Decarbonisation in the Shipping Industry
EU Emissions Trading System for Maritime Transport Explained – Part 2 of 6
UK & Europe
The EU Emissions Trading System (EU ETS), the world’s largest carbon market introduced in 2005 by the EU to combat climate change through the reduction of greenhouse gas emissions, by way of a cap-and-trade system, was recently expanded in June 2023 to include the maritime transport sector.
In the third article of our six-part series reviewing the changes introduced by the new EU rules, set to apply from 1 January 2024, we look at how EU Allowances are to be purchased and how the cost of these allowances may be shared between the parties.
As previously mentioned, the EU ETS is a “cap-and-trade” system meaning that a cap is set on the amount of carbon dioxide emissions that specific industries (shipping being one of them) are allowed to emit.
In simple terms, this “cap” on emissions is set at EU level on an annual basis and is then split in allowances, each of them counting for one tonne of CO2 which, in essence, means that each allowance permits a company to emit one tonne of emissions.
It is worth noting that in some industries, a number of allowances are or have been awarded for free during the initial period of the application of the relevant framework (such as manufacturing industries), but shipping is not one of those.
The EU is set to lower the cap annually, encouraging the regulated companies to invest in clean technologies. As a benefit, companies that do not make use of all of their allowances can trade them or save them for future usage, however where a company exceeds its allowances, a fine is imposed, as we discuss later.
The “polluter pays” is the predominant principle when it comes to the EU ETS framework.
Where the operations of a Shipping Company fall within the regulatory spectrum of the EU ETS, the Shipping Company must purchase allowances via auctions held through the European Energy Exchange (EEX) primary market (spot auctions) or the secondary market (spot continuous and derivatives), either directly or through brokers or traders who act as indirect access providers to the EEX platform.
Such intermediaries are usually called carbon brokers and their role is to bring together buyers and sellers to effect over the counter transactions. All brokers must be authorised by EEX in order to participate in the bidding process.
There is no fixed price per allowance. The cost of trading allowances depends purely on supply and demand.
There is also no upper price limit or floor, although there is a provision under Article 29a of the EU ETS Directive1 for a boost in the provision of allowances in case of severe price fluctuations.
This explains why companies may opt to protect their interests from exposure to price fluctuations by purchasing allowances via the secondary market mentioned above, especially as futures are listed on the EEX platform up to nine years ahead.
As auctioning is the default method for allocating allowances through the EU ETS, it is worth elaborating a bit further on the auctioning process.
The volume of allowances traded via auction is primarily determined annually based on the provisions of the EU ETS Directive and the Market Stability Reserve.
The EEX mentioned above is based in Leipzig, Germany, and is the regulated and closely supervised common auction platform (CAP), as provided by the Auctioning Regulation2, for all twenty-eight member states (including the three EEA EFTA countries), all of which have signed a Joint Procurement Agreement with the intention of engaging in a transparent, harmonised, and regulated manner for auctioning the allowances.
Germany and Poland have opted-out of the common auctioning platform, yet Germany has nominated EEX as its opt-out platform, and Poland is making use of the EEX to auction its allowances until further notice. Confusing as it sounds, in essence, Germany and Poland trade their allowances on different dates and volumes, but the rules governing the process of doing so are very similar to the ones followed by the rest of the EU Member States (including the EEA EFTA countries).
The EEX platform is also used by both the Modernisation Fund and the Innovation Fund for the purpose of auctioning their allowances.
The Modernisation Fund is financed through revenues generated from the auctioning of 2% of the allowances for the period 2021-2023 via the EU ETS and from allowances that are being optionally transferred to the Fund from other Member States or EEA EFTA countries.
Its goal is to support ten low-income EU economies during their transition to climate neutrality by helping them fund investments relating to the modernisation of their energy systems.
The Innovation Fund, on the other hand, was established to promote innovation in new, low-carbon technologies and procedures, and is one of the largest funds in its field. It also generates its revenues via the EU ETS and directs its resources to both large (over €7.5 million) and small (under €7.5 million) scale projects.
The auctioneer responsible for the auctioning of the allowances relating to the Modernisation and Innovation Funds is the European Investment Bank.
With reference to the auctioning process, each Member State and EEA EFTA State appoints an auctioneer, either a private or public body, which is responsible for the auctioning of the respective State’s allowances, the collection of the proceeds, and the payment of such proceeds to the respective State.
The organisations eligible to bid in the auctions are operators regulated under the EU ETS, investment firms and credit institutions, business groupings of operators regulated under the EU ETS, and other intermediaries authorised by the respective Member States or EEA EFTA countries, as well as public or state-owned bodies that have controlling rights over the aforementioned regulated operators, all of which have to fulfil certain admission criteria under EU and EEX rules before being allowed to trade using the platform.
Bidders are allowed to place bids specifying the number of allowances (always in bundles of 500) they would like to bid for and their price. Once the biding window closes, the platform publishes the clearing price. For the purpose of the EU ETS auctioning procedure, the allowances are classified as financial instruments.
As set out previously, the “Shipping Company” is the entity obliged to monitor and submit verified emissions reports to the administering body.
The “Shipping Company” is defined as “the shipowner or any other organisation or person, such as the manager or the bareboat charterer, that has assumed the responsibility for the operation of the ship from the shipowner …” and is the holder of the Document of Compliance under Regulation (EU) 2015/757.
The EU’s intention and well-accepted principle is that the “polluter pays”.
The Directive states that in line with the “polluter pays” principle, the Shipping Company should be entitled, under national law (to be implemented by Member States), to claim reimbursement for the costs arising from the surrender of allowances from the “entity that is directly responsible for the decisions affecting the greenhouse gas emissions of the ship”.
Where there is a time charter in the charter chain, the owner (or bareboat charterer) will exchange verified data as both of the owner’s and charterer’s decisions contribute to the emissions of the vessel.
The approach to EU Allowances (EUAs) will be a commercial decision: the owner/bareboat charterer could purchase and pass on the cost of the EUAs, or the time charterer could purchase and transfer the EUA allowance to the party responsible (i.e., the bareboat charterer/owner or technical manager).
As the quantity of emissions generated will be uncertain at the commencement of the charter term, the emissions will need to be recorded and verified on an ongoing basis.
Where there is a voyage charter, as emissions are difficult to quantify pre-voyage, it is anticipated that these would be calculated and settled at the conclusion of the voyage. The charterer would be provided with a statement, generated from verified data, confirming the EUA cost of each voyage.
Generally speaking, as owners control operational matters for a voyage charter, we would expect that the owner (or the technical manager) purchase EUAs and the charterers reimburse the actual cost.
However, as EUAs can be traded, there is no reason why a charterer could not transfer actual EUAs instead.
Shipowners and bareboat charterers will seek to negotiate costs clauses in commercial arrangements that make it clear who has the contractual burden of compliance and who must contribute to the cost of purchasing and surrendering the EUAs and on what basis.
The clause should clearly allocate responsibility for registering as an EU ETS participating company so that there is no doubt about this.
There are risks and opportunities for all players mentioned here as the EUAs are traded. There is a risk of price fluctuations in EUAs markets, an administrative burden of purchasing the EUAs and of developing hedging strategies. All of this could, of course, be seen as opportunities as well.
In terms of price fluctuation, by way of example, the price of an EUA was €100.34 per metric tonne of CO2 in February 2023, whereas in December 2021, the benchmark EUA price hit €50.05 a tonne, which was then the highest since the carbon market launched in 20053.
The standard BIMCO EU ETS clause4 suggests that the time charterer should be responsible for compliance, but not all owners/bareboat charterers will want to rely on this.
(1) Publications Office (europa.eu) Section 27 of Directive 2023/959
(3) EU Carbon price hits record 50 euros per tonne on route to climate target, Reuters (Nora Buli, Kate Abnett and Susanna Twidale), 4 May 2021
The forthcoming articles in the series will examine:
You may access the previous issues in the series here: