Finding the right formula

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Climate change is hot and aviation is about to feel the full blast of regulatory heat. The directive incorporating aviation into the European Union emissions trading scheme (EU ETS) entered into force earlier this year, meaning that from 2012 all airlines landing or taking off from EU airports will have to surrender carbon dioxide allowances - or carbon credits - under the bloc's cap-and-trade system.

And while member states have the next 12 months to draft the directive into national law, airlines are being warned that they need to look sharp because by the end of August they will need to have submitted a monitoring plan outlining the exact methodology of how they will go about accurately, reliably and transparently monitoring and reporting emissions and payload data.

Simply put, they will have to show exactly how they go about declaring how much fuel they burn carrying freight, mail and passengers between city-pairs.

The whole purpose of the directive essentially is to cap greenhouse gas emissions from aviation to 3% below average 2004-6 levels in 2012, with the cap increasing to 5% for the 2013-20 period. The cap means that fast-growing aviation will start trading carbon with an effective "shortage" from the outset, especially as, under the new rules, it may have to purchase 15% of its carbon credits either via auction or on the allowance market, or simply reduce emission to surrender allowances equal to their verified emissions.

 

CREDIT DISTRIBUTION

The distribution of carbon credits will be based on the number of tonne-kilometres (TK), which is basically the distance - a great circle, plus 95km (50nm) - times payload carried during the crucial 2010 benchmark year. So the method by which that data is collected and collated needs to be officially signed off by the end of 2009.

Benchmarking will determine the number of free allowances an airline receives based on its verified TK number divided by the total verified TK numbers for all airlines.

Should the quality of an airline's monitoring plan be queried by those charged with policing the system, however, then a carrier could severely jeopardise its all-important application for those free carbon credits from the competent authority of their administering member state.

From the first quarter of 2013, when carbon trading goes live, those allowances will need to be surrendered based on actual 2012 emissions that have been monitored and verified - until then, in 2010 and 2011 an airline needs simply to monitor and submit verified emissions reports. It goes without saying that all airlines will ultimately want as many free allowances as possible when trading starts.

The European Commission, which is still hammering out the detailed guidelines for the monitoring, reporting and verification (MRV) of the emissions and tonne-kilometre data stresses that these rules are necessary to ensure a harmonised application of the directive regardless of nationality and of which member states will be overseeing an airline's compliance with them.

Jeroen Kruijd heads MRV services for consultancy and verifier PricewaterhouseCoopers, which also advises member states and aircraft operators on the emissions trading scheme.

"MRV is an important concept in the EU ETS to ensure aircraft operators monitor and report both TK and emissions data in an accurate and comparable manner, verified by independent auditors," Kruijd says.

"Still, there may be a number of issues or gaps either in the regulations or the forthcoming guidance that will only become apparent when aircraft operators start to do the real thing, as some of the things they do in practice may not meet with the requirements."

Even so, he expects operators to have to make IT system changes throughout 2009 and have a constant dialogue with verifiers during that time in an attempt to develop workable and efficient solutions.

andy drysdale/rex features
 © Andy Drysdale/REX Features

"Operators must focus on producing a complete set of data in a reliable manner. If they report incomplete data or data that cannot be sufficiently proven to be accurate, then the verifier will not be able to sign off on the numbers presented.

"There is no point in saying yes, we possess all the source TK data and emissions reports for the year, but sorry, we can't reconcile and present it in a verifiable way."

Kruijd says large airlines will have much of the data systems available, although even they need to beware of missing out on specific issues such as wet-leasing and codeshares.

"The cost burden for some aircraft operators may be relatively high, and while bigger companies will have the means to develop robust data management systems that meet the ETS requirements, some smaller ones such as business jet operators may suffer from having inefficient reporting processes," he says.

STEERING GROUP

Kruijd forms part of an International Emissions Trading Association steering group in which verifiers, operators and regulators are working together to determine what different-sized airlines face in terms of issues and how to prepare for them. This may lead to effective group solutions for smaller operators such as joint IT-based MRV systems.

For Chris Essex, who heads business development at UK low-cost carrier EasyJet, the EC's approach has so far drilled down to the nth degree on the specifics of an individual flight and accuracy of fuel flow meters or weighing scales, something which he thinks is misguided when the real challenge resides in reporting data from mobile sources.

"For EasyJet, it's the complexity of getting the data back off the aircraft - and that's not such a simple task when you are running 1,000 flights a day with aircraft based all over Europe. We're facing a huge challenge," he says.

"Do you load it on to a USB stick, post it, use a terminal download or send it via a mobile phone link?" asks Essex. "All we are saying is keep it simple. The more the guidelines attempt to be specific, the more problems airlines will encounter. The original template issued by Entec - the consultancy charged by the Commission to formulate the MRV rules - went into micro-detail and we questioned whether this was necessary."

Essex adds that data needs to be presented on a simple aggregated emissions basis, beyond which a verifier can delve in an effort to plug any gaps in knowledge: what fuel was uplifted, what was burned plus data from any on-board metering device.

"Airlines will find themselves tripping up not because they want to ruin the environment, but simply because it's so complex. Emissions trading for most airlines will be owned by the finance department. That reality provided much of the motivation for EasyJet's launch of its carbon offset programme, allowing our treasury function to gain experience in this field."

Airlines will go to the allowance markets and buy extra carbon credits from industries that have excess allowances or alternatively invest in project credits Certified Emission Reductions and Emission Reductions Units to compensate for shortfalls.

Regarding revenues, business adviser Merrill Lynch attempted last year in its report Aviation in EU ETS An Incentive for Efficiency to gauge the potential cost to the industry. While it admits that its analysis is highly sensitive to key assumptions on growth and business model, carbon pricing and auctioning levels, in 2013 it estimates that the international airline community could be tapped for an annual €2 billion ($2.56 billion), rising to €3 billion in 2015 due to the lower cap.

Brussels says auctioning revenues should be used to combat climate change at home and in the developing world, but has ultimately left this to the discretion of individual member states, something that has caused consternation in the ranks of the world's airframers, who would like to see that level of money at least invested back into research and development of future aircraft technologies.

EXAMINATION

An examination of the preliminary list of administering states based on Eurocontrol data shows that France, Germany and the UK will administer half the operators actively flying into Europe. Data generated by Flight International's partner data service Innovata on the basis of available-seat-kilometres of non-EU airlines bears this out.

It could be a gold-plated bonanza moment for the three European powerhouses, although Boeing, for one, is rallying airlines in calling for vital government assistance to help tackle this costly environmental burden. Boeing managing director of environmental strategy Billy Glover says this cross-industry effort will include a focus on government policy and regulation so that it is more effective in accomplishing environmental progress - in other words help to fund it.

Boeing Financial Services managing director Kostya Zolotusky also envisages the costly environmental burden making an impact in a distinctly unilateral fashion. "Europe's plan creates non-market-based dynamics and we hope Europe can blend it into a sensible single global regulation," he says.

The prospects of such a single global regulation for aviation is elusive. While newly inaugurated President Barack Obama has moved forward with automotive emissions reduction plans, how his manifesto pledge on introducing an economy-wide, market-based cap-and-trade system to reduce carbon pollution will relate to aviation remains a mystery.

Even so, it is worth remembering that a cap-and-trade programme does not necessarily translate to a unilateral EU-style emissions trading scheme, according to Air Transport Association of America vice-president of environmental affairs Nancy Young, who says she would be surprised if the new administration does not challenge the legality of Europe's ETS.

However, Merrill Lynch points out, that if the USA was to implement a scheme similar to the EU's in an effort to cut aviation emissions, the upside to the aircraft and engine makers would be significantly larger. "This could accelerate the replacement demand in North America, where the US fleet represents around 7,070 jet aircraft [50% more than the EU fleet] and the average age of the fleet is 13 years above the world fleet average," it says.

MUSING ON THE POSSIBILITIES

While it is interesting to muse on the possible OEM effect, there is plenty of potential for radical shifts in business thinking at airline level: all airlines will need to assess their business model and operations - that could mean making strategic right-sizing fleet decisions on certain routes and maintenance scheduling.

Even a wholesale overhaul of network planning, with the traditional hub and spoke system a possible casualty, could be on the cards as direct "point-to-point" services typically produce lower emissions than two flights via a hub.

Airlines could further attempt to right-size their narrowbody fleets by fitting extra capacity, allowing them to spread their carbon costs over a greater number of passengers. Adding 20 more seats on an aircraft does not increase proportionally the required fuel to fly, with the only cost needing to be offset being for additional cabin attendants.

"Short-term sizing-up could imply some shift within the European airlines' narrowbody orderbook, as the A318/A319 could look much less attractive, as would the Boeing 737-700," says Merrill Lynch, which adds that in the long term, an increase in the number of seats could ultimately determine the next-generation single-aisle airframe design.

Then there are the merger and acquisition implications within this new carbon trading paradigm, as PwC's report Ready for Take-Off notes: "Benchmarking as an allocation method may impact mergers and acquisitions decisions, as aircraft operators with inefficient aircraft will be less attractive due to the higher cost to be in compliance with the EU ETS."

It adds: "The baseline period 2010 will determine future allowances and are thus a value driver for the company. Carbon assessment therefore needs to be a core component of mergers and acquisitions strategy and processes. Is the full carbon risk or opportunity of the asset understood and factored into the company's deal calculations? Has the market factored carbon into values - of the potential purchaser as well as the target? Are there synergies? Do due diligence processes look at carbon?"

LOW-COST MODEL

Hikmat Mahawat Khan, who heads consultancy CapGemini's Centre of Excellence Aviation is convinced. "Emissions trading stands to change the aviation industry - it could even have a similar impact as the emergence of the low-cost model, which led to a deep shift in thinking. In fact, we could see many of the themes that made low cost a success persisting: smaller aircraft using smaller airports. That could have a tremendous impact on the whole aviation supply chain."

EasyJet's Essex says that while carbon trading's cost pass-through effect is estimated at €1-2 per ticket, as an airline it will not know the costs until the 2010 benchmarking period is over.

"We are, however, expecting to do well on the benchmark due to our high load factors, although there is still huge uncertainty on auctioning and level of pricing. As an airline we actually like the ETS because it's a differentiating thing - it sets us apart - we are operating modern aircraft, we cut out waste wherever we find it and don't operate to many congested airports. That really is the unsung story of low-cost carriers," he says.

Khan at CapGemini can even foresee the value of these carbon assets appearing on the balance sheets of airlines - very much in the way UK carrier BMI last year added £770 million ($1.5 billion) to its balance sheet by revaluing its London Heathrow slot holdings in an attempt to reflect better its net asset value.

"That could see the accelerated fallout of many a shaky wet-leased airline that never made a dime of profit and simply decides to call it a day and cash in their carbon chips," he says.

For now, those airlines planning to keep flying should really think about the implications of their 2009 winter schedules, which implicates production throughout 2010.

He says they need to factor their TK aspirations into their strategies now to maximise their allocation of free allowances by boosting payload in that reference year.

"It's about uplift of payload - fly as much as you can during 2010 and then rein back on flight capacity if possible from 2012," says Khan.

He says that while airline boardrooms should be focusing on getting a bigger bang from their free carbon buck, so to speak, it is about more than simply compliance in the short term.

"It's about business transformation and strategy. It requires the collaboration of the entire business - not just a business manager printing out a spreadsheet," Khan adds.