Summer in Doha is hot. Your favourite airline revenue economist experienced 50 Celsius and 90 per cent humidity while living there. It was sticky and uncomfortable, and when your air conditioning broke it would take more than a few days to get the repair parts due to high demand.
So no wonder the fashionable thing to do in Qatar is fly away for the summer. Trendy cities like New York, Paris and Singapore are all favourites. Qatar Airways, the local flag carrier, cashes in on the demand with sky-high peak-date fares just after the schools break up in July and just before they start again at the beginning of September.
People accustomed to taking a bargain stopover in Doha might be surprised just how expensive Qatar Airways can get – it is Qatar market that pays for high service standards and the award-winning Q-Suite (see article).
Qatar residents looking for a deal might consider using their Avios. This frequent flyer currency is owned by Spain-based International Consolidated Airlines Group (IAG), which also holds the famous airline brands Aer Lingus, British Airways, Iberia, Level and Vueling (see article).
But unfortunately those looking for free flights will be disappointed. Qatar Airways will collect $398.60 (£317.84) from every passenger redeeming their points to go to Paris in business class. Only $162.40 of this goes to the airports or regulatory agencies and the rest, $236.2, is paid to Qatar Airways as a “carrier-imposed surcharge”, known in the trade by its fare filing categories YQ and YR.
Across the water in Dubai things are even worse for business class bargain hunters. Emirates wants $605 for a “free” ticket to Paris this summer.
Airlines first started filing YQ and YR in response to rising fuel prices in the early 2000s. These filing categories had existed before, but were obscure. At the time they called this a “fuel surcharge” and as the price of Jet A1 fuel went up, so did the surcharge. When the fuel price went down the surcharge did too, at least sometimes.
Some airlines, like Etihad, tried a different approach. They incorporated a moving charge into the fare called a Q-charge. The fare went up or down as the airline adjusted its Q-charge.
Benefits of YQ
From now on I will refer to all fuel surcharges as YQ. As airlines got used to collecting YQ they realised that it came with some important benefits:
1. YQ is easier and less costly to make available for sale than individual fares due to the way the global airline fares system is set up, so the simplest way to do a large-scale fare change is to adjust the YQ*
2. YQ is not commissionable – back in the early 2000s airlines were still paying fees to travel agents based on a percentage of the fare, but as YQ went up the amount airlines had to pay agents went down
3. YQ is paid on frequent flyer redemptions, creating a brand new revenue stream.
Note that the Q-charge does not have these advantages, which is why most airlines do not use it.
* Funny story: Once when I was at Qatar Airways back when YQ was still a new thing the management team required a global YQ increase which was duly filed. Following a request from the sales department, the pricing department then reduced all the fares by the same amount so there was no net change. Not only did this not meet the airline’s objectives to deliver a network-wide fare increase, it cost actual money and a lot of time both to do and to put right…
Redemption revenue is a huge cash machine
Rob Burgess at Headforpoints reckons that London-based British Airways has about 500k co-brand cards in circulation, of which 50k are on subscription (see article). Most of the paid-for cards will be associated with long-haul premium cabin redemptions otherwise hardly anybody would pay the £250 fee.
The card comes with a 241 voucher, so BA collect two lots of YQ when people redeem their Avios for a trip. On London to New York the YQ is £700 ($886) which is probably quite typical. Some routes are a bit more, others a bit less. This means that BA is collecting 50k x £700 x 2 = £70 million a year in YQ from just one market segment in the UK. The overall number for all global redemptions will be higher, possibly much higher.
On 16th March this year Rob broke the news on Headforpoints that BA increased YQ by £100 across the board (link).
It is easy to understand why. With lots of COVID vouchers to honour and travel only just starting to recover BA like all airlines is probably desperate for cash. Somebody at the airline saw a £100 YQ increase as an opportunity to increase revenue from Avios redemptions by £10 million.
The way they saw it at BA, they probably thought of it as money for free. But eventually if they keep on increasing YQ they will kill the programme. Once YQ goes up beyond a certain unknown point many people will lose interest. £1,400 plus Avios and other charges for two flights is already a big ask when you can redeem the points for cash at Sainsbury’s, a supermarket, instead.
So what will happen to YQ in the end if airlines cannot increase it indefinitely? I think there are five possibilities for the endgame. Read on to find out…
Endgame 1: Airline miles & points become a pure discount programme
Getting £1,000 off a business class air fare sounds like a great deal. But if the price left to pay is still £4,000 the proposition is much less compelling.
This is one of the YQ endgames, when airlines increase the surcharges so much that they end up replacing the fare components of a ticket price. This approach maximises the short-term cash generated by redemption tickets. But it has two big disadvantages.
First is loss of gamification. Playing the system to get the best deals possible is fun and keeps people engaged as they find great deals and tell their friends, creating a virtuous circle of growth. But if 100k points is just worth £1,000 off the next flight rather than most of the published price, many members will lose interest. This will harm the airline in both the short term and the medium term.
The second disadvantage is more long term. Airlines earn a lot of money from their co-branded credit cards, which is valued by the markets as funky fintech rather than vanilla operations. This is why in 2019 AAdvantage from American Airlines was worth $20,000 million in 2019 and the airline itself only $6,700 million, according to Loyalty Data Co.
If people decide to use competing credit cards from a hotel, supermarket or even a cash-back deal instead, the airline loses the card business and it’s fintech value. The resulting change in market capitalisation could be significant, increasing an airline’s cost of capital and making it harder to operate profitably in the future.
Endgame 2: YQ keeps going up, miles & points keep getting devalued
In 2018 Cathay Pacific made it’s Asia Miles prices more expensive. A business class seat from Hong Kong to New York went up from 145k to 170k Asia Miles. Devaluations like this are feared by points collectors and make flexible programmes like American Express Membership Rewards more attractive, as members can decide which programme gives the best deal when they are ready to make a redemption.
This is the second YQ endgame. It increases airline revenue by requiring more miles to be sold through the co-brand programme before many members can redeem. It also still allows gamification and the smell of victory when consumers secure an otherwise hard-to-get seat.
Cathay Pacific has much lower YQ than some other airlines because Hong Kong regulators are not keen on the idea. A good tip for points redeemers travelling to Hong Kong is to redeem FROM Hong Kong as much as possible to avoid YQ. When miles and points are devalued, YQ need not go up quite as quickly.
With all that said, your favourite revenue economist expects both increases to both YQ and mileage redemption rates at IAG….
Eventually this outcome on it’s own will lead to unfeasibly high redemption prices, although much further in the future than sky-high cash rates. When consumers no longer find the programme offers a meaningful reward they will switch to something else that does, with corresponding loss of revenue and increasing costs of capital for airlines.
Endgame 3: Revenue based redemptions
The third possibility is that airlines move to revenue-based redemptions, when the miles required for a ticket depend on the cash price. I am not keen on this approach as it makes programmes harder to understand, causes reward seats to appear unachievable and reduces appeal to the mass-affluent market segment which currently power loyalty’s success.
I asked Delta CEO Ed Bastian about this when he took questions at London’s Aviation Club lunch in March (see article). His answer came in two parts:
1. Business class cash fares used to be much higher than they are now and among the American carriers Delta have led the way in introducing fares that address the mass affluent market segment
2. Building and generating a currency that belongs to Delta is an important part of the airline’s strategy. It is important for airlines to experiment with new business models – Delta once bought an oil refinery for example – and issuing mileage currency is an important part of Delta’s business model.
You will notice that Ed did not actually answer the question. That does not matter – I did not expect him to.
But what was interesting was less what he said but rather the way in which he answered the question. His eyes lit up and he became quite animated when giving his response. I got the impression that Delta’s management team have had some interesting and no-doubt heated discussions on this topic. I felt that I had caught a fleeting glimpse inside a private meeting of Delta’s board.
Endgame 4: Points earning rates from flying increase to match inflation and growth
Every year inflation causes the value of each Pound, Dollar and Euro to decrease and every year people spend more nominal currency to catch up. Meanwhile due to economic growth average incomes increase and consumer spend rises accordingly.
This means that every year the number of points earned on co-brand cards increases too.
Meanwhile geography is immutable. The distance between London and Chicago does not change on any human timescale. So the number of miles people earn from flying stays the same.
More points from cards and the constant miles from flying competing for a limited number of redemptions seats will eventually crowd out the frequent flyers, which is something airlines will not want to do.
So I see a fourth YQ endgame – increasing the number of points which people earn each year. It is important that such a change considers both inflation and growth to avoid the problem. If the number of points people earn from flying goes up each year, airlines can safely increase both YQ and the points needed for a seat without devaluing their programme. Some people who like to hoard their miles and points might lose out, but this is no different to holding cash.
Endgame 5: Airlines forget about YQ
The final endgame is that airlines no longer levy YQ on redemption tickets, for many airlines most likely in conjunction with a massive one-off increase in the points needed to buy a ticket. It would then make sense to increase earning rates on flights with inflation to keep flying and co-brand earning rates in harmony.
This approach has all the benefits of gamification and consumer engagement, with accompanying high revenue from the co-brand schemes.
Unfortunately this outcome is all but impossible as abandoning a certain cash payment today for future loyalty benefits and potential but not guaranteed revenue growth in a co-brand scheme will be hard for airline leaders to accept.
Which outcome is most likely?
I will not be running an airline or a loyalty programme anytime soon. But if I did I would go for endgame four – increasing YQ and earnings rates based on distance flown by inflation. If I owned an airline outright without any other shareholders to worry about I would go for option five – forget about YQ.
Sadly I fear that in practice the industry will split two ways. We already see revenue-based redemptions with Delta and others. Points devaluations are long-established practice. My guess is that there will be more of the same. YQ increases will probably not kill airline loyalty programmes for a long time, but they do risk causing serious damage to revenue and valuations both today and in the long term. Caveat venditor.
oliver AT ransonpricing DOT com
PS. Welcome back to Airline Revenue Economics. Ricardo and I took a little break during May. Now we are back on and looking forward to seeing you here.
PPS. Congratulations to my Dad Mike Ranson, who won first prize at the Dalemain marmalade awards on 14thMay. You can buy his double-gold-medal-winning cider & Calvados marmalade at Fortnum & Mason (link) or direct from Dalemain (link). It is delicious! Buy direct from Dalemain and a portion of the price goes to my Dad’s nominated charity – the Motor Neurone Disease Association.
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