EU’s New Airline Carbon Emissions Levy Could Cost Industry Over $20bn by 2020

Early last week, EU confirmed its plans to implement the ETS (Emission Trading Scheme) regime at the beginning of 2012, bringing all major airlines flying into and out of a European destination, under its purview. The decision however was strongly condemned by the US and about 25 other countries that rallied against the new levy as it threatened to hamper recovery and further dent airline sector profitability. The move is expected to push up costs for major US airlines like Delta Air Lines (NYSE:DAL), United Continental (NYSE:UAL), and American Airlines (NYSE:AMR), having meaningful exposure to Europe.

Below, we take a look and to understand the nuances of ETS and how it can impact the US airline industry.

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How Does the ETS Work?

Under the proposed ETS regime, the airlines flying in and out of Europe in 2012 will be required to purchase permits for 15 percent of the carbon emissions they produce. The legislation applies to all outgoing and incoming flights landing at or departing from EU airports.

Under ETS, the carriers will be allowed to emit 85 percent of their cap for free for the first year to ease the economic impact on the industry. The cap is set at 97 percent of the average aviation emissions from 2004-2006. For the 2013-2020 period, the cap will fall to 95 percent of that number, and the free allowances will decline to 82 percent.

ETS Encourages Airlines to Reduce Fuel Costs

The levy is expected to cost the industry about $23.8 billion over the next eight years, with IATA estimating the cost of purchasing necessary carbon allowances to increase from $1.3bn in 2012 to $3.5bn in 2020. The biggest part of the carbon footprint for airlines is fuel consumption, so the additional cost burden from ETS is expected to motivate airlines to curb their fuel expenses by investing in more fuel efficient fleet or reducing consumption, thereby bringing down overall fuel bill.

Airlines May Not be Able to Meet Threshold

Under the ETS, if an airline manages to limit its emissions to 85% of the set cap, it doesn’t need to incur any costs at all. However, it is unlikely that the airlines will be able to reduce emissions immediately, to adjust according to this threshold.

This is because a lot of US airlines are currently in the process of revamping their fleet and expect to take deliveries over a period of next few years. With a younger fleet, airlines can expect to reduce carbon emissions as new aircraft burn less fuel. Although, both the free allowances and cap will decline over the coming years to partially offset benefits from the  fleet.

Additionally, it is not feasible for the airlines to resort to sustainable biofuels, given that they carry a price premium that makes them currently uncompetitive versus conventional jet fuel, and are not yet available in sufficient quantities to meet global fuel demand to be truly viable.

EU Sees ETS as a Potential Revenue Source

At current market prices these free allowances represent more than $27 billion over the next decade.

The EU believes that ETS allowances will save airlines money over the next few years, money that could be used in modernizing their fleets, improving fuel efficiency and start using non-fossil aviation fuel. It suggested that airlines should fund the purchase of new planes by passing the full cost of the carbon tax on to customers while the airlines can skip paying $27 billion of the tax. However, the airline industry has dismissed this view as any fare hikes can further worsen the profitability outlook of the industry already suffering from slowing demand. The additional charge to customers could be around $3-$16 depending on the flight length if the rule is implemented.

Overall, the ETS is expected to further strain the margins of the airlines industry as emission costs reduce bottom line and top line threatens to melt with any passing of the tax burden to customers in form of fare hikes. The industry will take time to curb emissions as new fleet comes into operation and alternative fuels make economic sense.

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