Introducing new Financial Mechanisms for Regional Subsidies to Stimulate Traffic Growth

2. Presentation for 19th Aviation Seminar Introducing new Financial Mechanisms for Regional Subsidies to Stimulate Traffic Growth 13th, November, 2014

3. Disclaimer This presentationwas createdfor the exclusiveuse of Estonian AviationAcademy With regard to the information contained in this teaser, we appreciate your undertaking to respect and preserve the confidentiality of this document and not to disclose or otherwise make available this material to any third party or use it for any purpose other than the tender process. Lufthansa Consulting GmbHRegistration: Von-Gablenz-Str. 2-6 Local Court of Cologne 50679 Cologne, Germany Commercial Register HRB 17788 Managing Director: Dr. Andreas Jahnke Estonian Aviation Academy seminar

4. Current situation in Estonian subsidised regional aviation does not offer content to any of the stakeholders • Estonian State is supporting regional aviation in next 5 years with more than 10 M € • Additionally Estonian State supports regional airports in next 5 years with more than 7M € • There is constant complaint and dissatisfaction from all parties involved: County authority, airline, passengers and airports Situation • Unreliability coming from old fleet which on Kuressaare route has lead to same amount of passengers as in 2006 (GDPgrowth by2013 145%) • Reduced frequencies and increased expectation about the quality of the service followed by numerous articles about fines for the carrier further escalate passenger distrust towards the service • State is unable to increase support for airports nor operators Problem Solution • Announce all tenders at the same time and find one single operator for all of them to have scale • Modernize the fleet and increase the number of frequencies in order to regain the passenger confidence • Compose a holistic plan which would include harmonization of state aviation strategy, tourism strategy and regional strategy Source: State PSO documents summed, Tallinn Airport, World Bank Estonian Aviation Academy seminar

5. Ability to buy a ticket from a global distribution system with interlinked sales and marketing activities can increase demand Source: Tallinn Airport Estonian Aviation Academy seminar When Estonian Air in 2008 started flying on Tallinn-Kuressaare route with less frequencies but bigger aircraft there were more than 4000 passengers per year added In 2012 Estonian Air stopped flights to Saaremaa and more than 5000 people a year stopped using the service Passengers are not generated by a global distribution system but constant and incentivized sales activities together with a reputable airline and competitive pricing The future growth opportunities on air traffic to regions comes with a requirement of code-shared services with a renowned carrier and accessibility

6. Executive summary • Lufthansa Consulting reviewed three biggest aviation markets in the world: China, United States of America and European Union to give overview on regional subsidies • Each come with pluses and minuses but in general Lufthansa Consulting sees that optimal solution for Scandinavian region would be exercising next 3 steps: • New central source of subsidies: Civil aviation development fund like in China where “trunk routes” passengers provide funds for “regional routes” subsidies • New matrix to “grade” regional routes by their social value, like in China, including differentiation in level of subsidy depending on geography and availability of alternative modes of transport • Integration of regional airlines and major airlines through a feeder model that could also be a result of further market consolidation (i.e. like in China) • Chinese model is adapted from USA model however comes with adaption towards regional operators whom have been integrated in 3 major airline groups in domestic China • EU model leaves ministries without tools to influence costs and in the end will see airlines benefitting too much from services provided (lack of competition) • US system provides extra money from state budget without creation of a separate fund which makes it too costly for the Scandinavian region Estonian Aviation Academy seminar

7. In order to support regional air routes, subsidies have been granted by governments worldwide Selected programs of world‘s big economies US EU China Essential Air Service Plan 1) Program name EAS (Essential Air Service) PSO (Public Service Obligation) DOT (Department of Transport) EU (European Union) CAAC(Civil Aviation Administration of China) Policy maker Beneficiary of the program Regional airlines that serve rural regional air routes All airlines who win the auctioned PSO route (rural air routes) will be granted “monopoly” operation right on the route and subsidies All airlines that serve rural regional air routes Subsidies amount (2014) USD 241 million Not disclosed ~ USD149 million 1) English translation for 基本航空服务计划 Source: www.dot.gov; http://ec.europa.eu; www.caac.gov.cn; Estonian Aviation Academy seminar

8. Europe hasproventhatoncemarketisderegulatedittakes time forthemarkettofill all theunefficiencycreatedbyformertariffs • Major Changes in Europe: From 1980s bilateral- tothe modern multilateral-system • Typicallyincluded 50:50 capacityallocation. • Tariffswereunderlyingtogovernmentalapprovalprocess • In Germany economy class ticket had to be more expensive than first class train ticket • In practicecarriersnegotiated tariffs on IATA conferences (poolingofrevenues e.g.) • Abolition ofcapacityrestrictionsandrequirementfor national ownership • Openingoftrafficrightsfor Community aircarriersto intra-Community airroutes • Market access/stimulation via PSOs • Intramodal Competition Tariffs • 1997: Insufficientinfrastructureslowed down thestimulationdespitenewairlines • 2/3 routesmonopolistic • Only 31 routesreachedthedesiredcompetition • Establishment of 80 newcarrierswith 20 surviving • Providesufficientairandgroundinfrastructure • Simplifying procedures for new-comers • Findingwaystoallocateattractiveslotstonew-comers • Dynamic reallocationofflightslots („useitor lose it“ rule) Estonian Aviation Academy seminar

9. Historical regulatory environment in US and Europe did not protect the customer as airlines were strong in lobbying Average one-way air fare in regulated and deregulated US 1979 1993 1978 1993 • 10 biggest carriers account for 75% of market • 13,2% of flights to periphery • 8 biggest carrier have 93% of market • 7,4% of flights to periphery 1983-88 > 200 carriers disappear – M&A and bankruptcies Source: University of Denver, Department of Geography Estonian Aviation Academy seminar

10. French government has found a solution to support far-away areas all year round with connectivity to Paris by supporting passengers • Since 1997 airlines that want to operate routes between France and overseas departments have to abide by the following rules: • 1 weekly all-year operations • Off-peak capacity > ¼ Peak capacity • 6 months notice before leaving the route • A minimum ASK is set for each destination • French government has decided to support certain interest groups with subsidies for overseas routes: • Students studying in metropolitan France • Individuals having professional insertion projects • Mourners • Overseas territories residents • As an incentive for airlines to operate these routes, carriers can enjoy tax benefits for their employees based oversea. Sources: Assemblée-Nationale, Sénat, developpement-durable.gouv.fr, Lufthansa Consulting Estonian Aviation Academy seminar

11. In European Union announcing and running a tender for public service is a long 3 level process which should limit market distortion Estonian Aviation Academy seminar

12. In European common airspace only way of regulating is use of PSOs which does not have to mean financial investment • EU has developed 2 different level of interventions to be implemented when market fails: • Process leading away from free market starts with the notice by the state for a PSO with exact market requirements (number of frequencies, schedule and expected ticket price) • In case a carrier willing to operate the route then it would be called limited intervention and carrier gets to operate that city pair without competition for next 3 years (time frame can be shortened) • Idea behind is to give carrier assurance to invest in the route and look for long-term gains • If no carrier indicates interest to operate the route then full PSO is announced but then it comes with financial obligation • European approach is that whenever possible market should regulate itself and intervention should be last source used • EU open market regulation is based on EEC No 2408/92 legislation • Limited market intervention is based on EEC No 2408/92 article 4 b legislation • Full market intervention is based on EEC No 2408/92 article 4 d legislation Estonian Aviation Academy seminar

13. In Europe each member state has to fund PSO routes themselves but EC is monitoring body to avoid distortion of competition Need for increased services by member-state and notifies EC EC approves that market does not regulate itself EC does not approve as market regulates itself Looking for interested carriers on public notification No subsidies and situation remains as is for time being No interest from carriers as market too small or yield low Only 1 airline interested in providing services More than 1 airline interested in providing services Can operate the route with no competition for up to 3 years Tender announced for up to 5 years Lowest bidder wins the right to provide service for up to 5 years Estonian Aviation Academy seminar

14. As all PSO routes have a 5 year cycle then EC sees that as the best example of getting lowest price and highest volumes Irish airports PSO levels2 • EC ideas in general are good and in theory system should allow lowest price and incentivize growth in passenger numbers • However reality is something else as majority of airlines are not interested to go through painstaking bureaucracy to apply for a route: • Very certain accounting procedures • Different marketing, pricing and revenue management procedures • Different GH procedures • Situation has lead to increased costs on some of the routes (for example Donegal airport) and reduced costs on some (for example Kerry airport) • Whereas in commercial aviation average growth in Europe was 10,5% between 2005-20091 Source: 1Albatros database for Europe traffic 2005-2009 Source: 2Flying in Ireland, 2009, February Estonian Aviation Academy seminar

15. EC does not set limits to city size or aircraft size needed as long as member state is able to prove it is essential for the development • EC procedure needs a proof for following requirements when establishing a public service obligation: • No airline is interested to serve the route on market conditions on a service level which would be acceptable for local community • The service level required is realistic and reasonable • Publicly supported route will not distort competition and no-one will get unfair advantage • Service is given to the lowest bidder • Local community has to be able to give reasonable explanations to a service level required such as: • Aircraft size • Frequencies • Schedule • Routes • PSO can be operated also on a route which already has regular services but not enough frequencies or unsuitable schedule List of PSO routes in EC database Estonian Aviation Academy seminar

16. In China, the provision of subsidies for regional aviation has become more focused and established in the past decade Development stage of Chinese regional aviation subsidies 90’s 2002 2006 2008 2012 1 Subsidies for total loss 2 Subsidies to regional government 3 Subsidies by airport • CAAC verifies the loss amount and authorizes subsidies for consecutive three years • No increase or decrease of subsidies amount within these three years • Subsidies are based on total loss of the past three years • Subsidies consist of two parts: 1) return of corporate tax paid to central government 2) airport construction fee paid to central government • Subsidies are paid directly to local government 4 Subsidies by rules • Subsidies are differentiated based on the regional airport definition issued by CAAC 5 Subsidies by civil aviation development fund • CAAC issued new rules to provide subsidies to regional airport (2008/15) • CAAC issued new rules to subsidy airlines serving regional rural routes (2008/17) • CAAC established civil aviation development fund which specifies 20% allocation for regional air routes subsidies Source: China Civil Aviation Business Management Research Base Estonian Aviation Academy seminar

17. To obtain the subsidies on regional routes, several pre-conditions need to be met Definition of qualified regional routes for CAAC subsidies • If the airport yearly passenger traffic is smaller than 5 million, the airport is qualified as regional airport • The qualified regional routes must connect on one end these regional airports. And the other end of the route cannot connect to major hubs (Beijing capital, Shanghai Pudong, Shanghai Hongqiao and Guangzhou Baiyun airport) and popular tourist destination airports 1 Airport passenger traffic 2 Stage length • Generally smaller than 120 seats aircraft • At the moment, 8 aircrafts are qualified to provide regional air routes (Cessna 208), D38, ATR-72, CRJ-200, ERJ 145, EM4, DH8, YN2) 3 Aircraft type • Air routes within one province is qualified as regional routes • Or air routes between provinces, but shorter than 600km are qualified 4 Passenger load factor • Passenger load factor should be lower than 80% 5 Seasonality • The frequency in low season should not be more than 20% less than in high season Source: CAAC Estonian Aviation Academy seminar

18. The level of subsidies depends on the route type and passenger load factor, focusing more in Western and Northeastern region of China Explanation on airport type Subsidies provided by CAAC Regional route type • Type I regional routes: Regional routes connecting airports located in Central eastern provinces (16 provinces) • Type II regional routes:Regional routes connecting airports between central Eastern provinces (16 provinces) and Western and Northeastern provinces (15 provinces) • Type III regional routes: Regional routes connecting airports located in Western and Northeastern provinces (15 provinces) PLF(Passenger load factor) The real subsidies vary from -20% to +20%, depending on the seasonality Subsidies are more favorable for Western and Northeastern provinces in China Source: CAAC Estonian Aviation Academy seminar

19. The subsidies from Chinese government on regional routes are substantial; however the majority still goes to the three big airline groups Breakdown on subsidies provided by CAAC to regional routes 2013 Subsidy in total revenue (%) Subsidy 2013 (in Mio USD) 0,91% 75 0,87% 71,0 15 0,40% 0,40% 10 5 0,12% 0,10% 0,04% 0 China Esatern China Southern Air China Tianjin Airlines Sichuan Airlines Tibet Airlines Lucky Air China United China Express OK Airways Joy Air Others Total Partially or wholly owned by the big 3 Partially or wholly owned by the big 3 Big 3 airline group(58% of total subsidies) • More than half of the subsidies(58%) 2013 is still allocated to the three biggest airline group in China due to the lack of regional carriers • For Tianjin Airlines and Sichuan Airlines, subsidies alone from CAAC account for almost 1% of the revenue. Other subsidies are possibly still available at the local government level • In 2014, subsidies for regional routes has increased by more than 100% to 149 million Estonian Aviation Academy seminar

20. The government collects civil aviation development fund both from passengers and airlines - part of them is then used on regional subsidies Usage of civil aviation development fund Collection of civil aviation development fund 1 Passenger • On domestic flight, c.a. USD8.18 (RMB50) per flight • On international flight, c.a. USD11,4 (RMB70) 1) per flight • Exception: passengers travelling on the regional aircraft don’t need to pay Civil Aviation Development Fund 1 Infrastructure development 38.5% * 2 Subsidies for air cargo, regional aviation, international routes, regional airports 13.7% 2 Airline • Airline pays in accordance with air route type 2), aircraft‘s maximum gross take off weight, flight mileage standards as follows • Airlines operation on regional routes with take off weight smaller than 50 tons pay 50% 3 Emission reduction 3.3% General aviation development 4 4.3% Take off weight Civil aviation education and information technology 7.0% 5 6 Civil aviation management 1.9% 7 Others subject to approval 31.3% * % of total spending in 2013 1) On international flight, passenger pay 90RMB. However, 20RMB goes to tourism development fund. The remaining 70RMB goes to civil aviation development fund 2) Route cat I: flights to Hongkong, Macau and Taiwan, flights connecting airports located in central eastern provinces (16 provinces); Route cat II: Flights connecting airports between central Eastern provinces (16 provinces) and Western and Northeastern provinces (15 provinces); domestic segment of international flights; Route cat III: Flights connecting airports located in Western and Northeastern provinces (15 provinces) Source: CAAC 2012/17 Estonian Aviation Academy seminar

21. The development of regional aviation market is meaningful in different ways Why developing regional aviation markets, because it helps to... 1 Nurture new markets 2 Provide feeder service for trunk routes 3 Fill in white sports in national air transport system 4 Offer essential transportation service in certain areas Estonian Aviation Academy seminar

22. China uses a different approach to ensure a reasonable level of competition and satisfy the travelling demand of domestic travelers Pricing scheme for domestic trunk routes • The price for economy class tickets of domestic flights is regulated by the state • The Civil Aviation Administration of China (CAAC) and the National Development and Reform Commission (NDRC) jointly publish guide price for existing routes and approve guide price for the new routes • The airlines operate semi-market pricing routes1) in China have the right to decide their price within the range of 25% above and 45% below the state guide price. The ticket price can also be lower than the price bottom if the airlines inform CAAC 30 days before implementation • The airlines operate the full market pricing routes 2) in China have the same price ceiling but have no price bottom Price ceiling (full fare) Upward price adjustment room State guide price (100%) Downward price adjustment room Price bottom Over competition 55% Note: Semi-market price routes normally refer to the routes where aviation is dominant way of passenger transportation Full market price routes are where multimodal transport has been established Source: The Civil Aviation Administration of China (CAAC), Lufthansa Consulting Estonian Aviation Academy seminar

23. China uses a different approach to ensure a reasonable level of competition and satisfy the travelling demand of domestic travelers (continued) Examples of semi-market pricing route Chengdu Airline flight From Shanghai to Chengdu (trunk) Shanghai Chengdu guide price RMB1290, price bottom RMB 710+RMB 50 airport tax Full fare price: 25% above state guide price RMB 1290 Examples of full-market pricing route Air China flight From Nanjing to Beijing (non trunk) Unrestricted price bottom Full fare price: 25% above state guide price RMB 1,072 Estonian Aviation Academy seminar

24. The current situation in China shows imbalance in the development of trunk and regional routes Regional airports Regional passengers Trunk-route passengers Regional passengers Trunk-route airports 10% 25% 75% 90% Regional airports • There are in total 150 regional airports, which account for 75% of total airports in China • Passengers carried on regional routes only account for 10% of total passengers Regional routes are unprofitable for both airlines providing the service and the regional airports, thus subsidies are necessary to maintain these services for public benefits Estonian Aviation Academy seminar

25. Contacts Sven KukemelkConsultant Lufthansa Consulting GmbH FAC 1/ Frankfurt Airport Center 1Building B, 7. OG Hugo-Eckner-Ring60546, Frankfurt, Germany Mob: +49 (0) 151 589 40 573Fax: +49 69 696 20830 e-mail: Sven.Kukemelk@LHConsulting.com www.LHConsulting.com Estonian Aviation Academy seminar