develops and that a party cannot presume that her partners are in symmetric

    position, so that incentives to behave strategically may occur. Second, measurement

    problems often emerge, due to the overlapping of rights. This is typically so when partners

    invest jointly in a new technology, or in marketing, or in R & D projects. Third, conditions

    that prevailed at the time the alliance was negotiated and accepted may change, creating

    unexpected reallocation of costs or profits, with the risk that one or several partners will not

    pass the adequate information, or will not transfer information on time. Fourth, the

    agreement may not have defined property rights properly, either because doing so would be

    too costly (contracts are most of the time incomplete) or because the contract was

    purposely left open to facilitate adjustments. Still, events may require more substantial

    adjustments than initially expected, as the financial crisis of 2008 illustrates, thus imposing

    drastic changes to the alliance. Fifth, the institutional environment may not provide

    adequate guarantees, as when some partners to an alliance are from a country that does not

    properly secure property rights, so that deviants could hardly be sanctioned.

    2.4 A governance issue.

    Potentially exposed to these hazards, hybrids must find a mode of governance that gives

    partners some control over the resulting risks of opportunism or at least some control over

    the behavior of partners. In that context, governance refers to the devices implemented to

    monitor the allocation of decision rights as well as property rights, while simultaneously

    minimizing the transaction costs generated by these actions. The allocation of decision rights

    determines the degree of centralization/decentralization of devices in charge of coordinating

    the joint use of assets of type a and b. The allocation of property rights determines the

    expected benefits from joint use of assets and the degree of control transferred by partners

    to the coordinating device.

  • 10

    Three stylized modes of governance can be adopted to monitor this allocation of rights.3

    When parties share very few rights, particularly rights over specific assets, but still can

    expect value added from some joint activities, they tend to rely on a limited coordination,

    developing information-based networks. There is no need in such cases to develop well-

    specified rules regarding rent-sharing and to establish complex, detailed contracts.

    Nevertheless, hazards can come out of asymmetric information, giving parties incentives to

    endorse devices that facilitate unbiased transfer of information, e.g., shared software.

    Therefore, some forms of control are needed, particularly with respect to the quality of

    information shared. As we will see in the next section, this type of arrangement corresponds

    quite well to the tactic alliances initially developed in the airline industry.

    When expected quasi-rent from joint activities becomes more significant but requires

    sharing important rights, parties become increasingly aware of the risks of potential

    opportunism. Pooling important decision rights and, in some situations, limited specific

    assets requires more intense coordination and forms of control. Contracts become more

    complex, adjustments more difficult to monitor, and the need to punish deviants more

    significant. Cooperation in this context requires mechanisms of governance with power to

    constrain and sanction. Typically, partners tend to rely on third party enforcers: clauses will

    refer to mediators designed as such in the agreement, to external arbitrators with

    procedures well defined, or even to courts in charge of filling contractual blanks, regulating

    adjustments, solving disputes when parties are not able to overcome directly their

    disagreement but still want to maintain cooperation, and even punishing deviants without

    challenging the possibility of shared activities. The shift from tactic to strategic alliances

    corresponds to that phase (see Section 3).

    There is a point, though, when these external enforcers cannot do the job adequately or can

    expose partners to too high transaction costs. When expected benefits require sharing

    strategic rights and depend on substantial joint investments and/or joint usage, risks in

    relying on third party become dissuasive: external enforcers may not have the required

    expertise or may depend on the support of highly priced experts, their decision can be highly

    unpredictable and at risk of being disruptive for the relationship, and so forth. Partners then

    3 Details on this typology can be found in Ménard (2012, section 5)

  • 11

    have an incentive to build a joint strategic center to which essential decision rights and even

    some key assets can be transferred, control over parties to the agreement can be delegated,

    and capacity to punish deviation may even be allowed. This strategic center can take

    different forms, although it almost always relies on a specific entity, as in joint ventures. As

    developed below, an original mode of governance of this type has been implemented in the

    venture between Air France-KLM, Alitalia, and Delta.

    Because these modes of governance are alternative ways to monitor and control hybrids,

    there is a trade-off. Our basic assumption, inspired by a transaction cost approach, is that

    parties have an incentive to select devices that can appropriately match the allocation of

    rights while facing the transactional hazards this allocation generates. The more rights are

    shared, the more parties have incentives to switch from information-based networks to the

    building of a strategic center. We now turn to the exploration of this evolution in the airline

    industry.

    3. From Tactic Alliances to Strategic Global Alliances to Joint Ventures

    Beside being now a leading force in the airline industry, H alliances have deeply evolved with

    respect to the nature of rights shared and their allocation among parties. In what follows, we

    briefly assess the importance of these alliances and, after a short reminder of their origin

    and the factors that gave the impulse to their development, we review the arrangements

    that marked their evolution and opened the way to the emergence of their most recent

    form, which we identify as ‘hybrids within hybrids’.

    3.1: How empires were born.

    Alliances between airlines are now a dominant feature of the industry. The three leading

    alliances represented in 2011 almost 60 % of all commercial air traffic (Star Alliance: 24,8 %;

    SkyTeam: 19,6 %; Oneworld: 15,1 %), with a total of 1547 million passengers transported

    that year4. The number of their active members grew from a handful in the early 1990s to 58

    4Star Alliance was founded by Air Canada, Lufthansa, SAS, Thai Airways, and United Airlines in 1997; Oneworld

    was founded by American Airlines, British Airways, Canadian Airlines, Cathay Pacific and Qantas in 1999; and

    Sky Team was founded by AeroMexico, Air France, Delta Air Lines, and Korean Air in 2000. Qualiflyer, created

    by Austrian Airlines and Swissair in 1992, was dissolved after Swissair went bankrupt in 2002.

  • 12

    at the end of 2011 (membership of

    Oneworld: 12 airlines). Members of the alliances are listed in table 1 below.

    TABLE 1: MEMBERS OF THE THREE GLOBAL ALLIANCES.

    Although a few members have

    Spanair), each alliance is still on strategy of expansion, targeting new members in specific

    parts of the world. For example,

    East member of a global alliance. However, the boom

    ‘open skies’ policies is now almost over and has left way to a more guarded ap

    focused on the provision of well

    for more efficient modes of organization, particularly through the development of varieties

    of joint ventures among subset of members within existing alli

    The power of the Big Three is well illustrated by some basic data.

    $445billion of total revenues, with shares relatively proportiona

    Alliance: USD 201.8 bn; SkyTeam

    yielded collective net profits of

    data with respect to these alliances and their power.

    TABLE 2: MAIN CHARACTERISTICS OF THREE LEADING ALLIANCES

    membership of Star Alliance: 27 airlines; Sky

    Members of the alliances are listed in table 1 below.

    LE 1: MEMBERS OF THE THREE GLOBAL ALLIANCES.

    Source: Authors’ compilation

    have disappeared or have been absorbed (e.g.,

    ), each alliance is still on strategy of expansion, targeting new members in specific

    rts of the world. For example, Saudia recently joined Sky Team, becoming the first Middle

    East member of a global alliance. However, the boom that followed the implementation of

    ‘open skies’ policies is now almost over and has left way to a more guarded ap

    focused on the provision of well-tailored capacities, consolidated revenues, … and the search

    for more efficient modes of organization, particularly through the development of varieties

    of joint ventures among subset of members within existing alliances.

    is well illustrated by some basic data. In 2011, the

    $445billion of total revenues, with shares relatively proportional to their traffic (

    SkyTeam: USD 137.1 bn; Oneworld: USD 106.6 bn

    collective net profits of USD 5.5 bn. Table 2 summarizes some of the most illustrative

    data with respect to these alliances and their power.

    : MAIN CHARACTERISTICS OF THREE LEADING ALLIANCES

    Sky Team: 19 airlines;

    Members of the alliances are listed in table 1 below.

    LE 1: MEMBERS OF THE THREE GLOBAL ALLIANCES.

    disappeared or have been absorbed (e.g., BMI, Malév, or

    ), each alliance is still on strategy of expansion, targeting new members in specific

    , becoming the first Middle

    that followed the implementation of

    ‘open skies’ policies is now almost over and has left way to a more guarded approach,

    tailored capacities, consolidated revenues, … and the search

    for more efficient modes of organization, particularly through the development of varieties

    2011, they generated

    to their traffic (Star

    bn). That year, they

    some of the most illustrative

    : MAIN CHARACTERISTICS OF THREE LEADING ALLIANCES

  • 13

    Star Alliance Skyteam Oneworld

    Year of formation 1997 2000 1999

    Members (airlines) 27 19 12

    Passengers (millions) 449 436 300

    Employees 448 926 436 000 299 967

    Daily departures 21 900 15 465 8 837

    Countries served 194 187 157

    Total revenues

    (in USD billions )

    * data for 2011

    201,8* 137,1* 106,6*

    Source: Compilation by the authors.5

    * data for 2011

    It took these alliances almost 25 years to reach that level of development. According to Oum

    and Yu (1998), the first international alliance linked Air Florida with British Island in 1986,

    although Li (2000) suggests that alliances emerge even earlier, as with the alliance between

    Avico and Iberia, established in 1948, and some may go as far as 1919.

    The early alliances were essentially bilateral, corresponding to tactical choices, with some

    shared flights, schedule coordination, maintenance consortia and/or joint ground/catering

    services. These bilateral tactical alliances are still used by airlines to address specific

    deficiencies in their networks, but most carriers providing international services now prefer

    to join a global alliance to take advantage of their worldwide networks. As emphasized by Li

    (2000: 65) “The general consensus is that if an airline does not join an alliance it will be

    operating under a serious handicap.”

    5 Based on the website of each alliance as of April 2013, with the exception of the item ‘Total Revenues’ based

    on Airline Business, September 2012

  • 14

    However, it is only in the mid-1990 that broad multilateral alliances took off. With the

    development of computerized reservation systems, early alliances evolved towards more

    complex arrangements, with code-sharing agreements, joint Frequent Flyer Programs,

    shared ground handling, and so forth. One of the earliest alliance of the new generation was

    the ‘Global Excellence Alliance’ between Singapore Airlines, Delta Airlines and Swissair; it

    started in 1989 and ended in 1997. The main impulse likely came from the deregulation of

    air traffic, giving incentives for airlines to go further than bilateral agreements. As noted by

    Button (2008: 61), “Open Skies air service have not only removed restrictions governing

    rates and fares, market entry, and the ways revenues are allocated, but have also permitted

    the emergence of various forms of business alliances”. It is noticeable in that respect that

    the three leading global alliances were all created between 1997 and 2000, and that “ [they]

    are no longer mere loose arrangements between a few airlines to share flight codes and

    cross-sell tickets. Rather, they are aiming at virtual mergers to bypass national rules

    governing foreign ownership of domestic carriers and provisions on cabotage” (Li, 2000: 66).

    3.2: Evolution

    Notwithstanding their short life span, these alliances went through quite spectacular

    organizational transformations. To better understand this evolution, it is useful to keep in

    mind the different ingredients that can enter in an alliance, the mix of which determines

    different hybrid forms. Li (2000:67) listed fourteen such ingredients that we can find in an

    airline alliance:

    BOX 1: INGREDIENTS THAT CAN BE FOUND IN AN AIRLINE ALLIANCE

    C01 – Equity: Taking up of shares in another carrier.

    C02 – Joint Frequent Flyer Program.

    C03 – Code-sharing: A marketing arrangement between airlines allowing them to sell seats on each other’s

    flights under their own designator code. In the case of connecting flight of two or more code-sharing

    carriers, the whole flight is displayed as a single carrier service on a computer reservation system.

    C04 – Block seat and space arrangements: A contractual arrangement between two airlines, whereby a

    specified number of passenger seats or cargo space are allocated between more than two points on

    a carrier’s route for a given period of time. The space swap agreement (usually as a side agreement

  • 15

    of a code-share package) is also included here.

    C05 – Joint marketing: usually involving setting up of joint sales office.

    C06 – Joint purchasing: An arrangement where partners in the agreement buy things in bulk to enjoy

    economies of scale. Examples include utensils, engine parts and etc.

    C07 – Ground support: Including ground handling, engineering, maintenance and cargo.

    C08 – Airport facilities sharing arrangements: These facilities include passenger lounge, hangars, slots and

    other equipment in the airport.

    C09 – Flight scheduling: Joint planning of flight schedule among carriers to minimize the transit time.

    C10 – Pool agreements (revenues and costs): Agreement between two or more airlines to combine capacity

    operated. Tickets for the agreed sectors are used interchangeably without endorsement. Aspects

    include revenue pooling, revenue sharing and cost sharing.

    C11 – Franchise/royalty: The use of another airline’s color/arrangements.

    C12 – Information technology co-operation: Linking of IT systems together.

    C13 – Joint operations: Including joint services/flights and business ventures. A scheduled air service operated

    by an airline between points on its own behalf and that of another airline by sharing the costs and

    revenue on an agreed basis. Each carrier assigns its own airline code and flight number, which is

    both, displayed as a joint service.

    C14 – Commercial agreement: Arrangement from one airline to another for use of certain traffic rights. This

    arises because there is no reciprocity in the exchange or usage. For example, Country A may allow a

    carrier from Country B to operate to Country A even when its own carrier has no plans to operate to

    Country B. To facilitate this, a carrier from country B may agree to a commercial agreement with a

    carrier from Country A.

    Source: Li (2000: 67)

    The number and type of ingredients entering in an alliance does not only define the variety

    of observable arrangements, it also corresponds to different steps in the development of

    alliances in the airline industry. In that respect, we can identify three major phases, with

    uneven degree of achievements depending on the alliance under review. These phases

    correspond to switches in the typology of modes of governance summarized in section 2.3.

    Phase 1: From Information-based network to shared decision rights.

    Alliances were initially tactical agreements that did not implied shared property rights and

    that pooled a very limited set of decision rights, such as the possibility to buy a ticket that

    would allow connection with a flight from the partner carrier (e.g. block seats, the C04

    ingredient in Li’s list). These agreements typically involved two carriers and covered a limited

    number of routes, the main objective being to facilitate correspondence for travelers having

    to use both networks. The coordination of Frequent Flyer Programs became a natural

    extension of these agreements.

  • 16

    It is obvious from these examples that tactical alliances were created and implemented to

    overcome two complementary difficulties: (1) to address loopholes in the respective

    networks of the partners, thus allowing their passengers to reach a wider set of destinations;

    (2) to circumvent restrictive regulations (e.g., connecting routes not opened to one partner).

    These arrangements remained very close to standard commercial agreements, that is, to

    market relationships based on some shared services, while property rights remained entirely

    distinct. However, shared information and coordination over some decision rights pushed

    towards better interconnected networks and more cooperation.

    Phase 2: Extended coordination: the development of strategic alliances.

    Tactical alliances remain part of the picture in the airline industry. There are still numerous

    bilateral agreements on limited issues. However, the need for more intense coordination

    pushed towards new forms of cooperation. In a changing environment, new features

    developed that are no longer limited to bilateral agreements or shared flight codes and

    cross-sell tickets and that has been identified as “strategic alliances” or “global alliances”

    (which is a variation on strategic alliances).

    First, expected benefits from economies of scale, scope, and density extend progressively

    beyond flights’ interconnections. Examples of increased coordination over important

    decision rights include joint marketing, airport slot sharing, check-in and baggage handling

    systems, joint purchase and repair of spare parts or fuel, shared use of hubs, the joint

    development of technical and training procedures, as well as facilitated access to

    financial/capital resources (Holloway 2003; Kleyman et al. 2004). Indeed, in the airline

    industry, scale economies come out of the extension of the network and the related increase

    in the number of passengers carried. Thanks to cost reduction through the development of

    joint activities (ground handling, shared lounge etc.) and through the possibility of market

    presence in areas that a single company could hardly serve directly, alliances can boost

    benefits of each partner (Gudmundsson and Rhoades 2001: 210). Alliances can also take

    advantage of scope economies, giving members the possibility to offer customers a ‘global

    seamless network’ that minimizes their travel time, increases potential connections, and

    extends benefits from frequent flyer programs (Tretheway and Oum, 1992). For airlines, the

  • 17

    possibility to offer an extended network also facilitate coordinated schedules, increased

    capacities, and the offer of a variety of services at lower prices.

    Second, there is an institutional dimension that plays a key role in the development of

    strategic alliances in the airline industry. The propensity towards better coordination for the

    reasons mentioned above has been amplified by the deregulation of the industry initiated in

    the US in the late 1970s and extended progressively to other countries in the 1980s and

    1990s. Deregulation intended to open skies to competing airlines. However, major

    constraints governing foreign ownership of domestic carriers and the possibilities of

    “cabotage” prevent airlines to freely serve international markets, making them dependent

    on bilateral agreements politically negotiated among countries. As emphasized by Kasper

    and Lee (2009, p. 2):

    « Airlines are precluded by a host of laws and regulations in the United States and

    abroad from acquiring control of foreign airlines and from carrying domestic traffic in

    other countries. These barriers to investment and market entry effectively preclude

    any single carrier from building a global network using its own network resources and

    aircraft and thus pose a particular problem for the airline industry, which has become

    an increasingly network---based business since deregulation. As a result, the only way

    a U.S. airline can provide convenient connections, common service standards, lounge

    access, and frequent flyer credits for its customers traveling internationally to points

    that the U.S. carrier cannot itself serve is by forming an alliance with a foreign carrier.

    Likewise, foreign carriers must rely on alliances with U.S. carriers to provide their

    customers access to routes that the foreign carrier cannot serve for legal or economic

    reasons».

    In that context, strategic alliances also became arrangements facilitating bypass of restrictive

    national rules.

    Phase 3: Building a strategic center.

    The next step in the industry was the development of global alliances structured by strategic

    center. Iatrou and Alamdari (2005: 127-128) define global alliance as “airlines participating in

  • 18

    a commercial relationship or joint-venture, where a joint and commonly identifiable product

    is marketed under a single commercial name or brand”. The strategic alliances created at the

    end of the 1990s rapidly consolidated in to the three dominant alliances already mentioned

    which, nowadays, the basic choice offered to non-member airlines. However, parallel to

    their consolidation global alliances became increasingly submitted to inter-alliance

    competition. In such a context, economic theory suggests that the absence of shared

    property rights as well as the maintenance of autonomous decision rights should threaten

    the stability of these arrangements. Parkhe (1993: 794) already emphasized that strategic

    alliances are “voluntary inter-firm cooperative agreements, often characterized by inherent

    instability arising from uncertainty regarding a partner’s future behavior and the absence of

    higher authority to ensure compliance.” This did not happen in the airline industry, at least

    so far. Beside the peculiar cases of Qualifyier, which was dissolved, and of KLM-Northwest

    which splitted when KLM merged with Air France and joined Sky Team , there are very few

    cases of airlines switching alliances.6

    Actually, two strategies have been developed to prevent instability. First, there is the

    classical solution of mergers and acquisitions. With one exception (the acquisition of

    Canadian Airlines by Air Canada), the main mergers and acquisitions over the last period

    have been among members of the same alliance (Air France-KLM, Delta-Northwest,

    Continental-United, British Airways-Iberia). However, competition authorities have been

    very reluctant to authorize mergers and acquisitions, fearing the potential negative impact

    on consumers’ surplus, particularly on routes that would fall under monopoly power.

    Hence, a second ongoing solution developed with the pioneering experiment initiated by Air

    France/KLM-Delta-Alitalia in 2008: building a hard core alliance within the global alliance.

    This arrangement, which is often described as a joint venture, can better be understood as ‘a

    hybrid within a hybrid’. 7 It is based on an agreement characterized by a substantial increase

    6 Canadian Airlines joined Star Alliance after its acquisition by Air Canada in 2000; Mexicana left Star Alliance in

    2004 then joined Oneworld a few years later; and Continental switched from Sky Team to Star Alliance in 2009

    after it merged with United Airlines. Ansett and Varing are different in that they left Star Alliance because they

    went bankrupt. 7 According to Bilotkach and Hüschelrath (2010, page 3) “the theoretical rationales for forming joint ventures

    rather than entering into regular contracts includes transaction costs savings, strategic behavior, and

    capitalizing on the organizational knowledge. The former of the three is well in line with the traditional

  • 19

    in shared decision rights and the building of strategic coordination devices that bring these

    arrangements very close to integration and require special agreements from antitrust

    authorities. The next sections come back to the nature and governance of

    of organization.

    To sum up, arrangements in the airline industry have evolved within 30 years from tactic

    alliances that were and remain very close to standard commercial agreements of the market

    type, to strategic alliances based on multi

    without shared property rights, to global alliances within which a subset of partners develop

    quasi-integrated forms of coordination with respect to decision rights while property rights

    remain distinct. Figure 2 summarizes these various forms

    according to the degree of integration among partners to an agreement

    FIGURE 2: A COMPLEX COMBINATION OF VARIOUS ARRANGEMENTS

    4. Quasi-joint ventures within strategic alliances.

    Stiglerian boundaries of the firm argument; t

    latter views joint ventures as a means by which the firms learn or retain their capabilities

    in shared decision rights and the building of strategic coordination devices that bring these

    arrangements very close to integration and require special agreements from antitrust

    authorities. The next sections come back to the nature and governance of

    To sum up, arrangements in the airline industry have evolved within 30 years from tactic

    alliances that were and remain very close to standard commercial agreements of the market

    type, to strategic alliances based on multilateral inter-firm agreements (usually contracts)

    without shared property rights, to global alliances within which a subset of partners develop

    integrated forms of coordination with respect to decision rights while property rights

    summarizes these various forms that developed over time, posited

    according to the degree of integration among partners to an agreement.

    FIGURE 2: A COMPLEX COMBINATION OF VARIOUS ARRANGEMENTS

    joint ventures within strategic alliances.

    Stiglerian boundaries of the firm argument; the second relates to longer-term profit maximization; and the

    latter views joint ventures as a means by which the firms learn or retain their capabilities

    in shared decision rights and the building of strategic coordination devices that bring these

    arrangements very close to integration and require special agreements from antitrust

    authorities. The next sections come back to the nature and governance of these new modes

    To sum up, arrangements in the airline industry have evolved within 30 years from tactic

    alliances that were and remain very close to standard commercial agreements of the market

    firm agreements (usually contracts)

    without shared property rights, to global alliances within which a subset of partners develop

    integrated forms of coordination with respect to decision rights while property rights

    that developed over time, posited

    FIGURE 2: A COMPLEX COMBINATION OF VARIOUS ARRANGEMENTS

    term profit maximization; and the

    latter views joint ventures as a means by which the firms learn or retain their capabilities ».

  • 20

    We now turn to the analysis of the last development in airline alliances, the building of a

    hard core within existing strategic alliances. However, it should be noted upfront that what

    we actually observe, with respect to figure 2, is not the disappearance of initial forms such as

    tactical alliances but rather a complex overlapping of various forms of hybrid arrangements.

    Indeed, the three leading global alliances nowadays typically involve numerous partners with

    various degree of cooperation, with forms quite closely to the ‘pure’ hybrid arrangements

    identified in section 2.

    Nevertheless, confronted to the increasing competition that characterize a globalized

    market, with competition switching from firm versus firm to alliance versus alliance, and

    facing institutional constraints that limit their capacity to integrate or even coordinate,

    airlines had an incentive to find new modes of organization. This pressure was amplified by

    the crisis that started in 2008. Operating in a pro-cyclical industry, the major airlines quickly

    understood that they had to reduce their capacity, the frequency of flights, etc., and to

    reorganize their network configuration in order to cut costs and adapt offer to the changing

    demand. These difficulties were accentuated by inter-firm competition, including among

    members of the same alliance, on the most important markets. Before 2008, some key

    players were already looking at means to circumvent this “destructive competition.”8. They

    put high on their agenda the creation of ‘joint ventures’ that would coordinate much more

    closely substantial decision rights. The existing literature does not provide a clear definition

    and delineation of joint ventures as distinct from strategic alliances. Jay Barney (2002)

    proposed to subdivise alliances into non-equity alliances, equity alliances, and joint ventures.

    Bilotkach and Hüschelrath (2011: ) went a step further, noting that: « The key difference

    between the latter and the former two is that only a joint venture leads to the creation of a

    legally independent new corporation in which the parent companies hold shares. Following

    this delineation, airline alliances must typically be categorized as ‘non-equity alliances’

    rather than ‘joint ventures’ ».

    The organizational arrangement under review does not fit well within these definitions. On

    the one hand, some members of alliances have developed joint ventures, usually with

    8 For the time being, Oneworld is unambiguously dominated by American Airlines and British Airways; Star

    Alliance by Lufthansa and United airlines; and Sky Team by Air France-KLM and Delta-Northwest.

  • 21

    outsiders to the alliance. For example, All Nippon Airways (ANA), a member of Star Alliance,

    got involved in a joint venture with the low cost Air Asia. On the other hand, more puzzling

    for organization theory and with respect to the stability of contractual agreements is the

    development among selected members of a broader alliance of ventures run through very

    tight coordination of decision rights, although property rights remain entirely distinct. In that

    respect they differ from joint ventures, although they do ressemble joint ventures if one

    looks at the specific activities on which they share almost all decision rights, so that they

    could be labelled ‘quasi-joint ventures’. Examples are provided by the Air France-KLM / Delta

    / Alitalia or Air Canada / Lufthansa / United Airlines agreements on transatlantic routes.

    Before looking at the expected benefits and difficulties of such arrangements, the

    institutional issue must be clarified. Indeed, these arrangements go against the regulatory

    constraints imposed by several national antitrust authorities, so that there implementation

    requires a derogatory regime. Nowadays, the three global alliances have been able to get

    antitrust immunity (ATI) for their North Atlantic routes (see the graph below).

    GRAPH 1: HYBRIDS INSIDE HYBRIDS: THE CASE OF SKY TEAM

  • 22

    4.1: Getting antitrust immunity

    Indeed, building a tight network among a small number of firms and for a limited number of

    routes often overlapping represents a major source of concern for competition authorities

    since it involves price setting, with potentially negative impact on consumers’ surplus,

    particularly through price setting. Consequently, the possibility to create the new type of

    arrangement described above required approval from competition authorities of the

    countries in which participating carriers are based and/or operate.

    In that respect, the US Department of Transportation (DOT) is a key player. Getting ‘antitrust

    immunity” from DOT requires submitting the proposed arrangements to standards quite

    close to those applied to mergers. Two criteria are of particular significance in that respect:

    (1) would the proposed alliance “substantially reduce or eliminate competition”? and (2)

    What conditions should be imposed (particularly ‘carve outs’ solutions) to cure potential

  • 23

    competitive problems? Referring to these criteria, the US DOT took a positive stance

    towards alliances as early as 1999. As stated in a report from that year:

    « [N]o airline, however strong, is able to efficiently provide service with its own

    aircraft and crew to every destination its customers require. Using the transatlantic

    market as an example, there are several hundred cities in the U.S. and also in Europe

    that will never have the benefit of non-stop service. [Alliances] are the only practical

    way to provide better service to thousands of passengers in long distance, low-density

    international markets. (….) Multinational alliances have fueled enormous increases in

    connecting traffic, ...newly stimulated traffic accounts for a large proportion of alliance

    growth” (US DOT, 1999: 2)

    Based on this analysis, US DOT developed a position favorable to the delivery of ‘Antitrust

    Immunity’, conditional to the demonstration by applicants that: (a) the proposed

    arrangements would allow significant public benefits; and (2) these benefits would not

    materialize if ‘Antitrust Immunity’ was not granted. The impact on prices is of course a major

    concern in that perspective.

    4.2: Expected benefits and impact on prices

    This paper is not about issues of fares and welfare but about the characteristics of the new

    arrangements and the mode of governance implemented to make them efficient. However,

    some expected consequences of these arrangements on prices must be mentioned because

    they explain several restrictions imposed under the ‘antitrust immunity’, largely as the result

    of tensions between the US DOT and the US DOJ. Indeed, the US Department of Justice

    expressed serious doubts about the benefits to be expected from this derogation to general

    rules as well as about the governance embedded in the new arrangements. 9

    Similar concerns can be observed in the position adopted by the European Commission in

    2011, as assessed by IATA (2011). According to this comment, which is of course a bit biased

    in favor of alliances, “[H]orizontal cooperation agreements can lead to substantial economic

    benefits in particular if they combine complementary activities, skills or assets. Horizontal

    cooperation can be a mean to share risk, save costs, increase investments, pool know-how,

    9 See US Department of Justice, 2009.

  • 24

    and enhance product quality. On the other hand, horizontal cooperation agreements may

    lead to competition problems …” (IATA 2011: 5).10 The expected benefits of the (quasi) joint

    ventures under examination can come out from (among other factors) . They « , These

    competition problems are mainly be related to pricing strategies and their impact on fares.

    On the one hand, “for interline trips, cooperation in fare setting under anti-trust immunity

    eliminates a type of horizontal double marginalization. Instead of non-cooperatively setting

    the components of an interline fare for travel across two networks, the two carriers under

    the antitrust immunity jointly set the entire fare reducing their two separate “markups” to

    one”, which would benefit passengers. (Brueckner and Proost 2010: 657). On the other

    hand, antitrust immunity could well introduce anti-competitive effects, particularly on

    overlapping non-stop hub-to-hub routes.

    There are few studies already available on these effects (see Brueckner 2001 and US DOJ

    2009). In their recent paper, Brueckner and Proost (2010) provide an analysis of both effects

    and show that the net impact on price and welfare is ambiguous. Making a distinction

    between inter-hub and interline markets,11 Barla and Constantanos (2006: 412) already

    noticed that: « In both cases, cooperation leads to an internalisation of each firm’s impact on

    the other firm’s profits. In the inter-hub market, this results in less competition and thus

    higher prices. In the interline markets however, cooperation leads to lower prices, since

    airlines’ demands are complementary. The empirical findings […] confirm that cooperation

    significantly reduces interline fares while the evidence on fare increases in inter-hub markets

    is less conclusive ».

    The risks of a negative impact on consumers’ welfare, particularly with respect to inter-hub

    markets may explain why competition authorities have imposed ‘carve-outs’ conditions12

    10

    According to the same comment, expected benefits can come out of demand-side – relating to the creation

    of new or improved services through expanded networks or seamless service, or supply-side – essentially the

    ability to produce the same services at lower cost taking advantage of traffic densities, improved utilization of

    capacity and lower transaction costs. Potential demand-side benefits include the elimination of double

    marginalization, expansion of route networks, expansion of flight frequency, and improved ‘online’ service

    options. Supply-side efficiencies include cost reductions through economies of traffic density, cost reductions

    through coordination of second-degree competition parameters (sharing of facilities), and cost reductions

    through coordination of first degree competition parameters (pricing and yield management, capacity ) » (IATA

    2011: 6) 11

    Interline trips mean that passengers have to cross the networks of an alliance partners. 12

    A carve-out prohibits collaboration in hub-to-hub fare setting, while allowing cooperation in other markets.

  • 25

    while delivering antitrust immunity, restrictions that have had ambiguous results according

    to Brueckner and Proost (2010)13 .

    4.3: Property rights issue: The « metal neutral » concept.

    Beside their ambiguous impact on fares, another puzzling aspect of the new arrangements is

    that they share many characteristics of a full joint venture or even resemble a merger when

    it comes to strategic decision rights (on specific line, partners share revenue, costs, and

    profits –more on this below), while they do not pool property rights.

    Part of the explanation might be institutional. Antitrust Immunity allows parties to the

    arrangement to share information, pricing, capacity and frequency, as well as route

    strategies, scheduling, pricing, distribution, frequent flyer programs, and so forth on on

    specific routes. However, immunity does not allow merger or acquisition. The resulting

    arrangement can be qualified as a ‘restricted joint venture’, as opposed to a full joint

    venture in which significant assets would be jointly owned.

    Indeed, participating carriers engage in “comprehensive revenue sharing on international

    routes, so that a partners' revenue from a passenger is independent of which airline actually

    provides the service. This arrangement leads to what is known as a “metal neutral” alliance

    structure, in the sense that the identity of the “metal” (the aircraft) involved in the service is

    irrelevant to individual airline revenue », (Brueckner and Proost, 2010: 658). At the same

    time, rights over the physical assets, particularly the aircrafts, as well as over human assets

    (e.g. labor contracts, management of human resources) remain strictly separated. In a word,

    it is merger-like in that on routes specified by the immunity, partners no longer compete

    with each other; but it does not share with mergers or acquisitions the main characteristic

    which is the transfer of property rights. The arguments developed by airlines to obtain this

    agreement from competition authorities have been summarized as follows:

    “This ‘metal neutrality’ is significant in that it maximizes the opportunity for pro-

    competitive efficiency gains from density economies. There is now substantial evidence

    that existing alliance relationships have led to significant consumer benefit for

    13

    In this paper the two authors refer to the idea that “carve-outs are beneficial when the alliance does not

    involve full integration of the partners’ operations on the hub-to-hub route, its key point is that carve-out may

    be harmful when imposed on a joint-venture alliance. A JV alliance involves full exploitation of economies of

    traffic density on the hub-to-hub route, and a carve-out prevents the realization of these benefits”, Brueckner

    and Proost 2010: 657.

  • 26

    passengers on interlining trips, both in terms of improved service and lower fares.

    Concerns about anti-competitive effects arising, for passengers flying hub to hub

    itineraries, where cooperating airlines’ services overlap, should be lessened by the

    potential for metal-neutral JVs to generate pro-competitive efficiencies » (IATA 2011:

    1).

    Not all competition authorities nor all economists have been fully convinced! Nevertheless,

    several such arrangements have now been accepted, so that we have these multiple forms

    of alliances as well as multiple layers within specific alliances, as described in section 3.

    5. Hybrids within hybrids: the governance issue.

    Beside the sharp separation between decision rights and property rights, another puzzling

    issue in the new type of arrangement developed within existing airline alliances concerns the

    combination of characteristics that should challenge the governance and stability of these

    alliances. First, the new venture is an arrangement among a small subset of partners,

    essentially the most powerful ones, among tens of members (Air Canada/Lufthansa/United

    Airlines in Star Alliance; Delta/Air-France-KLM/Alitalia in Sky Team; and British

    Airlines/Iberia/American Airlines in Oneworld). Second, the new ventures exist because they

    benefit from Antitrust Immunity, although strictly limited to certain routes. Third, these

    arrangements pool most strategic decisions on these routes while they remain competitors

    on these routes as well as on the global network. In what follows, we take advantage of

    access to privileged information on the pioneer venture linking Air France-KLM / Delta-

    Northwest / Alitalia to explore characteristics that may explain the success and stability of

    these arrangements.

    5.1: A short historical reminder.

    The transatlantic venture between Air-France, KLM, Delta, Northwest and Alitalia is the

    result of a long process of mutual commitments. This process began in 1997 with the

    signature between Northwest and KLM of the first ever joint venture agreement in the air

    transport industry. At that time, the motivation behind that move was largely due to the

    restrictions imposed by US laws on foreign ownership of national carriers.

  • 27

    Not long after that, in 1999, Air France and Delta started building a global alliance, Sky Team,

    officially created in June 2000. A few years later, in 2004, Air France and KLM got the

    authorization from the European Union to merge, a movement followed not long after by

    the acquisition of Northwest by Delta Airlines (in 2008). During that period, the Air France-

    KLM group and their American counterpart and nevertheless rival, Delta, developed an

    increasingly diversified commercial and technical cooperation.

    In the context of the ‘open sky’ negotiations between Europe and the USA, this evolution

    found an achievement with the grant of ‘Antitrust Immunity’ for transatlantic routes by both

    the European Commission and the US DOT, allowing Air France-KLM and the newborn Delta-

    Northwest group to implement a venture that officially began operating in 2008. This special

    arrangement, joined by Alitalia in 2010, after Air France took over 25 % of its shares, was

    created to monitor their transatlantic routes. The result was the emergence of a hybrid

    arrangement within the existing hybrid, Sky Team alliance, which at the time involved

    already ten airlines. 14

    We now turn to the analysis of this venture, which created a hybrid form within the already

    existing hybrid arrangement that is the Sky Team alliance.

    5.2: A contractual venture

    The very first quasi-joint venture in the airline industry, between KLM and Northwest, lasted

    for almost twenty years (1989-2007). It went through a series of conflicts, adaptations and

    modifications in its governance structures that provided a unique source of lessons for the

    venture that progressively emerged between Air France-KLM and Delta (with which

    Northwest later merged). Actually, the formal structure of the venture under review is

    deeply embedded in this pioneering experience.15

    Like most inter-firm agreements with significant shared rights, the new arrangement is

    based on a contract. However, this contract has some unusual characteristics that make it a

    bit like a Russian doll, with sub-contracts within the core contract! Indeed, the European

    partners, Air France-KLM-Alitalia are linked through specific contracts, part of which is

    14

    Aeroflot, Aeromexico, Air France-KLM, Alitalia, China Southern Airlines, Continental Airlines, Czech Airlines,

    Delta Airline-Northwest, Korean Air. Continental left this alliance a few months later (June 2008) to join United

    Airlines (with which Continental will merge in 2012). 15

    For an examination of the KLM-Northwest model, see De Man, Roijakkers, de Graauw (2010)

  • 28

    embedded in their contract behind their North Atlantic venture with Delta-Northwest. As a

    result, we have formally a two side arrangement, with the Delta group on the one hand and

    the Air France-KLM-Alitalia partners speaking as if they would form a unique entity when it

    comes to the venture on the other hand.

    Formally this contract is relatively short (a bit over 150 pages) and quite dense. Although it

    is strictly confidential, prohibiting parties to reveal publicly any information about profits

    and costs associated to the venture, information obtained through extensive interviews

    reveal two fundamental dimensions to the contract: (1) a financial agreement; and (2) broad

    indications about the governance structure, mainly focused on the entities responsible for

    piloting the agreement and the decision-making procedure to be followed. This second

    aspect, which is the one on which we focus, is complemented by Codes of Conduct jointly

    agreed upon, finalized by July 31th, 2009, approved by the Steering Committee (more on this

    below) and incorporated as part of the Agreement. The table below summarizes some key

    specifications of this agreement.

  • 29

    TABLE 3: KEY CHARACTERISTICS OF THE CONTRACT

    GOAL Sharing revenue, costs and profits on the routes defining the

    scope of the contract (Bundle 1)

    LEGAL FORM A joint venture (defined in a 150 pages contract)

    TERMS OF THE

    CONTRACT

    The agreement is an « evergreen » : it will run indefinitely and

    the first possibility for a partner to notify termination of the

    agreement is after 10 years, and requires a three year notice

    period.

    FINANCIAL

    COMPONENT

    The key clause is a 50–50 profit sharing rule between

    European and US partners (AF/KLM/Alitalia & Delta).

    SCOPE OF THE

    VENTURE

    Bundle 1, which identifies transatlantic routes

    DECISION-MAKING Consensus (no unilateral action is allowed for the routes agreed

    upon in the contract

    Discretionary Decision are taken into account in the contract:

    it is specified that they shall be listed in the codes of conduct,

    allowing unilateral actions (to make the contract flexible)

    if in accordance with the Codes of Conduct, and after prior

    written notice to Co-Chairmen of the relevant committee in

    case of disagreements or conflicts.

    GOVERNANCE CEOs’ committee

    Steering committee 11 working groups

    COMMUNICATION Viewed as central to the arrangement and organized along two

    channels.

    Formal Channels Informal Channels Multiple points of contacts are

    defined in the governance

    procedures

    (JV’s weekly meetings,

    steering committee, …)

    -Personal relationships at

    Board level and inside

    the companies - Social events to build personal relationships (even

    between the CEOs)

    Source: Authors.

  • 30

    5.3. A complex financial agreement

    The financial part of the contract is of course essential to the definition and stability of

    the venture, particularly since it concerns only a subset of the decisions each partner

    has to make. Indeed, the members of the venture cooperate on a bundle of

    transatlantic routes (“trunks routes”) on which they operate according to a ‘metal

    neutral’ agreement: joint operations, competitive fares, harmonized ground and in-

    flight services, and shared revenues and costs characterize all related routes, without

    consideration for who owns the aircraft. At the end of 2012, the agreement is relevant

    for 27 points of entry in North America and 33 points of entry in Europe, with 7 major

    connecting hubs involved (Amsterdam, Atlanta, Detroit, Minneapolis, New York-JFK,

    Paris-CDG and Rome Fiumicino). All in all, this venture operates 250 transatlantic flights

    per day with 144 aircrafts, and it represents 26% of the total passenger capacity

    between Europe and North America, generating revenues of USD 11 billion.

    Although confidential, we have been able to collect information about the main financial

    characteristics of the agreement. First, there is a fifty–fifty profit/cost sharing rule

    between the European partners (AF/KLM/Alitalia) and the American partner (Delta) on

    all the routes (« trunks ») specified in the ventures’ scope. Second, the profits (or losses)

    are allocated by reference to a ‘Base Line’ determined by the situation in 2008, that is:

    the revenues before the venture was formally created. All additional revenues (or

    losses) on top of this base line are shared equally between AF-KLM/Alitalia and Delta.

    Third, 25% of the revenues generated beyond the bundle routes and resulting from the

    connections made possible by the agreement are transferred to the other partner (US or

    European). Fourth, once a year the total sum of the incremental revenues (and costs) is

    formally estimated (for trunk routes as well as for routes connected to trunk routes) and

    a « check » is delivered to one or the other partner (Air France-KLM/Alitalia or Delta).

    Fifth, the venture has its own accounting system. For example, not all costs are

    integrated in the costs charged to the venture. Also, some costs are adjusted (e.g.

    wages/charges for Pilots and/or stewards; fuel cost without hedging). On the other hand

    some important costs are referenced in well defined tables (e.g. lease of aircrafts).

  • 31

    These contractual clauses frame the domain of action of the partners to the venture.

    However, they leave open the modalities of the implementation of the contract as well as

    the way partners are going to deal with the numerous unexpected events that characterize

    the airline industry. In other terms, the contract is substantially INCOMPLETE. It defines a

    framework within which partners operate. Hence the importance of the governance

    mechanisms adopted.

    5.4: The Governance structure adopted in the agreement: building a strategic center

    Although property rights of Air France-KLM on the one hand, and Delta-Northwest on the

    other hand remain distinct,16 the new venture has indeed implemented a specific structure

    to monitor their joint activities and make joint decisions for all relevant routes and their

    associated services. This structure is hierarchical, close to what we find in integrated firms,

    but relies on procedures that work bottom-up. In other terms, for a specific segment of their

    activities, partners behave ‘as if’ they were an integrated company (which they are not) and

    combine a highly centralized decision-making process with a highly decentralized

    management of the joint activities.

    There are three main components in this governance structure. First, the ‘CEO committee’,

    with the CEO of Delta and one CEO representing the European partners is in charge of

    strategic decisions and meets at least once a year. Second, a steering committee of a

    minimum of 10 members (5 from the European consortium, 5 from Delta) is in charge of

    monitoring and implementing major decisions with respect to the organization of the

    alliance, its marketing and sales activities, finance, coordination of the network, and

    operations on the relevant routes. This steering committee meets at least once every three

    months and is usually prepared on the European side by an informal meeting since the three

    participants have to contribute to the steering committee as one single voice! Third, and

    most importantly for the actual coordination of the venture, the 2008 agreement created

    eleven working groups.17 Each working group is co-chaired by a representative of Delta and a

    representative of the European partners and report to the steering committee. Working

    16

    It must be remembered that Air France and KLM merged in 2004, Delta and Northwest in 2008, and that Air

    France bought 25 % of the shares of Alitalia in 2010. 17

    The groups are: Network, Revenue Price Management, Sales and Distribution, Product, Loyalty, Operations,

    Information Technology, Finance, Cargo, Advertising and Brand, Corporate Communications.

  • 32

    groups must formally meet at least four times a year but are actually interacting much more

    often, for some of them on a daily basis, as is the case for the Network working group.

    The decision process works essentially bottom up. The working groups deal with all daily

    problems as well as with specific issues defined by the Steering Committee. When a decision

    is required, the relevant working group examines the issue at stake, arbitrates among

    possible solutions, and prepares the implementation of the decision. In most cases, the

    approval by the Steering Committee is formal. This committee mostly operates as an

    arbitrator, overcoming diverging interests and making decisions when conflicts develop

    between working groups or, more likely, among them. It is very noticeable that so far the

    committee of CEOs has never been formally involved directly in this bottom-up procedure,

    although such a possibility is explicitly stipulated in the contract. The CEOs are essentially

    consulted on a relatively informal basis when important issues are under discussion among

    partners at the working group level. Nevertheless, the CEOs clearly operate as a strategic

    center, very much as a Board of Administrators would do in an integrated firm.18

    5.4: The key role of the working groups

    Clearly the working groups play a central role in this governance structure. Each group is led

    jointly by two members, one appointed by Air France-KLM-Alitalia, the other by Delta group.

    The composition of each group is also symmetrical. Between the so-called ‘joint venture

    week’, that is, the formal meeting of the steering committee which is planned four times a

    year, the working groups monitor the activities of the venture and make most decisions.

    They are in constant contact, through conference calls, phone calls, e-mails, and it is at their

    level that most conflicts are solved. An indicator of their significance is that before the

    contract was signed in 2008, each group, provisory at that time, had to write down its own

    code of conduct. In other terms, they were considered from the very beginning as teams

    that had to create their own rules. The codes of conducts are explicitly referenced in the

    contract.

    18

    A recent decision about full flat seats illustrates well how the governance works. Delta initially introduced at

    the level of a working group a request to significantly improve the quality of services, particularly through the

    provision of full flat seats for business customers, in order to compete with similar strategies developed by

    competitors, e.g., British Airways and Lufthansa. Air France was initially reluctant to make these costly changes.

    The favorable recommendation of the different working groups went all the way through the steering

    committee to the CEOs and Air France finally accepted the changes for its 2000 seats in business class (decision

    made on June 21st

    , 2012, and to be fully implemented in 2013-2014)

  • 33

    These groups walk on two legs, so to speak, with quite different human resources required.

    On the one hand there are experts, selected to participate to a specific group because of

    their technical knowledge (e.g., the network planner of Delta). On the other hand, there are

    so-called ‘generalists’, almost all of them directors of different departments of the partners

    (e;g., the alliance director of Air France), many of them having played an active role in the

    writing and initial implementation of the contract. These generalists remain active in the

    different working groups, and some are members of the Steering Committee, so that they

    can keep an eye on the various activities of the alliance and signal problems early on.19 Since

    both generalists and experts have been working together for while, for many of them even

    before the venture was formally implemented, they have developed tight connections and a

    ‘team spirit’.

    This ‘team’ approach, with its division of tasks among various governing bodies, seems to

    work very well. The governance implemented has effectively faced numerous adaptations

    required by a rapidly changing environment, it has solved numerous conflicts without

    noticeable clashes, and significant changes have been adopted and implemented without

    disruptions, for example after the 2008 crisis. The contract has been renegotiated (five times

    as of June 2012) to adapt to this changing business environment, without any significant

    crisis in the governance of the venture, which has remained remarkably stable through all

    these episodes.20

    An important key for understanding this success is that the contract provides a formal

    framework substantially complemented by informal contacts. Formal meetings are usually

    paired with informal ones (e.g., the Board meetings of Air France-KLM and Delta are held in

    the same town, the same day, with an informal diner organized among the CEOs). Other

    events also provide opportunities to develop informal contacts (e.g. the opening of the “S 4”

    19

    As emphasized by De Man, Roijakkers, and de Graauw (2010: 177). “They act as a lubricant when different

    interests need to be reconciled. (…) There are links between the generalist groups and the specialists groups,

    through personal unions. A balanced staffing ensures that problems are identified early on. When they do

    occur the right persons in the alliance can be found to deal with them. This reduces the impact of internal

    tensions in the alliance ». 20

    Examples of this smooth adaptation are the entry of Alitalia in the venture, or the inclusion of cargo freight in

    the contract. Alitalia began to be closely associated to the arrangement in April 2010, although its association

    was formalized only later on, and the pact is planned to last at least until the end of March 2022, with Alitalia

    part of all the initiatives of the venture, including many that have been decided long before it joined the

    venture (e.g., the agreement on joint sales). As for cargo freight, financial terms had to be substantially

    renegotiated after the 2008 crisis. Again, the adaptation was endorsed without any major problem.

  • 34

    satellite dedicated to Sky Team at Roissy airport, which created an opportunity for an

    informal meeting of the CEOs).

    5.5: A sustainable agreement?

    Of course, important questions remain to be answered regarding the future of this hybrid

    arrangement within the global alliance. Is it only a step towards full integration? And how

    will partners to the global strategic alliance who are not part of this arrangement react in the

    long run? It is difficult to provide a clear answer at this point, since the venture is relatively

    young, concerns only part of the activities (and therefore the rights) of the parties involved,

    and is developing in an industry submitted to rapid changes. However, several factors

    provide indications that the arrangement may remain stable, without a formal integration,

    for a significant period of time. Let us illustrate with a few insights.

    First, as already mentioned, parties to the agreement share substantial decision rights on

    part of their activities without sharing property rights, and it is not clear that competition

    authorities who delivered the antitrust immunity would accept any move in that direction.

    Nevertheless, partners have developed interdependence on specific assets, which provides

    incentives to keep the arrangement stable. For example, Air France recently bought an

    Airbus 380 to deserve NY for its own sake and that of its partners. Would the venture

    collapse, Air France could well end up with over-dimensioned capacity and costly fixed costs

    to support (pilots, stewards etc.). Symmetrically, Delta has closed many of its European

    agencies, leaving to Air France-KLM the task of selling its flights. Would the venture be

    terminated, Delta would have to rebuild a substantial sales force. Other examples could be

    provided, e.g., the joint development of a costly information system, the sharing of strategic

    information on costs and the efficiency and profitability of different segments of the shared

    network, etc. In other terms, we are typically in a situation of interdependent firms with

    respect to some specific assets while other strategic assets remain distinct, which is typical

    of hybrid arrangements and the source of their stability.

    Second, this interdependence raises the risks of opportunistic behavior fed by contractual

    hazards. Transaction cost economics has pointed out that when these hazards are paired

    with important investments specific to the agreement, there are strong forces pushing

    towards integration. Clearly, the parties to the venture under review have adopted

  • 35

    measures to face these difficulties. The mode of governance specified in the contract, the

    decision process it contains and the codes of conduct embedded in the contract define ex-

    ante a formal framework to shape the behavior of agents and limit risks of opportunism.

    Also, partners have substantially invested in measures oriented towards building and

    encouraging trust. The organization of working groups as teams sharing joint procedures,

    developing common habits overtime and learning to operate cooperatively would involve

    important switching costs, including psychological ones, would the venture fail. The

    significance of investments in resources that are complementary, notwithstanding the fact

    that property rights remain distinct, and the resulting interdependence already mentioned

    also favor stability of the contractual arrangement.

    Third, we also know from the literature on hybrid arrangements that important conditions of

    stability rely on the mode of governance implemented and the procedure of selection at

    entry. We have already discussed the first issue, emphasizing the important combination of

    formal and relational mechanisms (see subsection 5.3), which confirms what the literature

    on relational contracts predicts (see Baker et al., 2008; Malcolmson, 2012). Selection at

    entry is another important issue. Parties to the arrangement under review have been very

    cautious in focusing on partners that had already developed a long experience of

    cooperation, including as founders of the global alliance, which is the case for Air France and

    Delta.

    However, this selectivity may well create problems with parties that are members of the

    global alliance but not integrated in the venture. In a sense, restrictions imposed by

    regulators may contribute to the consolidation of the existing venture, giving arguments to

    its participants to not accept new members, or to do so very selectively, in fear of

    developing positions that would not be acceptable to competition authorities. If it is so, it

    means that the stability of the venture depends on a complex combination of endogenous

    factors, such as the mode of governance implemented, and of exogenous factors coming out

    of the regula