Airline Economics Growth Frontiers Dublin 2022: Associate Round-up25 May 2022

Russia, Ukraine and Insurance

As another black swan event, Russia’s invasion of Ukraine came up in many panel discussions. We were reminded of Russia’s violations of both the Cape Town Convention and Aircraft Protocol and the Chicago Convention on International Civil Aviation of 1944, particularly with respect to the dual-registration of aircraft leased to Russian airlines and those same airlines being directed not to comply with lessors’ enforcement actions. Some panellists highlighted that, consequently, lessors’ risk assessments when considering exposure in emerging markets will become more stringent than ever before.

With many aircraft trapped in Russia, a key impact of the invasion for aviation is on insurance policies as lessors look to their own coverage as they consider their aircraft lost. Owing to the volume of claims, many panellists noted the likelihood of litigation for many lessors. Although lessor’s interests align in wanting insurers to pay out, the differences in each case will likely boil down to factual issues (such as the timing of insurers’ service of seven-day cancellation notices).

In any event, future insurance premiums are expected to rise significantly. Some panellists predicted that new insurance policies may propose carve-out style variations on the liability limits for certain high-risk jurisdictions to limit exposure. However, at such an early stage, the full impact on the aviation insurance market is not yet clear.

Post-pandemic recovery

Despite the impact of the Covid-19 pandemic (with passenger traffic dropping by 90% at its peak), there was cautious optimism among panellists regarding the aviation industry’s ability to recover. This is largely due to leisure-focussed travel being on the rise following the release of pent-up demand (whilst business travel is seeing a slower rate of recovery). Airlines, in particular low-cost carriers, employed various methods to manage cashflow challenges and unprecedented demand volatility (including converting aircraft to cargo and cargo-light configurations). Maintaining high liquidity through a ‘fortress balance sheet’ approach is crucial to airlines’ recovery and their continuing resilience. However, overall yield has not yet fully recovered and remains an ongoing issue for many airlines.

Despite the promising signs of recovery, global interest rate rises; a shortage in supply of pilots and flight instructors in the US (which are hoped to be resolved in the next 12-18 months); the soaring price of jet-fuel; and manufacturers struggling to meet delivery timeframes are points of concern for the market. These issues (in particular, the supply chain issues) risk causing difficulty for lessors who will be seeking to capitalise on the post-pandemic recovery. For lessees, there seemed to be consensus among panel speakers that air travel will be capped out by the limit of operational recovery and labour availability, as opposed to being predominantly driven by fuel price. Low cost carriers, in particular, will focus on maintaining flexible fleet strategies, fuel efficient aircraft and minimising operational costs as key strategies for recovery.

ESG and SAF

Environmental, social and governance (ESG) matters were at the forefront throughout the conference. Speakers highlighted the challenges the industry faces in achieving net-zero carbon emissions by 2050 in line with the 2015 Paris Climate Agreement as well as various other ESG related legislation in the near-term pipeline, particularly from the EU Europe. Overall, the broad consensus is that industry engagement in the short, medium and long term is crucial in achieving ESG related targets.

The short-term focus for the industry is on developing efficiencies, including the use of more efficient air-traffic control and direct routing. With fuel representing the largest proportion of an operator’s expenditure (particularly with record-high fuel prices), the latter may prove an easy win for operators’ margins and working towards the net-zero targets.

The uptake of sustainable aviation fuels (SAF) is being recognised as a key means of reducing emissions in the medium-term. Many airlines are setting ambitious goals, typically aiming to have 10% of their fuels be SAF by 2030. However, some predict that SAF supply may only constitute 6% of overall jet fuel used globally by 2030, so only a handful of airlines may reach the 10% target and there will be notable competition around supply.

Long-term ESG goals will be driven by the design and introduction of next generation aircraft and engines, including continued and sustained investment and development of emission-free technologies (noting that operators’ demand for reduced fuel burn have already driven aircraft and engine development in recent years). Whilst this will take time to materialise, there are promising signs as manufacturers’ engagement has been met with investment from leasing companies and airlines and orders for emission-free technologies such as eVTOLs.

The return of the ABS

Despite current market conditions, there was general optimism amongst speakers that aircraft ABSs will see a return to the market in the coming months. Panellists agreed that the structures put in place for previous deals operated as expected during the turbulence in recent months and are fit for continued use. With this in mind, panellists suggested that tweaks could be made so as to become increasingly protective of investors by relying on cash sweeps, tightened debt service coverage ratios (DSCRs) and other mechanisms to mitigate risk to liquidity following unforeseen market events. Pent up demand may pose challenges for issuers in distinguishing themselves to investors – as such, early investor engagement may prove to be key when the market reopens.

Although the ABS structure works, speakers noted that recent black swan events have highlighted the importance of the quality of the servicer as a key consideration for investors. Given that the servicer ultimately drives operational control when recovering aircraft, mitigating losses and re-leasing repossessed aircraft.

With higher interest rates, investor appetite for new ABS deals is likely to resume with demand for both senior and junior series notes. The E-Notes market is expected to trail behind, but many anticipated that these would eventually return.