Isra-Mart srl: EU ETS and the aviation industry: between a rock and a hard place

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In this exclusive CAPA interview, AVOCET Principal Barry Moss puts the European Union Emissions Trading Scheme (EU ETS) under the microscope to analyse its effects on airlines and lessors.

How will the EU ETS apply to aviation?

By introducing aviation within the EU ETS, it is estimated that by 2020 CO2 savings of as much as 46%,or 183 million tonnes, could be achieved each year – equivalent for example to twice Austria's annual greenhouse gas emissions from all sources – compared with business as usual.

From 1 January 2012, all qualifying aircraft operators flying in to, between or out of EU airports will have to comply with the EU ETS. The scheme will be administered by 31 Competent Authorities representing each of the EU national states as well as Iceland and Norway. For the purpose of EU ETS compliance, approximately 50% of all aircraft operators will be administered by France and the UK. In February 2011, there were 4883 aircraft operators listed under EU ETS.

To qualify for free allowances, each aircraft operator had to submit a monitoring and reporting plan by December 2009 as well as annual verified CO2 emissions report and an annual tonne/kilometre report by 31 March each year (with effect from 2011).

Aviation allowances are benchmarked against the average emissions for each airline for the period 2004 to 2006 which has been estimated to be 219,476,343 tonnes of CO2 in total for qualifying aviation activities. 82% of allowances set against the benchmark will be distributed to aircraft operators for free in 2012 reducing to 80% of the benchmark for the annual periods from 2013 to 2020.

What will be the most significant impact for the airline industry under the EU ETS?

There is no doubt that the introduction of aviation within the EU ETS will incur additional levels of compliance and complexity that will significantly increase operational risk and ultimately credit risk exposures to airlines. The EU ETS may also have an influence on an airline’s route and fleet planning activities.

However, the most significant financial impacts resulting from the EU ETS will include market distortions resulting from the ability to pass compliance costs on to fare-paying customers and a potential liquidity crunch in the air finance markets in the event of non-compliance or default by airlines under the system.We estimate that the EU ETS will add approximate 1.5% to the current cost of an airline ticket.

How will the ETS affect operational risk management?

Simply because of the amount and level of technical resources required to manage compliance and the very tight deadlines involved. There is a direct linkage between emissions data and fuel consumption as one kilogramme of jet fuel produces 3.15kg of CO2. This equation is simple enough but capturing and recording emissions data and fuel density from aircraft logs and systems is not necessarily that easy and can be extremely time consuming without specific software and IT systems to manage the process automatically.

Tier 1 airlines can allocate existing human and technical resources and in some instances have developed specific ITC systems to manage EU ETS compliance and reporting efficiently. However, smaller airlines are more likely to have difficulty obtaining data capture, consolidating information in an acceptable format and within the deadlines required under the EU ETS. The EU ETS does not allow aircraft operators to outsource their ETS reporting so specific resources will have to be dedicated to managing ETS compliance in house.

In addition, there is only a very small number of accredited verifiers available (presently under 20 worldwide) to verify annual emissions and tonne/kilometre reports. Those airlines that may have left it rather late to appoint an accredited emissions verifier may also struggle to submit their annual emission and TK reports by the 31 March the following year, which could exclude them from obtaining free allowances.

What financial issues does the ETS present?

There is an operational cost to ETS compliance as well as the cost of purchasing any additional credits required over and above the free allowance allocation. However, such costs are insignificant compared to the cost of non-compliance.

EU ETS allowances, known as EUAs, are presently trading at around EUR17. Aviation EUAs will not be fully tradable or "fungible" with general EUAs. Aircraft operators will be able to buy general EUAs from say a steel mill or power plant but will not be allowed to sell aviation allowances to non-aviation emitters. Aviation allowances will therefore only be able to be traded between aircraft operators.

Carbon market analysts predict that aviation EUAs will initially trade slightly lower than general EUAs. Needless to say that being allocated 82% of these allowances for free will provide a huge competitor trading advantage compared to those aircraft operators that may not have either applied or qualify for free allowances. Failure to provide a verified annual tonne/kilometre report by 31 March each year will disqualify an aircraft operator from obtaining free allowances.

The real financial exposure however is the cost of civil penalties imposed by the EU in the event of default under the EU ETS. A default constitutes not submitting sufficient allowances by 30 April each year (commencing 2013) for the previous year’s trading period or failure to provide a verified annual emissions report by 31 March each year (commencing 2012).

There is a statutory civil penalty in the event of a default under the EU ETS of EUR100 per tonne plus the cost of surrendering the allowances that should have been submitted for the previous year’s emissions trading period.

An aircraft operator ETS default is likely to equate to the operator’s annual fuel bill or to put it in simple terms, put them out of business. We have calculated that the cost of civil penalties and replacement EUAs would equate to approximately USD6,000,000 per aircraft for an A320/B737 class aircraft or a staggering USD25,000,000 per aircraft for an A330/B777 class aircraft. Therefore a default under the EU ETS would almost certainly lead to bankruptcy and the risk of the operator’s aircraft being impounded, sold or repossessed.

How will the ETS affect airline credit risk assessment?

The EU ETS is likely to require a paradigm shift by aircraft financiers and lessors in their airline credit risk assessment and risk management procedures. For many existing aircraft finance and leasing transactions EU ETS non-compliance will not have been included as a specific event of default. Therefore obtaining EU ETS compliance information from aircraft operators may be extremely difficult. It is possible if not probable that an aircraft lessor may only become aware of an EU ETS default after the event and may be required to lift any EU lien imposed on its aircraft in order to repossess it.

The main difference between Eurocontrol liens and EU ETS liens is that the latter will be enforced by each of the 31 national Competent Authorities and not through a single entity such as the EU or Eurocontrol. This will make risk assessment and monitoring an extremely complex process. The EU regulations controlling aviation within the EU ETS have to be incorporated within each state’s national law and therefore enforcement of the rules is likely to differ, at least initially, between each Member State.

The magnitude of potential civil penalties and remedies under the EU ETS is likely to lead to an impact on financial risk weighting and credit assessments by banks and aircraft lessors. Assessing EU ETS compliance risk may become increasingly critical in order for financial institutions to comply with proposed Basel III banking regulations and also for the future credit risk assessment of aircraft lessors by the major credit rating agencies.

The inclusion of aviation within the EU ETS could therefore within a very short period of time affect the amount of liquidity available from the aircraft finance market and thereby restrict the ability of airlines to obtain new aircraft or enter into any new sale/leaseback transactions.

China is strongly opposed to the EU’s ETS. Do you predict the EU will re-work the scheme to consider developed vs developing countries, or stand strong?

It is fair to say that many existing industries captured under the EU ETS are also strongly opposed to their inclusion within the EU ETS. Rightly or wrongly they may see it as an additional cost burden compared to their competitors outside the EU that are not subject to emissions market based measures.

As far as aviation is concerned, it does have a much wider implication as for the first time the EU ETS covers emissions that were not generated from within the EU but from the point of departure of an aircraft, including those emissions generated by an aircraft’s APU when located on the ground at say Los Angeles or Beijing airports.

Four US airlines are presently bringing an action against the UK concerning the legal enforceability of the EU ETS. This action is scheduled to be heard by the European Court of Justice in July this year, although a final ruling is unlikely to be given before the full inclusion of aviation within the EU ETS in January 2012.

China on the other hand is threatening not to comply with the EU ETS and has called for a meeting with the EU to discuss an exemption based on is target of reducing Chinese aviation emissions by 22% by the end of 2020 (compared to 2005 levels). China argues that as a non-Annex 1 country listed under the UNCCC Kyoto Protocol and because of its Combined by Differentiated Responsibilities (CBRD) exemptions under the UNCCC Conference of the Parties meetings, it should not be included within the EU ETS. Other non-Annex 1 countries and particularly the other three BRIC countries will no doubt be waiting to see with interest what may result from these negotiations.

It has also been recently reported from some sources that China has threatened to exert political pressure on Airbus in terms of future orders and deliveries from the European manufacturer if the EU does not give way on this issue.

In my view, the EU is caught between a rock and a hard place concerning enforcement under the EU ETS. Whilst the EU would undoubtedly not wish the EU ETS to result into a full scale trade war with China, regardless of the high moral ground the EU may have concerning carbon emissions, it cannot be seen to give into pressure that may result in the unravelling of the entire scheme. If China should be exempted without having a mandatory carbon emissions scheme in place which is equally stringent in its effect compared to the EU ETS, then other countries may also seek similar exemptions. If this were to happen then existing fixed installation emitters already operating within the EU ETS would be likely to call foul and would probably also look for get-outs too.

What does not help is that income from the EU ETS will almost certainly be used as a revenue source for national Treasuries rather than being ploughed back into aviation R&D or reducing carbon emissions elsewhere, as is supposed to happen. This would effectively make the EU ETS yet another aviation stealth tax that would be in addition to, rather than replacement of existing aviation environmental taxes.

Will the EU ETS lead to an increase in demand in more fuel-efficient aircraft? Should lessors be acting proactively in this case?

The demand for more fuel efficient aircraft will be determined by the price of oil and not by the cost of EU ETS compliance. In my opinion carbon allowances would need to be priced in excess of EUR65 (a four-fold increase in the current price) before having any real influence on fleet planning or the acquisition and further development of new aircraft technologies.

New aircraft are only likely to make up one percent of aircraft kilometres flown by 2020 and 11 percent by 2030. Likewise aviation biofuels (which are presently zero-rated under the EU ETS) are anticipated to have no more than a 10% penetration by 2050. We estimate that over 80 percent of RPKs that have been flown during the pre-compliance period of the EU ETS were/are produced by narrowbody aircraft. It looks to us like both Airbus and Boeing are at least 12 years away from producing all-new models to replace their comparatively emissions inefficient cash cow narrowbody models.

In all fairness to the OEMs, the technology just isn’t available yet to justify the design of all new replacements for the existing A320 and B737 aircraft families. Whilst the A320neo for example is likely to reduce fuel burn and thereby emissions by 15 percent or so, even on the most pessimistic growth curves, aviation emissions will continue to outstrip emissions reductions obtained from the introduction of such new derivative aircraft.

As far as investor appetite is concerned, the jury is still out on whether aircraft lessors will see derivatives such as the A320neo as a sound investment or whether they will just be a stop-gap before completely new narrowbody models come off the production lines. Aircraft financiers and lessors will no doubt be scratching their heads regarding what the medium to long term residual values of re-engined existing models will look like and also what impact they may have concerning residual values for legacy narrowbody models.

What aircraft lessors must do is start to manage the potential impacts of the EU ETS on their businesses. Managing the fortunes and operation of existing aircraft assets with an economic life and payback period of over 20 years is difficult enough. The EU ETS is likely to add a whole new strata of complexity to that process and will require the development of new risk management tools and procedures within the next six to eighteen months.