The EU Parliament and the European Council have agreed on a joint proposal1 to incorporate CORSIA2 into the EU ETS3 monitoring, reporting and verification (“MRV”) framework and to gradually phase out free aviation emissions allowances to airlines by 2027. A “trialogue” compromise agreement meeting between the Parliament, Council and the Commission will be held later this year to agree on a final Directive4.
Parliament’s Extra-Territorial Proposal Dismissed (for now)
Whilst the Parliament and Council are in accord with respect to the phasing out of free allowances and inclusion of CORSIA MRV within the EU ETS, the Council has dismissed Parliament’s proposal to include all extra territorial flights into and out of EU airspace within the EU ETS framework. This is because EU Member States5 are concerned that expanding aviation EU ETS ambitions at this stage,could potentially derail CORSIA negotiations at the ICAO Triannual General Assembly meeting in Montreal this September. The EU Council may decide to reconsider its position should the ICAO Assembly fail to set a long-term carbon reduction goal for aviation.
ICAO to discuss Long Term Ambition
ICAO has yet to agree on a carbon reduction commitment beyond 2035 when CORSIA is scheduled to end. The ‘R’ (Reduction) in CORSIA is a misnomer as the scheme does not include any mechanisms for carbon reduction. CORSIA relies on offsetting emissions above an aggregated emissions baseline for international aviation. The baseline had originally been set at the average emissions from international flights between 2019 and 2020, however, it was reset to 2019 emissions as a result in the sharp reduction in flight activity that arose from the Covid pandemic. As international aviation continues to make a steady recovery, ICAO will need to decide whether to revert to the original baseline or maintain the revised 2019 baseline. Should the status quo be maintained, ICAO’s climate change ambition is likely to come under further scrutiny.
Emissions offsetting through ICAO approved offsetting projects has recently been criticised by some developing countries as being an export of capital and a lost opportunity to invest in domestic aviation infrastructure, such as the production of sustainable aviation fuels (“SAF”). A particular concern within the aviation industry is a mechanism within ICAO’s Resolution A39-36 that allows the Assembly to terminate CORSIA should it be considered an “inappropriate economic burden”. This provision could be invoked should the price of CORSIA eligible offsets (“Emissions Reduction Units”) continue to rise.
All major aviation industry representative groups including IATA, ATAG and the Clean Skies for Tomor- row Coalition have aligned carbon reduction commitments with carbon net zero. IATA’s plans rely heavily on SAFs to provide 65% of emissions cuts and therefore it is becoming generally accepted that the cost of flying will need to increase.
A conundrum for the EU is whether the aviation EU ETS trialogue should be held before or after the ICAO assembly. If before, the EU will be firmly locked into CORSIA, a scheme that is seen by many as having low ambition and lacking environmental integrity. If the trialogue is held after the ICAO assembly, the EU will be able to assess whether any significant progress has been made with respect to ICAO’s long term aviation emissions reduction targets, particularly with respect to alignment with the Paris Agreement ambition of maintaining global warming to well below 2°C and becoming carbon net zero by 2050.
Credit Risk Concerns
The proposal to phase out free European aviation allowances and incorpo- rate CORSIA reporting under EU ETS is likely to create significant addition- al credit risk implications for aircraft operators and aircraft owners. Most airlines captured under the EU ETS have received around 40% of their emissions allowances (”EUA”) for free and some carriers have made windfall profits from surplus EUAs during the past two years as a result of the significant downturn in activity during Covid. That is about to change as by 2027 all airlines subject to EU ETS compliance with be required to purchase all allowances as free allocations are withdrawn. The price of EUAs is currently trading at around €85 per unit (representing one tonne of CO2). The European Central Bank (“ECB”) recently published its first climate change stress test7 which concluded that a carbon price of around $300 per tonne in 2030 is required to remain on an orderly pathway to Paris Agreement warming target and that stringent measures were urgently required to avoid billions of financial losses across euro zone banks.
How Fit Are We For Fit For 55?
The European Commission expects to have its “Fit for 55” regulations for aviation in place by the end of 2022, including EU ETS reforms and an aviation taxonomy structure for transition linked finance.
Carbon emissions reduction of 55% for aviation by 2030 is simply not achievable and so the Com- mission is discussing a lower ambition for the sector. The EU is also proposing under its Refuel EU initiative, that fuel suppliers to airports should use blends of at least 2% SAF as standard, gradually increasing to 63% by 2050. This will apply to all suppliers, for flights within and beyond the bloc. The proposal has met stiff opposition from some European airline groups aviation trade bodies and there- fore the EU is proposing to introduce a “Contracts for Difference” structure where offsetting obligations will be replaced by an investment in SAF production.
Mind The Data Gap
Climate change risk assumptions for airlines and aircraft lessors are now being included in banking credit risk rating decisions. Financial regulators including the European Banking Authority (“EBA”), the European Securities and Markets Authority (“ESMA”), the Bank of England (through the Prudential Regulation Authority (“PRA”)) and the US Securities and Exchange Commission (“SEC”) are all building climate change stress testing and scenario analysis into their systemic risk models.
Financial regulators have recognised that financial risk assumption parties are experiencing difficulties obtaining sufficient Scope 3 emissions data at a portfolio level. Regulators acknowledge that addressing data gaps for climate analysis is a priority if banks, investors and insurers are to deliver effective climate risk management, and to innovate and develop aviation finance and leasing products to support the transition to a more climate-sustainable pathway.
1 Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC as regards aviation’s contribution to the Union’s economy-wide emission reduction target and appropriately implementing a global market-based measure (30/06/2022) https://data.consilium.europa.eu/doc/document/ST-10798-2022-INIT/x/pdf
2 Carbon Offsetting and Reduction Scheme for International Aviation
3 European Emissions Trading System
4 Amending Directive 2003/87/EC
5 ICAO membership comprises of 193 member States. Each State is represented individually, and voting is not delegated to regional blocs such as the European Union
6 Consolidated statement of continuing ICAO policies and practices related to environmental protection – Global Market-based Measure (MBM) scheme
7 ECB 2022 Climate Risk Stress Test (July 2022) https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.climate_stress_test_re- port.20220708~2e3cc0999f.en.pdf