Australia: Update on the inclusion of aviation into the EU Emissions Trading Scheme
Legalflyer - July 2011

Since we last reported on the introduction of aviation into the EU Emissions Trading Scheme (EU ETS) in December 2010's edition of the Legalflyer there have been further developments regarding the scheme which will be of interest to airlines, leasing companies and aircraft financiers. Firstly, on 30 June 2011, another milestone date in the lead up to the inclusion of aviation into the EU ETS passed with the publication of the total quantity of aviation emissions allowances available for 2012, 2013 and each year thereafter up to 2020. Secondly, as we near the 1 January 2012 launch date for full compliance with the expanded EU ETS, there has been growing public opposition from various governments along with manufacturers and airlines to the EU ETS, with threats of retaliatory measures against the EU and EU airlines. Finally, we report on an interesting article published by Standard & Poors looking at the estimated costs which the scheme will have on the aviation industry.

European Commission (EC) publishes historical emissions data on which allocations will be based.

In the Commission Decision of 30 June 2011¹ the EC decided that the total number of aviation allowances to be created in 2012 amounts to 212,892,052 tonnes of CO2 and the number of aviation allowances to be created each year from 2013 onwards to 2020 amounts to 208,502,525 tonnes of CO2. The number of aviation allowances for 2012 represents 97 per cent of the average historic aviation emissions over the period 2004 - 2006 (with the 2013 - 2020 (Phase 3) allowances cap representing 95 per cent of the average historic emissions). The calculation was based on data from Eurocontrol and actual fuel consumption provided by aircraft operators. In addition, calculations were carried out to account for fuel consumption associated with the use of auxiliary power units on aircraft at airports.

The next step in the process of establishing the EU ETS will be the publication by the EC on 30 September 2011 of the benchmark that will define how many free allowances aircraft operators will receive. Airlines which will be subject to the EU ETS have been monitoring their emissions during the 2010 (being the benchmark year) and were required to verify and report these emissions to their administering Member States by 31 March 2011. Based on the information submitted by Member States and the aviation allowances caps set out above, the EC will calculate the benchmark that will determine how many free allowances aircraft operators receive. The EC will at the same time also publish the percentage of allowances to be auctioned, given away free and allocated to the special reserve (for later distribution to fast growing airlines and new entrants into the market).

Growing opposition to the EU ETS

Until now, public criticism of the EU ETS has mainly come from airlines and industry trade groups. Over the past few months however there has been growing opposition to the expansion of the EU ETS to include aviation, with foreign governments weighing heavily into the debate. In response the EU is holding firm, stating that the legislation will not be changed. Much of the opposition centres on the 'extra-territorial' nature of the scheme as it applies to emissions from flights into and out of Europe, including the emissions outside EU airspace - one US airline executive stating: 'If we're starting an auxiliary power unit in Los Angeles , [for flights to Europe], the European Union is regulating that'.

The Financial Times reported on 5 June 2011 that the head of Airbus had warned Brussels that it faces a trade war with China and other powerful countries over the EU ETS. In a joint letter with the Virgin Atlantic chief executive, Tom Enders warned that 'it was madness to risk retaliation' from major global powers should it proceed with expanding the EU ETS to include aviation. The letter continues: 'If the EU goes ahead with its plans, China has already....announced its intention to deploy countermeasures against European aviation'. The EU climate commissioner, Ms Connie Hedegaard, responded that it would set a worrying precedent if Brussels caved in to China's demands. The Guardian reported on 6 June that British Airways and Iberia chief executive Willie Walsh echoed similar concerns to those raised by Airbus at the annual general meeting of the International Air Transport Association held in Singapore in early June. Walsh said that if major powers are forced to pay for carbon dioxide emitted by services to and from the continent, they could impose aviation taxes on European carriers or block flights. Walsh has called for a global emissions trading scheme for airlines and urged the EU to implement a compromise in the meantime in the form of having the scheme apply to intra-EU flights only.

The US administration has expressed 'strong concerns' about the EU ETS and has informed the European Union that it does not want US airlines included in the ETS when it comes into effect in 2012. The Financial Times reported on 22 June 2011 that during an US-EU aviation meeting held in Oslo on 22 June 2011 officials from various departments of the US government had set out a list of questions for the EU representatives ranging from what the process was for changing the legislation for ETS to how it could be deferred. The EU officials responded that the trading scheme legislation was set in law and that the EU had no intention of changing it.

There has also been significant opposition from China to including the aviation sector in the EU ETS. The Head of the China Air Transport Association has threatened legal action against the scheme and in an escalation of China's opposition to the EU ETS and perhaps the most drastic action taken against the EU ETS to date, the Financial Times reported on 24 June 2011 that Beijing had blocked a multi-billion dollar order for 10 Airbus A380 aircraft for Hong Kong Airlines. However China has also announced its own aviation emissions plan which EU officials are studying to assess whether it is an 'equivalent measure'. The EU ETS legislation provides that airlines may be partially exempted from the scheme if they are from countries with equivalent measures to deal with aviation emissions.

We reported in December 2010's edition of the Legalflyer about the legal challenge to the EU ETS being brought by the Air Transport Association of America along with a number of major US airlines. While the case was initially heard before the High Court in England, as the challenge raised novel questions on the interpretation of EU law, the High Court referred the case to the European Court of Justice in Luxembourg (ECJ) - the EU's highest court. The hearing before the ECJ took place on 5 July 2011 and while a preliminary ruling from the ECJ is expected towards the end of 2011 the case is then expected to be returned to the High Court in England, so it is likely to be some time before a final decision regarding the case is handed down.

Cost of EU ETS Compliance

It is likely that the inclusion of aviation into the EU ETS will increase costs for airlines, a point which has always been accepted by the EC. The International Air Transport Association expects airline emissions to grow at a faster rate than the rate at which the industry can improve fuel efficiency and accordingly airlines operating within European airspace are likely to be net buyers of carbon allowances in the EU ETS. Standard & Poor's estimates that while the initial cost of compliance with the EU ETS will be marginal compared to fuel and lease payments, in such a cyclical, capital-intensive and highly competitive industry, managing EU ETS compliance costs will over time differentiate aircraft operators.²

In terms of the amount of additional allowances which the airline industry will need to purchase, research conducted by Standard & Poor's suggests that the industry will need to purchase a minimum of 20.5 per cent of its 2004 - 2006 emissions plus actual growth on European routes since the 2004 - 2006 baseline.³ In terms of the monetary cost to the industry, the Carbon Trust believes that airlines are likely to purchase potentially €23 - 35 billion of allowances over 2012 - 2020 (based on a carbon price of €25 per tonne of CO2).⁴ Standard & Poor's considers that, prior to taking into consideration any cost pass through, the EU ETS is likely to cost the aviation industry in the area of €1.125 billion (at a carbon price of €15/t CO2 - which more closely reflects the current price of carbon).

In terms of the potential impact on airline revenues, in the short term analysts consider that the EU ETS will not have a significant impact on rated European airlines. This is because CO2 emissions are directly related to fuel efficiency - which airlines are already focused on improving. Furthermore, the amount of free carbon allowances is fairly high and carbon prices are relatively low compared with fuel prices.⁵

In the longer term, however, the aircraft operator's ability to pass on additional carbon cost will be a key differentiator between operators. Some of the factors which will differentiate operators will be the efficiency of an operator's fleet (i.e. young fuel efficient fleet vs older aircraft), the route network (i.e. long haul non-stop routes are relatively more fuel efficient that short-haul, multi-stop routes covered by the same aircraft) and its marketing pricing point (i.e. airlines with a higher proportion of premium revenues may find it easier to pass on carbon costs to their passengers in comparison with low-cost and/or short haul airlines).⁶

Additional factors which are likely to impact on an airline's performance under EU ETS are the rate of pass-through of carbon costs from airlines to customers and the resulting change in demand due to increased ticket prices.⁷ In terms of pass-through of carbon costs, according to an EU Working Document, fully passing on the cost of carbon to passengers would mean that by 2020, airline ticket prices for a return journey could increase by between €4.60 and €39.60 depending on the length of the journey.⁸ This assumes coverage of all departing and arriving flights and a high allowance price of €30.⁹

A secondary factor which may impact on airlines' performance as a result of the EU ETS is so-called 'carbon leakage' - that is, the risk of traffic being diverted from EU operators to the benefit of non-EU operators. Flights that either connect at a non-EU airport or fly direct between two non-EU destinations would compete more effectively against those flights that connect at a EU airport.¹⁰ For example a flight from Dubai to New York would not bear a cost of carbon under the EU ETS and would have an increased advantage over a similar flight that connected via Frankfurt, which would bear the full cost of carbon on both legs under EU ETS.¹¹ The issue of carbon leakage may lead to European airport hubs becoming somewhat less competitive for passengers coming from outside the EU and transiting through to an end destination outside Europe.¹²

Many are expecting opposition to the EU ETS to grow as the launch date nears and also from September 2011 when airlines will be informed of the number of free allowances to which they are entitled and when the cost implications of the scheme become more apparent. We will continue to provide updates of developments regarding the EU ETS. However, in the meantime, please do not hesitate to contact anyone from our team should you have any queries or require further information regarding the scheme and how it may impact your business.

Footnotes

1. Commission Decision of 30 June 2011 on the Union-wide quantity of allowances referred to in Article 3e(3)(a) to (d) of Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowances trading within the Community

2. 'Airline Carbon Costs Take Off As EU Emissions Regulations Reach for The Skies', Standard & Poor's, February 18, 2011, pg. 2

3. ibid footnote 2, pg 6.

4. 'Fasten your seatbelts: Airlines and cap and trade', (CTC 764), The Carbon Trust, pg. 1

5. ibid footnote 2, pg 8.

6. ibid footnote 2, pg 9.

7. ibid footnote 2, pg 10.

8. Commission staff working document - Summary of the Impact Assessment: Inclusion of Aviation into the EU Greenhouse Gas Emissions Trading Scheme {COM(2006) 818}

9. Loc cit.

10. ibid footnote 3, pg 26.

11. Loc cit.

12. ibid footnote 2, pg. 10.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.