Update - September 2005
Aviation & Transport Services
Green sky thinking Aviation emissions trading: potential impacts and policy options Aviation emissions are damaging to the environment, and the sector will be a growing contributor to global warming over the coming years. But although ICAO has endorsed global aviation emissions trading in principle, concrete proposals for a world-wide trading scheme have yet to emerge.
“The details of a European aviation emission trading scheme will determine its impacts on both the industry as a whole and on different airlines and types of flight.”
However, the UK Government regards the inclusion of aviation in the Phase 2 of the EU’s own Emissions Trading Scheme (EU ETS) as a priority of its EU Presidency, and the European Commission has now launched outline proposals on the scheme. Phase 2 of the EU ETS is due to run from 2008 to 2012, in line with the EU’s Kyoto commitments for reducing Greenhouse Gases (GHGs). The European Commission recently published a study which reviewed a number of policy options for including aviation in the EU ETS, while the Commission has also supported proposals for the introduction of tax on aviation fuel within the EU (albeit that it has also been promoted to help fund development assistance). In its outline proposals, the Commission sought suggests that a Working Group should develop detailed policies by 2006. For its part, the IATA has instead proposed that the focus should remain with the parallel global dialogue being taken forward under ICAO auspices.
The details of a European aviation emission trading scheme will determine its impacts on both the industry as a whole and on different airlines and types of flight. This paper discusses some of the key policy issues still to be finalised, and their possible impacts.
What could happen without further policy action? Projections prepared for the UK Government’s Aviation White Paper assumed that UK air traffic would grow from 189 million passengers a year in 2001 to 500 million in 2030, with “no frills” carriers accounting for a significant proportion of the growth. Significant growth is also anticipated in other EU markets. Competition in intra-EU markets is likely to remain tough, with a continued focus on operating cost efficiencies, including fuel costs. Despite the competitive pressures, these costs have recently risen sharply, biting into industry profits.
See for example http://www.eubusiness.com/afp/050215122841.o10roct8/view
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Key recommendations of this paper are: •
To develop an integrated package of fuel tax and emissions trading proposals at EU level – as “aviation-only”, or “go it alone” measures would be inefficient and potentially more damaging for the industry;
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To specify the efficient applications of tax receipts before setting tax rates – while these could extend beyond the industry (as proposed by France and Germany) there is also potentially room for targeted applications to help reduce abatement costs in the industry;
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To avoid setting arbitrarily “tight caps” for aviation emissions, which are likely to create more economic damage than needed to achieve given GHG reduction targets at a global level; To ensure that, in “grandfathering” initial emissions allowances, the process does not unduly undermine pre-existing competitive positions in the intraEU markets concerned. This may be best achieved through EUwide allocation specifications, set out in a Regulation (as for slot allocation); and To ensure that the industry is able to respond efficiently to trading signals, the new arrangements should be finalised well before they are introduced – and Phase 3 implications should be fully evaluated (at global level, with dialogue involving ICAO) before Phase 2 trading commences. The discussion over Phase 2 of the EU ETS should begin the countdown to a genuinely global aviation emissions trading regime.
Faced with these pressures, aircraft and engines should become significantly more fuel-efficient in any event. In the UK White Paper, the Department for Transport assumed that, even with oil prices at $25/barrel, efficiency gains would outweigh any industry cost impacts from internalising emissions costs (from taxes and/or trading), allowing real air fares to carry on falling at 1% a year. Recent rises in oil prices suggest that these projected impacts on fuel efficiency may now be conservative. The tighter fuel market now expected over the coming years could mean that even greater fuel efficiencies will be identified, further mitigating the growth in emissions – industry representatives have recently noted that technology could deliver a 50% reduction in CO2 emitted per passenger-km by 2020. Nevertheless, rapidly growing demand for air travel could still result in aviation emissions increasing in the period to 2020, contrasting with the plans in other sectors to achieve significant overall GHG reductions in the same period.
Are fuel taxes an alternative to emissions trading? Different commentators have treated fuel taxes as substitutes or complements to emissions trading. Deloitte estimates suggest that, even with aviation demand becoming more price-sensitive, post-tax fuel prices would need to rise by 16% to achieve the same emissions outcomes by 2012 as a trading scheme that reduced emissions by 5% (without additional taxes). In theory, a global tax system could reflect emissions costs directly in the prices that users pay for air travel, and avoid the need for emissions trading.
In practice though, not all sectors and not all countries follow consistent tax policies, and many have reservations over ceding their national competency over tax-setting. The European Commission has observed there remain difficulties over harmonising global policy on aviation fuel tax. In this real, “second best”, world, relying on aviation fuel taxes alone would be an inefficient way to strike the right balance between restraining global emissions and sustaining economic growth across different sectors.
“Aviation fuel taxes can provide the public sector with an additional source of ongoing revenue to help fund initiatives which may be most effectively sponsored by the public sector.” Such narrow “polluter pays” policies could also reduce the flexibility for the aviation sector to identify, with other economic sectors, the least-cost ways to achieve sustainable growth, and increase the financial costs of air transport operations within Europe. Airline groups have argued that this would affect the EU’s overall global competitiveness. In contrast, emissions trading can allow existing operations to be continued without imposing average cost increases on the aviation sector, while still exposing the industry to marginal incentives to help meet global emissions targets. This is not to say that aviation fuel taxes should be ruled out as a policy instrument. For example, unlike trading following one-off “grandfathered” allocations of emissions allowances (or allowances distributed via one-off auctions like radio spectrum licences), they can provide the public sector with an additional source of ongoing revenue to help fund initiatives which may be most effectively sponsored by the public sector.
See for example para 12 of the European Aviation Industry joint position paper on emissions containment policy, 7 July 2005.
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For example, some research activities, where there may be market failure in developing abatement technologies fast enough, could be sponsored this way. Airlines have argued in favour of continued public funding in this area, and hypothecated taxes or charge revenues could provide a source of this funding, particularly in light of the external costs imposed by aviation users via the “non-Kyoto” emissions from aircraft. Trading and taxation therefore need not be regarded as “either/or” policy instruments – they can, if appropriately structured and applied within State Aid constraints, be complementary.
The need for an open trading system We assume that airlines would be allowed to trade with the other EU ETS sectors after 2008. Depending on the prevailing EU ETS allowances price, and the state of the air transport market, a growing aviation sector could hence buy in allowances, where and when it needed them, from those other sectors where emissions reductions could be achieved more cheaply. There are a variety of options for achieving this within the EU in the period to 2013, ahead of a wholesale renegotiation of the global Kyoto structures. The European Commission and the industry are currently examining the detailed options such as the aviation industry being able to sell back as many allowances as it buys from other sectors.
As the result of a lower future average EU ETS allocation price of (say) £6/tonne of carbon dioxide (above the “low and medium” level scenarios assumed by the UK Government in drawing up its Phase 1 EU ETS proposals, but significantly below current levels, which have been influenced by oil prices well above $50/barrel), we estimate that intra-EU air ticket prices might only need to rise by around 4%, with passenger demand reduced by around 5% in consequence. In contrast, a “closed” (aviationonly) system would be much less efficient in economic terms. We estimate that the trading price would need to be several times higher within such a system to achieve the same level of emissions reductions, which could seriously affect both ticket prices and the viability of the industry.
How should initial aviation emissions allowance levels be set? Cutting emissions rapidly can cause economic pain and, depending on the costs of abatement, the economic choice between compensation and abatement can be finely balanced for individual countries and sectors. The UK Government has concluded that some further increases in the total level of aviation emissions will be a price worth paying for the economic benefits that further growth in the aviation sector is expected to bring. Capping emissions by reference to historic levels of outputs (e.g. 1990 or 2000 levels) in the way used for other sectors in Phase 1 of the EU ETS would be inherently arbitrary and inefficient in such a dynamic industry.
But if aviation is to be included in Phase 2 of the EU ETS, the relevant EU ETS cap will need to deal with the aviation sector’s increasing contribution to the total emissions concerned.
“Capping emissions by reference to historic levels of outputs in the way used for other sectors in Phase 1 of the EU ETS would be inherently arbitrary and inefficient in such a dynamic industry.” In this paper we have therefore assumed that the total EU ETS cap would effectively be increased to accommodate aviation within the trading scheme. We assumed that this increase could be based on currently-predicted total aviation emissions from the relevant flights during the period, less an allowance (such as 5%) to take account of expected reductions in aviation emissions arising from the introduction of trading. This could translate into a ceiling, based on the start year emissions, plus or minus a factor. The scope of the affected flights was addressed during the European Commission’s recent consultation on the issue. On the one hand, a narrow scope of intra-EU flights would imply relatively limited environmental impacts from trading. On the other, the inclusion of non-EU flights within the mechanism would widen the stakeholders affected and could make early implementation more difficult to negotiate. In consequence, some industry bodies have suggested the adoption of the narrower, intra-EU scope in the first instance.
For example, see para 10 of the European Aviation Industry joint position paper, op. cit. Annex 7, Final Projections to inform the National Allocation Plan, DTI, November 2004. If the carbon dioxide price remained at more recent levels in the £10-15/tonne range, the demand impact could be correspondingly greater, up to around 10%.
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Similarly, the relevant allowances could be allocated at national or EU level. Phase 1 involves allocations by Member States to the fixed installations associated with the existing sectors covered by the EU ETS. Such an allocation basis may not be practical or appropriate for the international aviation industry, which has accordingly favoured EUlevel allocation mechanism, which the Commission has also supported. The total caps for the aviation sector within the EU ETS could simply be derived from, and monitored with respect to, the average carbon dioxide produced by aviation fuel. However, aviation emissions are more damaging to the environment, due to “radiative forcing” at altitude. An “exchange rate” for trading between the relevant aviation and non-aviation allocations of CO2 could therefore potentially improve the environmental efficiency of the scheme.6 However, as with many aspects of greenhouse gas impact measurement, the science on the full environmental cost of aviation emissions is uncertain. Industry representatives have therefore suggested that these uncertainties point towards setting specific limits for other pollutants (such as NOx), with no “exchange rate” set for aviation CO2. However, economic principles imply that the efficient approach would be to reflect in prices a reasonable estimate of environmental costs, rather than do nothing to address the issue (“approximately right rather than precisely wrong”). In this respect, landing and en route charges offer an alternative market mechanism with which to reflect the specific environmental impacts of non-CO2 aviation emissions, and avoid the “exchange rate” approach.
Assigning initial allocations to individual users In Phase 1 of the EU ETS, each producer has been given initial “free allowances” based on historic activity levels. “Free allowances” will also be a feature of Phase 2, although a greater proportion (10%) can be allocated by auction. “Free” allowances do not discourage efficient trading, as they do not affect marginal incentives. However they do risk conferring windfalls on those allowance owners whose output then falls in the interim. Such a basis of “grandfathering” allowances, based on an arbitrary historic “base year”, could therefore be inappropriate in the more dynamic aviation industry, where post-2008 patterns of activity may look quite different from today’s, let alone yesterday’s. The industry is still evolving, as mergers, start-ups and bankruptcies continue to change its horizontal structure.
“Landing and en route charges offer an alternative market mechanism with which to reflect the specific environmental impacts of non-CO2 aviation emissions.”
But extending this allocation basis to emissions allowances could still provide incentives, at the margin, for airlines to “bulk up” their starting allocations in the relevant qualifying seasons (which could then be traded for cash). An alternative would be to “grandfather” the allowance allocations based on standardised (rather than estimated actual) benchmark unit emissions levels. The allocations could then be derived (at the EU level) from airlines’ proposed schedules for the starting seasons (e.g. 2008), using standard unit emissions rates per available seat-departure and available seat kilometre and, possibly, a factor to allow for aviation emissions growth during Phase 2. This would leave the airlines free to decide on their actual operations (including flights, routes and load factors, and equipment and engines), based on evolving costs and market conditions, varying their emissions allowances via trading in the EU ETS. This would ensure that their decisions reflected the emerging emissions allocation prices from the EU ETS alongside aviation market developments in the 2008-2012 period, such as fuel prices, travel demand levels and equipment costs.
One amended approach could be to “grandfather” allocations based on the immediately preceding season’s actual operations, as with airport slot allocations. These slot allocations are made by comparing airlines’ forward scheduling requests with their utilisation of slots in preceding seasons.
By structuring the initial allowances to reflect available seats, and reflecting the emissions from takeoffs/landings as well as level-flight fuel burn, there need be no significant underlying bias for or against large or small equipment (for example the aircraft used on “thick” versus “thin” sectors, or different times of the week), or long haul versus short haul flights.
For intra-EU flights, the slot allocations also incorporate the application of “use it or lose it” rules, utilising both the global IATA scheduling procedures and the EU’s slot allocation Regulation.
This allocation basis would however still need to be applied with care, to strike an acceptable balance between the seating configurations and cabin factors used by different carriers on particular types of flight.
6 The Department for Transport in the UK noted that, in terms of relative damage, work by the Intergovernmental Panel on Climate Change has indicated a factor of 2.7 (Para 8, Annex B, The Future of Aviation – White Paper, op cit). Hence, if this was the trading “exchange rate”, an airline would need to buy 2.7 times the amount of allowances from other sectors to emit a given quantity of physical carbon dioxide. See for example “How airlines can fight climate change”, Rod Eddington, Financial Times, 4 January 2005
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The single European market concerned suggests that the appropriate rules would be best set down in an EU Regulation (as with airport slot allocation). Airlines would then be encouraged to reduce their emissions (and cash in any excess allowances) for intra EU flights where this made business sense. Potential impacts on different types of airlines If airlines were given “free” initial allowances, their inclusion within the EU ETS would (like the “grey” slot markets at some airports) inevitably confer financial strength on incumbents at the expense of startups. The impact on statutory accounts would also need to be reviewed, as the accounting implications of the EU ETS would need to be extended to airlines in Stage 2. In addition, a trading scheme would then start to influence different airlines’ relative competitive positions in specific intra-EU markets. In particular, “no frills” airlines largely operate point-to-point within the EU. An intra-EU scheme would therefore affect the bulk of these carriers’ flights, many of which are (intentionally) marginal in revenue and cost terms.
“It would be sensible for the likely basis of future aviation allocations and trading to be indicated to the aviation industry before Phase 2 started.” In contrast, “flag” carriers operate more complex schedules, including greater use of “hub” networks, where intra-EU volumes typically help to feed non-EU sectors, often based on commercial arrangements with nonEU alliance partners. Only some of the sectors operated within these networks would therefore be subjected to the scheme (transatlantic flights would be excluded for example).
Further, where airlines compete directly on intra-EU origin-destination pairs, their offers are usually still differentiated, so that many “no frills” passengers can be characterised as being more price-sensitive, and less journey time and quality-sensitive. Accordingly, the increases in operators’ marginal opportunity costs that are implied by emissions trading would be expected to: •
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Be passed on via average ticket prices more systematically in the “no frills” sector, where the airlines do not have portfolios of different affected and unaffected sectors, or significant numbers of sectors which enjoy the benefit of substantial slot rents at congested airports (such as Heathrow); and Affect the total demand for their available seats more directly, as some of this marginal demand will be more price-sensitive.
The impacts on the different carriers’ relative financial performance will however also depend on their cost structures. Those which can adapt their fleet and crew more flexibly could potentially weather the impacts from emissions trading better (as with other changes in their marginal costs, such as fuel prices). “No frills” carriers have been historically more flexible than the larger network carriers, as they have fewer complexities to deal with - from bilateral traffic rights, slot trading restrictions, labour agreements in different jurisdictions, code and revenue share agreements with other airlines, and so on. Nevertheless, it is unlikely that an introductory version of emissions trading, of the form sketched out above, would fundamentally affect the relative competitive positions of the different carriers operating in the different types of intra-EU market. The increases in marginal operating costs involved are likely to be only a fraction of those arising from the larger fluctuations in fuel prices that the industry has already had to adapt to in recent times. But some additional impacts around the edges can be expected.
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The impact of Phase 3 If airlines’ Phase 2 allocations did not survive into a post-Kyoto Phase 3 of the EU ETS from 2013, the value of any initial “free” Phase 2 allocations would be reduced, and the initial trading system would accordingly have less effect on emissions levels. While few airlines can look as far ahead as 2013 with confidence in today’s market environment, such short-term emissions incentives would still be inefficient in economic terms.
“Any involvement of the US and/or China and/or India in post-Kyoto arrangements could transform the whole picture” This is because, although individual carriers can (and do) flex their operations at relatively short notice, the industry’s assets have much longer economic lives. Without continuity in the underlying economic signals, inefficient investment decisions will be made (for example in different types of aircraft and engine). Hence all the participants in the industry’s supply chain have a role to play in emissions reduction. Engine and airframe design can have major impacts on the supply side, while consumers need sustained awareness of the wider impacts of their decisions to fly. Only an integrated package of regulatory and market-based policies, deployed consistently at the global level, will achieve sustainable aviation growth in the longer term. It would therefore be sensible for the likely basis of future aviation allocations and trading to be indicated to the aviation industry before Phase 2 started. In this respect, work is underway to examine broader Phase 3 options, but with some major uncertainties still to be resolved. For example, the basis of any involvement of the US and/or China and/or India in post-Kyoto arrangements could transform the whole picture for carbon pricing and hence aviation emissions trading.
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Conclusions Our illustrative assumptions, including a low medium-term £6/tonne price for carbon dioxide in the EU ETS, suggest that including intra-EU aviation emissions in Phase 2 of the EU ETS could put less than £1 on the average price of a typical low cost ticket for an intra-EU flight. Such a regime, if based around existing patterns of flight activity, might reduce longer term aviation demand by around 5 % - or just over one year’s growth - other things being equal. In practice, variations in the future price of oil could continue to have greater impacts on fuel consumption and ticket prices, and more directly affect the future growth of air travel and aviation emissions. The corresponding emissions reductions would then potentially be somewhat larger, as fuel-efficient flight activity would be further encouraged, and the EU ETS price could be sustained at higher levels. But the specific impact of any initial EU trading regime on the aviation industry’s growing contribution to global warming is still likely to be relatively modest.
Nevertheless, while these impacts might be relatively limited, this would reflect the relatively high marginal abatement costs in the sector. Accordingly, it will often be more efficient for the EU to adjust its other economic activity, rather than aviation, and to trade with other Kyoto signatories, such as Russia, in order to meet its overall GHG reduction targets. In addition the impacts of aviation emissions trading would be felt more on some types of flight than others. For example, the expansion in the “no frills” sector has been rapid in recent years, and has occurred without the associated environmental costs being reflected in fares. In future, the growth of some of the more marginal markets would probably be affected by emissions trading.
Trading, combined with higher oil prices and/or aviation fuel taxes, could therefore help to slow the longer term growth in aviation emissions, particularly in specific markets where the environmental cost/economic benefit equation is more finely balanced. However, a trading regime which itself simply sought to stop the longer term growth of aviation emissions entirely would do significant and unnecessary economic damage, particularly if it is confined to the EU markets. Policies should be aimed at encouraging the aviation sector – a global industry – to help tackle a global problem on a sustained and rational basis in the longer term.
Contacts For more information, please contact: Aviation: Paul O’Neill
+44 (0) 20 7303 7110
paoneill@deloitte.co.uk
Transport Economics : Robin Pratt +44 (0) 20 7007 1693
rpratt@deloitte.co.uk
Greenhouse Gases: Robert Casamento +44 (0) 20 7007 0625
rcasamento@deloitte.co.uk
Robert Casamento is a Special Advisor to the G8/World Economic Forum CEO Roundtable on Climate Change.
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