Unlike mainline and low-cost carriers, India's regional aviation sector has not yet taken off. This may soon change now that emerging regional airlines are expanding their fleets, although high taxes and stringent regulations are impeding faster development.

The change in pace is highlighted by a massive order for Embraer E-Jet E2s placed by start-up carrier Air Costa. The airline, which began flying only last year, bought 50 Embraer aircraft, to be delivered from 2018 onward, with options for more.

Almost all domestic carriers are looking to expand by connecting to smaller cities with smaller aircraft. With increased hub congestion and a leveling of demand for the densest routes, the aviation industry here seems poised for a substantial increase in traffic between regional hubs and Tier 2 and Tier 3 towns.

The deal is the biggest order for regional aircraft in India, and it indicates that regional airlines could for the first time contribute significantly to aviation growth in the country.

“If India's airlines are to make the most of this growing demand, they will need to expand their fleets. And while fleet growth is likely to occur across all aircraft categories, we believe aircraft designed for regional service (60-120 seats) will grow fastest,” says Manish Mathur, an analyst with A.T. Kearney global management consulting firm.

India's regional aircraft fleet is expected to grow from 55 in 2011 to as high as 261 by 2025 at a compound annual growth rate of 12-13%, he adds.

Air Costa's order comprises 25 E190-E2s and an equal number of E195-E2s. The airline has options for 50 more and, with options, the deal could total $5.88 billion at list prices.

According to Chairman Ramesh Lingamaneni, deliveries will be spread out over a long time. “It is the cumulative number of jets we would buy from Embraer over the next several years. The actual delivery will be one a quarter—about four a year on average.” From January 2018 onward, delivery of four aircraft will be taken every year for the next 20 years, he explains.

Currently, Air Costa operates two aircraft and another two will be operational by the end of the month, says Lingamaneni. The airline is still a small operation: it offers 12 flights a week.

The regional market is underserved and demand at large metropolitan areas is growing at nearly double the pace, thanks to escalating disposable incomes and economic growth. Airports Authority of India (AAI) expects air traffic from non-hub airports to rise to 45-50% of total air traffic in India in the next few years, up from 35-40%.

Low-cost carrier SpiceJet also has plans to enhance connectivity to Tier 2 and 3 cities and towns, with the addition of Bombardier Q400 turboprop aircraft to its fleet. The carrier wants to establish five more regional hubs in an effort to expand its regional network and connect all major towns via its Q400 regional fleet.

“We decided to strategically focus on improving air connectivity in Tier 2 and 3 towns, as we believe there is a large market in India that has yet to be touched by the benefits of the aviation revolution,” says a SpiceJet official.

The Indian government, despite current turbulence in the commercial aviation sphere, also sees robust growth ahead for the aviation sector if airlines reduce fares, introduce smaller aircraft and connect cities beyond the largest markets. “Our next focus is on providing air connectivity to remote and interior areas of the country by developing low-cost airports and encouraging the growth of regional airlines,” Civil Aviation Minister Ajit Singh says.

India's Directorate General of Civil Aviation eased the requirements for regional airlines several years ago. Carriers looking to initiate regional air services are now required to reach a three-aircraft fleet within two years instead of the previously stipulated one year. At the end of five years, they are required to operate five aircraft, an easing of the previous two-year deadline.

As a result, several private companies have applied to the government for permission to establish regional airline services, the minister says. In 2010, five applications were received; three were successful. In 2011, four companies had applied and three were given clearance to operate. In 2012, there were five applications and four were cleared.

However, airport development has so far been focused on large cities and is likely to be a hindrance for air services in more remote areas. AAI has identified 35 secondary and 27 additional airports for upgrades or development, alongside 15 greenfield sites that will be established through public-private-partnerships. There are 463 airports and airstrips in the country, of which only 281 are operational, but only 90 runways in the country are suitable for jet operations.

Operating smaller aircraft has significant tax advantages in India because the federal sales tax on fuel is only 4% and airlines are not charged parking or landing fees. However, the price of fuel is a major wrinkle that continues to impede the growth of small airlines. That “is the biggest issue. We need to rationalize it,” the minister says. At present, aviation fuel here is nearly 50-60% higher than in countries such as Thailand, Singapore or the United Arab Emirates, driven by factors such as an approximately 30% additional sales tax imposed by local states. This boosts the cost of operations by about 30%.