Aviation carbon emissions and regulatory compliance proving a concern for aircraft financiers and insurers
Wed 9 June 2010 – The inclusion of the aviation industry within the European Emissions Trading Scheme (EU ETS) with effect from 1st January 2012 could result in a number of adverse implications and potential liabilities for the global aircraft finance and aviation insurance markets, writes Barry Moss. These include credit risk, operational risk, political risk and asset (or aircraft value) risk.
The mandatory scheme will allocate free carbon emission permits to aircraft operators covering about 82% of their historic carbon emissions. Had the EU ETS been introduced in 2008, it would have covered four million scheduled airline movements carrying over 500 million passengers. Over 4,300 aircraft operators are presently included within the scheme.
Depending on actual reported carbon emissions during 2010, aircraft operators are likely to have to purchase additional carbon allowances, called EUAs, which are also commonly referred to as carbon ‘certificates’. Any shortfall in certificates will have to be purchased through the emissions trading scheme. Aviation EUAs can only be traded between airline operators and are not fully ‘fungible’, or interchangeable, with standard EUAs used by other large carbon emitting industries currently trading within the system. This is because the EU has concerns that the ETS could potentially become flooded with aviation carbon credits. Aircraft operators can, however, buy and trade in standard EUAs in addition to aviation EUAs.
For most aircraft operators, entrance into the EU ETS cap-and-trade system will be costly, both financially and operationally in terms of compliance and human resources.
So, how could the EU ETS or any other aviation emissions trading scheme affect the aircraft finance and aviation insurance markets? To my mind, the potential risks that need to be addressed are credit risk, operational risk and asset risk, also commonly referred to as aircraft residual value risk.
European Directive 2008/101/C brought aviation into the EU ETS. It is presently unclear under this directive whether aircraft owners, including banks, investors and operating lessors have a contingent liability to pay fines and penalties in the event of a default under the EU ETS by an aircraft operator. By way of comparison, a smaller carbon emissions trading scheme operated within the UK, the Carbon Reduction Commitment, places a clear contingent liability on, for example, a commercial property owner or landlord in the event of a defaulting occupier or tenant.
The extent of any contingent liabilities as far as aviation in the UK is concerned will be determined by what is known as the Second Stage Regulations. These regulations were scheduled to be placed on the statute book earlier this year but have been delayed due to lack of Parliamentary time and the UK general election. Until these regulations have been adopted, it is difficult to know what, if any, potential financial liability exposure aircraft financiers and lessors may have in the event of an aircraft operator defaulting under the EU ETS. With 29 Competent Authorities providing compliance oversight throughout Europe, the picture becomes even more complex when taken in its widest context.
The introduction of aviation into the EU ETS could also provide an additional liability risk for the international aviation insurance market. It is quite possible that in the event that EU ETS financial penalties have been enforced on a defaulting aircraft operator, the aircraft operator or aircraft owner may seek to attempt reimbursement, either under the compulsory liability insurances purchased by the aircraft operator or under contingent liability insurances that are often purchased by aircraft financiers and lessors.
The present Lloyd’s and international aviation insurance markets’ ‘Noise and Pollution and other Perils Exclusion Clause’ (referred to as AVN46B) specifically excludes “pollution or contamination of any kind whatsoever”. The question is whether carbon emissions are legally considered to be a pollutant or a naturally occurring and very common gas?
Scientists believe that around 6% of global carbon emissions are anthropogenic (man-made) – the rest are naturally occurring. Aviation currently accounts for about 2.6% of anthropogenic carbon emissions but in a ‘business as usual’ scenario, this figure is projected to increase to over 5% by 2030. If insurers wish to avoid any potential liability under the EU ETS then the AVN46B noise and pollution exclusion clause may need to be revised or strengthened to specifically exclude any potential liability arising under any carbon (or other greenhouse gas) emissions trading scheme.
Compulsory emissions trading schemes will become an increasing cost burden for aircraft operators. We have calculated (in conjunction with Ascend and Ecometrica) that on a future projected allowance cost of €40 per tonne (or EUA/certificate) and an average passenger load factor, the cost of compliance for a well-known UK low-cost carrier could add around 1.6% to operating costs. This may not seem much until compared to the 2008 pre-tax profit margin of that airline which was coincidentally also 1.6%. This is a respectable profit margin for the airline industry where margins are generally razor thin. Therefore the EU ETS could well tip the balance between profit and loss for many aircraft operators, particularly those that are already operating on the edge of, or are close to, bankruptcy.
Depending on price elasticity, it may be extremely difficult for many aircraft operators to pass such costs onto their customers by way of increased fares and cargo costs, particularly as many air passenger duties and other aviation ‘environmental’ taxes have also increased recently, or are about to increase, across some EU States, including the UK. The German government has just announced that it too is to introduce an ‘ecological’ passenger departure tax to help reduce the country’s deficit.
However, the real exposure is likely to arise from those aircraft operators that have failed to register or may fail to comply with the EU ETS in 2012. For example, 38% of aircraft operators listed on the UK register, representing 362 aircraft operators failed to register under the scheme for free allowances prior to the deadline of November 2009. That means that they may well have to purchase 100% of their emissions certificates rather than initially claiming approximately 82% of them for free. Such operators could therefore be put at a distinct competitive disadvantage compared to those aircraft operators that have submitted what are referred to as their monitoring, reporting and verification plans in order to gain free allowances.
If this is typical throughout the 27 EU States and other countries that have signed up to the EU ETS, then somewhere in the region of 1,500 aircraft operators may not be compliant under the scheme. Although many of these aircraft operators are small in size, the cost of penalties for non-compliance is draconian at €100 per tonne of carbon emitted, plus the cost of making up un-submitted allowances at future carbon prices.
About 90% of all scheduled airline movements within European airspace are short-haul. A typical Airbus A320 or Boeing 737 operating into, out of or within Europe will emit on average in the region of 20,000 tonnes of CO2annually. Therefore assuming the cost of an EUA carbon permit post-2012 could be as high as €40 (currently trading at €16 per tonne/EUA/certificate), the penalties and costs for non-compliance under the EU ETS could be as high as €5 million to €7 million per aircraft.
Widebody aircraft could easily incur penalties and costs exceeding three times that amount. This would roughly equate to the aircraft operator’s current annual fuel bill for each aircraft and would almost certainly put any defaulting airline out of business. Under the scheme, the EU has the legal right to impound, confiscate and sell any aircraft owned by or financed to the defaulting operator in the event of non-compliance (perversely, different rules may apply for leased aircraft). The EU or any of its member States can also rescind an aircraft operator’s Air Operators Certificate (AOC).
The credit risk and political risk for the airline industry is therefore a potential threat that should not be ignored. Standard & Poor’s recently stated that “in our view, [the ETS] will likely lead to further strain on airlines, in light of the competitive and economic pressures already weighing on that industry.” Similarly, Moody’s “believes that there is a long-term potential for regulation of carbon emissions that may limit the future growth of aviation traffic and could have significant financial impact across the aviation industry...”
Aircraft financiers and lessors may therefore have to assume an increased risk of financial default as a result of the EU ETS and increase their balance sheet provisioning accordingly. Any degradation in credit risk quality could ultimately lead to credit rating downgrades, particularly for aircraft leasing companies and securitized aircraft portfolios.
Aviation insurers should be concerned that the EU ETS or any other emissions trading scheme could seriously add to the decline of the aviation industry and therefore demand for insurance and future premium income.
Aircraft owners, whether financiers or operating lessors, are usually named as an addition insured on the aircraft operators insurances under what is referred to in aviation insurance terminology as the Airline Finance/Lease Contract Endorsements, or AVN67B/C. This endorsement gives aircraft owners the same levels of protection as the aircraft operator under their insurances. Therefore the aircraft owner could in theory claim in its own right against the aircraft operator under the aircraft operator’s own insurances. Aviation insurers could thereby unwittingly find themselves being sued by creditors should the courts uphold that ETS penalties or carbon emissions are covered under the insurance terms and conditions.
Finally, aircraft residual values and airlines fleet values are likely to get hit even harder should Airbus and Boeing decide to introduce re-engined, more fuel efficient narrowbody versions of the A320/B737 or brand new aircraft designs.
Both manufacturers are concerned about incursion into the bottom end of their narrowbody aircraft market duopoly by other manufacturers providing new aircraft designs with new technology ‘geared turbofan’ engines that are likely to be 15-20% more fuel/carbon emissions efficient than those presently installed on the Airbus A318/A319 and the smaller Boeing 737 models. Whilst it is difficult to see how new build re-engined versions of current narrowbody models would justify the development and acquisition costs, it would certainly put further downward pressure on existing narrowbody aircraft residual values and therefore future fleet values.
As hull insurance premiums are generally calculated as a percentage rate of an aircraft’s ‘agreed value’, this could again lead to a reduction in premium income, particularly where airlines are financially so constrained that they may be willing to further reduce the agreed values of their aircraft assets.
In addition, any such hybrid models would only be a stop-gap before the design and construction of completely new narrowbodied aircraft from the Airbus and Boeing stables within the next 10 to 15 years or so. New technology aircraft are only likely to contribute one percent of aircraft kilometres flown in 2020 and only 11% in 2030. It is therefore questionable whether many airlines would be interested in such interim model aircraft, bearing in mind their acquisition cost, untested technology and anticipated low investor appetite due to their potentially poor residual values. Aviation fuel and carbon prices would need to increase significantly in order to for most airlines, aircraft lessors and investors to consider whether such interim models would represent a significant operating cost advantage.
The EU ETS and other prospective greenhouse gas emissions trading schemes therefore represent a number of potential consequences for the aircraft finance and aviation insurance markets and, as such, are already being stress tested by a number of banks, aircraft lessors and major aviation reinsurers.
Barry Moss is a principal of Avocet, an independent aviation insurance and aviation emissions trading scheme risk management consultancy. He can be contacted at firstname.lastname@example.org