OREANDA-NEWS. September 26, 2016. The United Nations International Civil Aviation Organization is poised to take a ground-breaking decision on a global market-based measure to control aviations greenhouse gas emissions in a matter of days.

If signed off at ICAOs general assembly meeting in Montreal running September 27 to October 7, this will be the first time any sector has agreed a global market-based system for controlling emissions.

How significant is this deal, and what does it mean for commodity markets? What will the impact be in the carbon and jet fuel markets?

The short answer is: in the short-term, there wont be much impact. In the long run however, expect to see airlines buying up carbon credits and increasingly switching to sustainable fuels as they seek to manage their carbon exposure.

Aviation has for a long time enjoyed a special status and been relatively free of environmental regulation at the national level. Thats partly because aviation is a truly international sector and needs a regulatory approach that is also global. Matters including environmental impact, noise and many other aspects of the industry are coordinated at global level to avert the risk of a patchwork of different regulatory frameworks that would distort healthy competition between regions. Aviation is a strategic wealth enabler, boosting economies as well as bringing other social benefits.

But the aviation sector is growing at 4% to 5% per year, making it a rising contributor to the build-up of atmospheric greenhouse gases. The challenge for policymakers lies in finding ways to work with this important sector to promote growth while cleaning up its environmental footprint. Other sectors are increasingly pulling their weight as part of global efforts to reduce GHG emissions. A dramatic and ongoing decarbonization of Europes electricity sector is a case in point.

Tackling aviations emissions has been a particularly thorny issue. The EU introduced legislation in 2006 to bring aviation within the scope of its legally binding EU Emissions Trading System from 2012, including from flights originating outside of Europe. This prompted accusations of jurisdictional over-reach by many of the blocs key trading partners, legal action against the EU legislation and a major diplomatic spat in 2011 that threatened to descend into a trade war.

Those against the EUs actions argued that a solution should be global, not regional. The EU agreed, but said global action had not been forthcoming, prompting Europe to take a lead. Much of the recent momentum at ICAO has been attributed to pressure from the EU, whose legislation bringing aviation within the EU ETS was upheld by the European Court of Justice in 2011.

Amid an international backlash, the EU agreed to hold off on regulating inter-continental flights to allow ICAO to agree a deal this year.

In short, ICAO is about to take a decision that aims to deliver carbon-neutral growth in the aviation sector. To do this, ICAO will create a global carbon market for airlines, by requiring operators to buy carbon offset credits to match any growth in greenhouse gas emissions over and above their 2020 level, alongside other measures to curb emissions.

So why should this latest deal go ahead when previous attempts have been so difficult? Here are a few reasons:

  • ICAO backs the use of markets: ICAO has already endorsed the market-based approach to reducing greenhouse gas emissions as early as 2004.
  • Governments back it: The ICAOs proposed system is backed by most governments, and few want to see another international clash on this issue.
  • Industry supports it: Global airline industry groups including the International Air Transport Association back the global carbon offsetting system.
  • Its global and fair: Aviation groups say equal treatment of airlines and uniformity of regulations will preserve fair competition.

Some non-governmental groups warn that the proposed deal doesnt go far enough and that it doesnt do enough to ensure that aviation pays its fair share in the decarbonization effort. In particular, there are concerns over the quality of offset credits, which will be critical in delivering real and verifiable emissions reductions. Other observers say even an imperfect deal that covers a substantial percentage of global aviation emissions will be better than no deal, and agreement on the system will focus the industry on innovating toward lower carbon growth while preserving profitability.

Why do aviation emissions need to be reduced?

EU lawmakers note that CO2 emissions from international aviation are projected to be seven times higher in 2050 than 1990, threatening to eclipse emissions reductions achieved in other sectors such as power generation and other heavy industries. Those projections are at odds with global targets to reduce GHG emissions to limit global warming to well below 2 degrees Celsius from pre-industrial levels by 2100.

Whats the deal?

ICAOs Global Market-Based Measure for aviation emissions (called CORSIA the Carbon Offsetting and Reduction Scheme for International Aviation) will require the global aviation industry to benchmark its GHG emissions at 2020 levels and offset any additional emissions growth by buying carbon offset credits for each additional ton of CO2 equivalent emissions.

This means airlines will have to bear a cost for emitting carbon dioxide, providing an additional incentive to become more energy efficient. Airlines are already focused closely on fuel efficiency gains because jet fuel prices are one of their biggest input costs.

In time, the CORSIA system will act as disincentive to continued operation of the least efficient engines and most emissions-intensive fuels, while providing a relative advantage for those using high efficiency technology and cleaner fuels.

Whats likely to be agreed?

If agreed in Montreal, the global market-based mechanism for aviation emissions will consist of a broad regulatory framework including political buy-in from most of ICAOs 191 member countries. ICAO released a text on September 2 setting out a draft framework for adoption.

Much work will still need to be done, including on the details surrounding the rules and regulations on matters such as the eligibility of offset credits, which has been delegated to the ICAOs Committee on Aviation Environmental Protection.

Those rules may allow the use of carbon credits from existing market mechanisms such as the UNs Clean Development Mechanism, which allows investors to earn carbon credits by investing in projects that cut GHG emissions in developing countries.

Those finer details are expected to be developed further ahead of the system coming into effect in 2020.

The CORSIA system is one part of a much wider strategy adopted by the airline industry to reduce its environmental impact, including efforts on aircraft technology development, operational improvements and sustainable biofuels.

Where do airlines stand now?

CO2 emissions from airlines operating intra-EU flights are already regulated by the EU Emissions Trading System. Those that operate intercontinental flights to or from European airports are exempt from the EU ETS under the so-called stop-the-clock measure.

However, in light of the ICAO general assembly outcome, the European Commission is expected to need to propose new legislation before the end of 2016 to further extend that exemption. Flights that are not included in the EU ETS will be expected to come under the terms of ICAOs CORSIA scheme. CORSIA is expected to take effect for airlines operating in the richest countries first, from 2020, with other countries following later and with an exemption for poorer countries.

projected-global-co2-emissions

Source: ICAO/Stockholm Environment Institute

Whats the market impact?

This is where things get less clear. In theory, the CORSIA system will mean that airlines must buy an increasing volume of carbon credits as the industrys emissions rise year on year above the 2020 level.

As mentioned earlier, the international aviation industry is growing at about 4% to 5% per year. But it is achieving fuel efficiency gains of about 1% to 2% per year. That translates into expected growth of about 3% per year to the sectors GHG emissions, even as technological improvements continue.

That means demand for carbon credits from the aviation sector is likely to be small in the initial years, but could become significant over time as the industry continues to grow.

breakdown-offset-credit-supply

Source: ICAO/Stockholm Environment Institute

A study by the Stockholm Environment Institute released this year found that global aviations CO2 emissions stood at 490 million mt in 2013, about 1.5% of global CO2 emissions from fossil fuel combustion.

Aviations emissions are expected to grow to between 682 million mt and 755 million mt by 2020 and increase further to 1.223 billion mt and 1.376 billion mt by 2035, the study said. Total demand for carbon offset credits from aviation is forecast at 3.3 billion mt to 4.5 billion mt in the period 2020-2035, in aggregate.

carbon-offset-supply-demand

Source: ICAO/Stockholm Environment Institute

The supply of offset credits with a high environmental integrity score is forecast at 3 billion mt almost enough to cover demand at the low end of expectations, it said. Credits with a medium environmental integrity could supply a further 1.6 billion mt, while credits with neutral development impacts could provide a further 500 million mt, it said.

In addition, the supply of alternative jet fuels is subject to greater uncertainties but the authors believe 100 million mt to 300 million mt of CO2 could be avoided by using biofuels produced with little or no land use change impacts and backed up by strong sustainability certification schemes.

The analysis shows that ICAO can apply high environmental and sustainable-development standards to both carbon offsets and alternative fuels without compromising its 2020 carbon neutral goal, ICAO said.

What does this all mean for carbon credits?

Much of the detail of ICAOs CORSIA system has yet to be nailed down, making detailed impact analysis difficult at this stage. Further clarity is expected before the system goes live in 2020.

If the Stockholm Environment Institutes analysis is correct, this suggests that the aviation industry can easily meet the requirements of the CORSIA scheme using high quality credits, with some additional use of medium quality credits.

Well-supplied markets tend to generate low prices, so a very crude analysis of the data suggests that the price of these aviation credits may be relatively low, as has been seen in other carbon markets to date.

Even in a strong growth scenario in which aviation emissions grew more rapidly than expected after 2020, this would simply incentivize investment in more emissions reduction projects to meet the additional demand.

As the supply and demand for these credits find a balancing point, the price of the offsets may end up being determined by the marginal cost of running an eligible emissions reduction project. That cost will depend on the type of projects ultimately allowed in. If different qualities of offsets are eligible, this would make no difference to their compliance value, hence no differentiation in their price (all credits being worth 1 mt of CO2), unless a consumer-driven demand emerged for higher quality offsets and airlines took this seriously as a reputational issue.

What this theoretical aviation carbon offset credit price turns out to be is anyones guess. But if the price is set by the marginal project cost, its unlikely to be more than a few dollars per mt, in a market with unconstrained supply. If ICAO regulators decide at a future date to cap the supply of these credits, then the price could go much higher, but that looks unlikely based on the framework being discussed by ICAO as of mid-September 2016.