On January 1, 2012 airlines became part of the EU’s Emissions Trading Scheme (ETS), heralding the first international attempt to calculate and cap airline emissions.
While a theoretically elegant solution to combating climate change, the scheme is proving highly controversial, with American airlines having attempted, but failed, to challenge its legality, Chinese airlines flatly refusing to pay the resulting bills and IATA warning it could spark an international trade war.
While critics argue it is simply a new stealth tax on aviation, the ETS is the cornerstone of the EU’s efforts to change the carbon costs of air travel from an unknown social cost that is not reflected in its price, to a known and monetised quantity that is reflected in fares.
Growth in carbon emissions over and above the cap that has been identified by the EU must be paid for by reductions in emissions in other sectors. It both incentivises airlines to increase fuel efficiency, thereby allowing them to do more with their allocated allowances, and funds development of low carbon technologies in other sectors where carbon abatement is cheaper.
Ultimately, it means that passengers must pay the ‘true’ costs of air travel.
In the short-term, the effects of ETS are relatively obvious and have been well documented by a range of commentators. The inescapable fact is that airlines will face increased costs.
This stems from the fact that many airlines’ operations have grown from the point at which the sector’s carbon cap was set – the average emissions for 2004 to 2006 – and only 85% of this cap will be distributed as free allowances, with the others having to be purchased on the open market. Airlines face a world in which, even to stand still, they will need to buy additional carbon allowances.
Estimates of the size of this increase in costs vary, with variables ranging from the speed of demand growth, the cost of carbon allowances and the extent to which costs can be effectively passed on to consumers to the price sensitivity of the market.
IATA has recently estimated that the bill for airlines in 2012 could be around €900 million and could rise to around €2.8 billion per annum by 2020.
PricewaterhouseCoopers (PwC) has estimated that with allowances at €30 per tonne, annual costs could reach €3.5 billion, while Ernst & Young and York Aviation estimated that total ETS costs for the period to 2020 could be as high as €65 billion, depending on allowance prices and precise scheme design.
Whichever scenario proves correct, it is clear that the costs are significant.
The impact of these rising costs on airline profitability will depend on the extent to which airlines can successfully pass on the costs of ETS to passengers and maintain margins, which is fundamentally a question about the overall price responsiveness of the market.
Economic theory suggests that, in the end, in a competitive market, airlines will have to pass on the costs to passengers. This will ultimately result in falls in demand and lost profits.
In the short- to medium-term, the extent to which airlines will be able to pass on costs is less clear; it may be that some more load factor active airlines will be forced to absorb them in order to maintain demand levels. Equally, others will seek to pass on costs immediately.
In early January, Lufthansa became the first airline to announce that it would directly pass on the additional costs imposed by the ETS to passengers via its fuel surcharge.
The airline stated that it will need to purchase around 35% of the allowances it needs in 2012, adding around €130 million to its cost base.
Ryanair has since followed suit, adding a surcharge of €0.30 to all its flights from January 17, in an effort to cover its estimated €18 million exposure to ETS.
Impact on routes
The potential impact of ETS on the competitive balance within the air transport market is also worthy of consideration. The ETS covers a substantial geographic area and one of the world’s largest air transport markets.
As such, competitive distortions are likely to be limited. It is relatively difficult to avoid ETS liability and hence it should not offer a significant advantage to one airline over another in most cases. However, there are issues at the margins and there are a number of specific instances in which certain airlines may benefit at the expense of others and their European counterparts in particular.
This applies primarily to airlines that have significant hubs that are either close to the edges of the geographic area covered by the ETS or that can act as alternatives to European hubs for travellers with origins and destinations outside the EU.
In the case of the former, airlines with hubs close to the edges of the EU gain an advantage, as travellers using these hubs to travel to more distant destinations will only be liable for ETS costs on the flight to the intermediate hub.
For instance, a passenger travelling from London to Hong Kong must pay their share of the carbon costs of that journey. If they were to travel via Dubai, they would only need to pay their share of the carbon costs of flying to Dubai.
This means there is potentially an opportunity for the airline based at that hub to ‘undercut’ prices of airlines serving passengers’ final destinations either directly from Europe or via more distant hubs.
The latter case applies primarily to the North America–Asia-Pacific market, where many passengers choose to hub at European airports but could choose a variety of alternatives outside the EU.
In this case, airlines offering routings via non-EU hubs face no ETS liability and consequently gain a cost advantage over European-based competitors.
In both these circumstances the most likely winners are Middle East airlines, with their hub airports based both relatively close to Europe and in an ideal location for the North American–Asia-Pacific market.
Overall, it would appear that these changes in the competitive balance are likely to have a relatively minor impact. However, these effects are there and they are likely to be magnified over time as the marginal decisions made now begin to affect future patterns of development.
In general, it would seem fair to say that ETS will ultimately become more of a burden for airlines in the medium to longer term and it’s only going to get more expensive for airlines to secure the carbon allowances they need to enable future growth.
Currently, carbon prices are at an all-time low. During 2011, allowance prices hovered around €7 per tonne and it is unlikely that aviation’s entry into the scheme will significantly change this.
However, estimates of future prices have varied considerably, ranging from a relatively mild €15 per tonne to in excess of €100 per tonne. What does not seem to be in dispute is that prices will rise in the future and consequently the costs to airlines will grow.
Furthermore, the incentive to reduce carbon emissions already exists and has existed for a long time. Fuel has always been among the most significant costs for airlines and consequently the need for fuel efficiency – and by extension carbon efficiency – has always been there.
Consequently, airlines have been investing in technologies to improve fuel efficiency for many years, albeit there has been a greater focus on low carbon fuels in recent years.
The result is that many of the relatively easy and cheap avenues for improving fuel efficiency may have been used up already or will be in the next few years. Simultaneously, this is likely to be true of the costs of abatement in other sectors.
Squeeze on growth
The result will again be that it will become harder for airlines to grow in the future as abatement of carbon costs becomes more difficult and more expensive.
The raft of uncertainties around the future impact of ETS means that it is very difficult to predict what, ultimately, it will mean for the air transport industry.
However, there are a number of fundamentals that seem clear. Firstly, it will, to a greater or lesser extent, reduce future growth. Simply put, it will increase the cost of travel to some degree and hence fewer people will fly. Secondly, it will narrow airline margins, which will have a knock-on effect on route sustainability and route development.
ETS has the potential to damage currently marginal routes to the extent they could be withdrawn; a dramatic example of this is AirAsia X, which is ending its London Gatwick and Paris CDG services because of the costs of ETS. Similarly, the narrowing of margins is likely to make it harder to support the case for starting new routes.
In terms of its overall impact on route development, ETS is likely to reinforce the status quo, with airlines focusing on higher yielding, proven markets over more marginal, emerging opportunities.
Finally, the increasing importance of carbon/fuel efficiency and the increasing cost of abatement are likely to bring forward fleet renewal programmes, as airlines seek to take advantage of the efficiency advantages offered by the next generation of passenger aircraft.
The counterpart to this dynamic is whether the costs of ETS will ultimately damage airlines’ ability to invest in new aircraft.
This article features in Routes News 2012 Issue 1