The Canadian Transportation Agency has decided that the existing practice of paying $100 cash or $200 travel voucher is unreasonable.
It has given the airline 30 days to submit new compensation guidelines.
The agency sided with Gabor Lukacs, a former University of Manitoba math professor, who has challenged several airline industry practices.
"I'm extremely pleased by this decision and it is a very important step forward for Canadian in terms of rights of passengers," he said from Halifax, where he lives.
Lukacs suggested to the agency that passengers be compensated between $200 and $800 depending on the length of delay.
Delays of less than two hours would prompt the minimum compensation. Bumped passengers who are delayed two to six hours would get $400 and the maximum would be given for longer delays.
The agency said the airline must indicate why it shouldn't approve the model suggested by Lukacs or one used in the United States.
In the United State, twice the airfare up to a maximum of US$650 is paid for delays of one to two hours and four times the fare to a maximum of US$1,300 is paid for delays exceeding two hours.
The federal agency ruled that Air Canada's 12-year-old bumping payout rate is outdated and doesn't reflect the current price of airline tickets, accommodation and other incidental expenses.
"Mr. Lukacs has presented a more compelling case that Air Canada's statutory, commercial and operational obligations fail to outweigh the rights of passengers to be subject to reasonable terms and conditions of carriage," it said in a 17-page ruling.
The ruling doesn't affect WestJet Airlines (TSX:WJA) because it doesn't overbook flights.
Air Canada (TSX:AC.B) could appeal the agency decision to the Federal Court of Appeal.
"At this time it would be inappropriate to comment as we are currently in consultation with the Canadian Transportation Agency on this topic," said airline spokeswoman Isabelle Arthur.
Air Canada successfully argued that it can overbook and deny compensation in limited cases when it has to switch to smaller aircraft for operational and security reasons that are beyond its control.
Lukacs argued that this was a catch-all excuse the airline could use to deny compensation.
However, the agency agreed Air Canada should have this flexibility as long as it is able to demonstrate that the events prompting the substitution were beyond its control and that it took every possible measure to avoid the situation. Otherwise, it must pay compensation.
While the ruling applies only to domestic flights, the agency is considering a complaint filed by another person dealing with international flights.
Lukacs, who has taken Canadian airlines to task over baggage and other fees, said Canadian passengers face what he says are among the worst conditions in the world.
The advocate said he was prompted to file a complaint in December 2011 after he and some passengers were told by Air Canada that they were not entitled to compensation if they responded to a request for volunteers to be bumped.
"As long as we put up with it they will do it and somebody has to stand up and say no, the buck stops here, this is unacceptable and unreasonable," he said.
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