Since its establishment in 2005, the European Union Emissions Trading System (EU ETS) has predominantly covered heavy industry and power production in Europe, with limited changes to its coverage. In 2012, domestic aviation was included, but the EU had to backtrack on plans to incorporate greenhouse gas (GHG) emissions from international flights due to opposition from the US and China, which threatened repercussions for Airbus aircraft sales. To accommodate this, the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) was introduced but has been significantly weakened since its inception. In 2013, a few more industrial sectors, such as aluminum smelting, were added to the EU ETS, but calls to expand coverage to other sectors like road transport and heating fuels were resisted until now.
The European Union has now determined that it is easier to include shipping emissions in the EU ETS, signaling its commitment to regulate the greenhouse gases produced by European citizens as part of the Green Deal initiative.
This development should not come as a surprise to observers of the EU ETS or ship owners. The International Maritime Organization (IMO) has already mandated the maritime sector to monitor and report fuel consumption as a proxy for carbon emissions since January 1, 2019. Additionally, the EU has implemented rules requiring ships to monitor, report, and verify their GHG emissions since January 1, 2018. While the IMO has set a target for reducing carbon intensity, it does not cap total emissions, making it easier to achieve. However, the IMO aims for a 50% reduction in total GHG emissions by 2050 (compared to 2008 levels) and eventual net-zero emissions in this century. As the IMO refuses to commit to market-based mechanisms like the EU ETS and CORSIA, the EU believes it is compelled to regulate the shipping sector itself, at least concerning EU shipping.
Considering that international shipping is responsible for only 2% of global GHG emissions, the key questions lie with shipowners themselves: on what basis will the EU include shipping emissions in the EU ETS, and will they backtrack on this decision as they did with international aviation?
Details of the Rules
Although the Commission has yet to finalize the precise rules, some insights can be gleaned from available policy information.
Timing: The expansion of the EU ETS to include shipping emissions is primarily driven by the Green Deal. The enabling legislation is expected to be introduced in June 2021, indicating that shipping’s inclusion will likely commence in 2023. However, an amendment adopted by the EU Parliament on September 15th allows for the possibility of shipping emissions being included from January 2022.
Scope: Following the EU’s previous unsuccessful attempt to regulate aviation emissions beyond its borders, it is anticipated that only intra-EU shipping will be subject to the proposed changes in the EU ETS. However, the Commission’s position suggests that “at least” intra-EU journeys will be counted, while the EU Parliament insists that all ships arriving or departing any EU port will be subject to the EU ETS. Europe’s Monitoring, Reporting, and Verification (MRV) requirements already cover ships (passenger and freight) with gross tonnages of 5,000 or more, which represents approximately 85% of the industry’s emissions. It is thus likely that this threshold will be the minimum requirement for inclusion in the EU ETS.
Size: According to MRV data collected by the IMO for 2018, intra-EU journeys accounted for 54 million tons (Mt) of GHG emissions out of a total of 142 Mt for all ships operating to, from, or within Europe. Depending on the extent of journey coverage, the inclusion of shipping in the EU ETS could increase the existing system by 3% to 10%.
Free Allocation: Similar to the aviation sector and EU industries, the shipping sector can expect some free allocation of carbon credits (EU Allowances or EUAs) for annual compliance. Three crucial factors affect free allocation:
Efficiency-based allocation: Industrial installations receive free allocation based on their efficiency relative to competitors. The top 10% efficient plants receive free allocations that meet or exceed their emissions, while the rest receive less and must purchase any shortfall. Considering that the shipping fleet has an average age of 21 years, it is reasonable to expect that the EU would aim to reward efficient carriers, potentially applying benchmarking to the shipping industry. However, the aviation sector currently employs a blanket free allocation per tonne kilometer, so shipping may also be treated similarly.
Decreasing cap: The EU ETS relies on an overall emissions cap that declines over time. To achieve the current 2030 target of a 40% reduction from 2005 emissions levels, the cap will decrease by 2.2% annually from 2021. As the Green Deal envisions a stricter cap reduction of 50-55% by 2030 (the Commission and EU Parliament position is a 55% reduction), the cap could decline by up to 5% per year, depending on when the higher reduction rate takes effect.
Auction vs. free allocation: Free allocation is subject to the availability of sufficient EUAs after deducting the auction quantity from the cap (the EU auctions around 57% of the cap in Phase IV, spanning 2021 to 2030). The aviation sector and most industrial installations currently receive (and will continue to receive in Phase IV) less free allocation than their emissions require. Consequently, it is reasonable to expect that the shipping sector will receive considerably less free allocation than needed for compliance.
Expected Cost: Energy Aspects forecasts that shipping’s tonne-kilometers will increase, but efficiency improvements will counterbalance this growth, resulting in static sector GHG emissions in Europe. They project a shortfall of approximately 90 Mt for the shipping sector between 2023 and 2030, based on intra-EU journeys alone. At a price of €30 per EUA, this amounts to an additional cost burden of up to €2.7 billion (or €340 million per year) for EU shipping journeys. Some analysts predict EUA prices to be twice this level due to forthcoming structural changes in the system. The shipping sector’s increased demand will further contribute to price escalation. If all journeys originating from or ending in Europe are included and higher price forecasts materialize, the cost of the shortfall could reach €14.2 billion (€1.8 billion per year).
Impact on the EU ETS: On the surface, the inclusion of shipping in the EU ETS appears bullish as it adds to demand. However, supply is likely to increase to compensate (allowing governments to generate more revenue through larger auctions). Consequently, the impact on EUA prices is expected to be muted. Over time, shipping demand is unlikely to be affected by the cost of EU ETS compliance, meaning that as the cap declines, shipping’s participation in the market will tighten the supply/demand balance and have a long-term bullish effect on EUA prices.
Possibility of a U-turn on the Policy
If the EU ETS inclusion is limited to intra-EU shipping and considering that the EU is not a major shipbuilder as it is in the passenger aircraft industry, it seems unlikely that the IMO or non-EU countries can significantly influence the EU’s plans. Therefore, the inclusion of at least some shipping emissions in the EU ETS appears inevitable and irreversible. However, the more aggressive move to include all journeys starting from or ending in Europe will face greater resistance and potential retaliation from other countries. If the IMO introduces a viable Market-Based Mechanism, the international element could be dropped from the EU ETS. The pressure is mounting on the IMO to take action.
Other Considerations for Shipowners
Carbon Leakage Risk: Depending on how the rules are defined, ships may call at non-EU ports during journeys between EU ports to avoid EU ETS costs. This phenomenon, known as “carbon leakage,” can result in more environmental damage due to attempts to circumvent environmental penalties. It remains to be seen how the EU will discourage such activity, which could even include ships making additional stops in UK ports depending on post-Brexit trade negotiations.
Winners and Losers: Older and less efficient ships will face the largest shortfalls and consequently incur the highest costs for EU ETS compliance. Depending on the rules governing free allocation, the most efficient ships and those powered by liquefied natural gas (LNG) could end up with surplus EUAs that can be sold for profit or used to finance conversions. If free allocation follows the same principles as those applied to fixed installations, free EUAs can be utilized in various innovative ways to bolster shipowners’ finances.
Redshaw Advisors Ltd specializes in assisting companies in managing their environmental market risks, providing information, advice, and carbon credit procurement. Please don’t hesitate to reach out if you would like to learn more about how we can support your company.
[1] Domestic aviation refers to all flights taking off and landing within the EU.
[2] The inclusion of shipping in the EU ETS has already received approval from ENVI (the European Parliament’s environment committee) in July 2020 and the European Parliament on September 15, 2020.
