This paper examines how climate change policy can impact on competition, prices and profitability in the air transport industry. It begins with an outline of the climate change policies that have been suggested, and it gives particular attention to the inclusion of air transport in an emissions trading scheme (ETS).This is likely to prove an important policy direction, with the EU, Australia and New Zealand all planning to include air transport in their ETSs. The scope for airlines to reduce their emissions intensity in the short run and long run is examined- it is concluded that the scope in the short run is quite limited. After this, the application of the emissions trading schemes of the EU, Australia and New Zealand to air transport is discussed, and the possible impacts on air fares are assessed. Allowance is made for the cost of permits for both direct and indirect emissions. The impacts of climate change policies, such as carbon taxes or requirements to purchase emissions permits, on airline competition, prices and profitability are analysed next. Impacts differ according to market structure- whether airline city pair markets are competitive, monopolistic or oligopolistic. They also depend on the time scale- airlines are unlikely to be able to pass on the full cost of their permits to their passengers in the short run, though in the long run, it is likely that airlines will exit from some city pairs, and this will enable to remaining airlines to raise their fares and restore their profitability. This may not occur in markets constrained by airport slots or capacity limits imposed in air services agreements on international routes, though the airlines’ problems are not likely to be as severe as has been suggested. If permits are provided free of charge to airlines, fares should still rise in the long run, assuming that airlines are profit maximisers and factor in the opportunity cost of the permits they obtain free. However even if airlines do this, there can be cases where fares do not rise by as much as they would if permits have to be purchased, because the operation of the ETS may discourage exit from markets. If airlines do not act as profit maximisers, air fare increases will be limited, and airlines will have the scope to cross subsidise less profitable routes. The limited evidence on airlines’ use of free inputs (such as airport slots) is examined to obtain insights into whether airlines do indeed maximise their profits- this evidence is inconclusive. Finally the application of an ETS to international air transport is considered – this can give rise to issues of competitive non-neutrality, even when permits are sold.
