CORSIA creates compliance complexities for aircraft owners and lessors, as well as operators
Fri 5 Apr 2019 – The airline industry has generally welcomed the International Civil Aviation Organization’s (ICAO) new CORSIA carbon offsetting scheme for international aviation, which went into effect on 1 January 2019. However, CORSIA’s Standards and Recommended Practices (SARPs) impose an immediate compliance obligation on international airlines and raises a number of potential and unforeseen credit, political and reputational risks, not only for operators but also for aircraft owners and lessors, write Jordan Labkon and Barry Moss. Owners and financiers will need to monitor the evolving landscape of CORSIA requirements and the consequences of non-compliance, as well as consider implementation of appropriate measures.
ICAO has yet to determine the types of carbon offset units that will be eligible under the scheme and whether grandfathering of existing offsets will be permissible. Any restriction concerning the type or vintage of eligible offsets may increase the cost of compliance and thus create an economic burden for many operators under CORSIA. The expected bottom-line impact of CORSIA compliance for airlines has attracted the attention of international credit rating agencies such as Moody’s, which has stated that “[g]rowing carbon offset costs have the potential to become significant relative to operating profit … carbon costs have the potential to lower operating income by between 4% and 15% by 2025, and by between 7% and 35% by 2030, all else being equal.”
CORSIA compliance will present aircraft owners with several commercial and legal risks and challenges. One such challenge is to identify who will be responsible for compliance under the scheme where the operator of a flight has not been identified. The first line of inquiry is the ICAO designator (ICAO CORSIA SARPs paragraph 1.1.3), followed by the aircraft registration mark and holder of an Aircraft Operator Certificate (AOC). If the ICAO designator and AOC holder cannot be readily established, CORSIA compliance will then fall to the aircraft owner identified in the aircraft registration documentation (paragraph 1.1.4).
Should an operator fail to submit an emissions monitoring plan and annual emissions reports, its CORSIA Contracting State may not be able to identify the operator of an aircraft’s international flight activity or, consequently, the party responsible for its emissions from such activity. Therefore, in such circumstances, CORSIA compliance obligations would automatically be attributed to the aircraft owner. Any such risk may become compounded for aircraft lessors and investors in asset-backed finance portfolio transactions.
ICAO lacks legal authority to enforce the CORSIA SARPs. This creates a risk that local governments and regulators may hold an aircraft owner responsible for CORSIA non-compliance. Each individual Contracting State is responsible for transcribing CORSIA into its domestic law. While it remains unclear how (if at all) and when each Contracting State will do so, States could pass laws allowing relevant government entities to impose a lien on – and seize and potentially sell – an aircraft pending cancellation of sufficient emissions offsets for the operator’s entire fleet, notwithstanding the rights of the aircraft owner or mortgagee.
Such a law could be similar to the Eurocontrol fleet lien and applicable regulations in certain jurisdictions under the European Union’s Emissions Trading System (EU ETS). In addition, legal and financial consequences may arise should an operator fail to cancel a sufficient quantity of eligible emissions offset units to cover its existing obligations following an insolvency declaration.
Furthermore, current lease and loan documentation practices need to be reconsidered in light of the differences between compliance under the EU ETS and CORSIA. The EU ETS is subject to an annual reporting and emissions allowance surrender cycle. In contrast, while CORSIA will have an annual emissions reporting cycle, cancellation of emissions unit offsets, effective 2020, will be subject to a three-year compliance cycle. The first CORSIA emissions credits are scheduled to be cancelled on January 31, 2025.
This longer cycle is likely to cause aircraft owners to accumulate much greater credit risk exposure. Requiring an operator, as a condition precedent under a lease or loan agreement, to deliver a CORSIA ‘Letter of Authority’ permitting the relevant regulator to disclose the operator’s emissions obligations as a means for a lessor or mortgagee to monitor this credit exposure will likely have little if any effect. It is presently unknown to what extent, if any, Contracting State regulators will honour such letters of authority, as CORSIA allows aircraft operators to request regulators to keep commercially sensitive emissions data confidential (paragraphs 22.214.171.124/7).
Moreover, until the three-year compliance cycle expires, the CORSIA regulator will not be able to confirm the level of an operator’s compliance and financial liability, by which time the damage (and potential exposure for the lessor or mortgagee) may be irreversible. Also, the price of eligible emissions units under CORSIA (measuring the cost of compliance) will not be known until the time of purchase by the operator, unless an operator hedges its CORSIA exposure through a forward contract with a carbon broker.
Should the EU decide to transcribe CORSIA as an annex to the EU ETS, then the existing enforcement measures for non-compliance, which is a statutory penalty of 100 euros ($112) per tonne of CO2, plus additional local fees, penalties and the rights of aircraft seizure, detention and sale.
Meanwhile, the uncertainties surrounding CORSIA could create challenges in disclosing climate change-related risks, trends or factors in publicly listed leasing and finance company annual financial reports and offering memoranda for securitisation transactions that require a credit rating. At least 40 countries, including all EU Member States, have mandatory emissions reporting programmes, according to the World Resources Institute. Credit risk arising from CORSIA should be a factor in future rating agency modelling.
While there is considerable momentum for commencing and implementing CORSIA as a global system for reducing aviation emissions, the scheme still presents many uncertainties and potential risks, but few clear solutions. It is important that aircraft owners and financiers understand the basic functions of the scheme, monitor the evolving landscape of requirements and the consequences of non-compliance, and consider implementation of risk mitigation measures in lease and loan documentation.