Shipping prepares for emissions trading

On 5 June 2023, amendments to the existing EU Emissions Trading Directive (ETS Directive) came into force, extending the EU Emissions Trading Scheme (EU ETS) to shipping as of 1 January 2024.

This much-anticipated development reflects global shipping’s ongoing commitment to reduce its carbon footprint. However, it will have significant legal, commercial and financial consequences for the industry. 

EU ETS 

Established in 2005 as the world’s first emissions trading system, the EU ETS covers a number of sectors, including power generation and aviation. It is a carbon market that operates on the basis of the ‘cap and trade’ principle and its objective is to fight climate change by reducing certain greenhouse gas emissions (GHGs).

Under the EU ETS, Member States allocate or sell a capped number of permits that allow discharge of a specified quantity of GHGs over a set time period. This cap reduces over time to lower emissions, although allowances may be traded between companies to reflect their individual requirements. Where a company exceeds its allowance, it may be penalized with a heavy fine. A company that has allowances to spare at the end of the relevant year can either save them for subsequent use or can sell them on. Funds raised from the sale of allowances mostly go back into Member State budgets. Where allowances are auctioned off, the money raised goes into projects investing in low carbon technologies and energy transition, for example the Innovation and Modernisation Funds

EU ETS in shipping

In the shipping context, a cap will be set on the total amount of GHGs that may be emitted by an entity and the cap is reduced over time. 

Who needs to comply?

The focus for compliance is the ‘Shipping Company’ which is liable to surrender allowances in respect of emissions within the scope of the EU ETS. ‘Shipping Company’ is defined as:

‘shipping company means 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 that, on assuming such responsibility, has agreed to take over all the duties and responsibilities imposed by the International Management Code for the Safe Operation of Ships and for Pollution Prevention, set out in Annex I to Regulation (EC) No 336/2006 of the European Parliament and of the Council [the ISM Code].’

By default, the Shipping Company will be the registered owner of the vessel, unless compliance with the ISM Code has been delegated to another entity which is named in the ship’s Document of Compliance and Safety Management Certificate e.g. bareboat charterer, manager. 
As compliance will be assessed on a company-wide (rather than per ship) basis, it must be ensured across the fleet. 

However, the ‘polluter pays’ principle means that the Shipping Company can recover compliance costs from the entity that is ultimately responsible for purchasing the fuel and/or operating the ship. Member States are encouraged to implement measures into domestic legislation to ensure that these costs are passed down.

Who will enforce?

Enforcement will be carried out by the ‘Administering Authority’ which shall be:

‘(a) in the case of a shipping company registered in a Member State, the Member State in which the shipping company is registered; 
(b) in the case of a shipping company that is not registered in a Member State, the Member State with the greatest estimated number of port calls from voyages performed by that shipping company in the last four monitoring years and falling within the scope set out in Article 3ga; 
(c) in the case of a shipping company that is not registered in a Member State and that did not carry out any voyage falling within the scope set out in Article 3ga in the preceding four monitoring years, the Member State where a ship of the shipping company has started its first voyage falling within the scope set out in that Article.’

What is the scope of the EU ETS for shipping?

The EU ETS is intended to work in conjunction with the EU MRV (monitoring, reporting and verification) Directive, which entered into force on 1 July 2015. This provides for the monitoring, regulation and verification of CO2 from ships arriving at, within or departing from EU ports and/or European Economic Area ports. 

(a)    Which vessels?
Pursuant to revised Article 2 and Annex I of the ETS Directive, and revised Articles 2 & 3 of the EU MRV Regulation, the EU ETS will apply to:

1. ships above 5,000 gross tonnage, but excluding warships, naval auxiliaries, fish-catching or fish-processing ships, wooden ships of a primitive build, ships not propelled by mechanical means, or government ships used for non-commercial purposes; 
2. performing voyages arriving at or departing from the EU or between EU ports of call;
3. a port of call being “a port where the ship stops to load or unload cargo or to embark or disembark passengers, or the port where an offshore ship stops to relieve the crew” pursuant to Article 3(z) ETS Directive. That Article also sets out exclusions to the definition of port of call, including “stops of containerships in a neighbouring container transhipment port listed in the implementing act adopted pursuant to Article 3ga(2)”. According to Article 3ga(2) of the revised ETS Directive, that list shall be established by 31 December 2023 and updated every two years. Those will be ports within 300 nm of an EU port and where 65% of the port container traffic is transhipment (unless the country of the port has a corresponding ETS in place); 
4. GHGs released into the atmosphere by those ships on those voyages, and produced by those ships whilst in EU ports, being, pursuant to Annex I of the revised ETS Directive, carbon dioxide emissions in 2024 and 2025 and, from and including 1 January 2026, carbon dioxide, methane and nitrous oxide.

(b)    What emissions?
Pursuant to Article 3ga(1) of the ETS Directive, but subject to the phase in detailed below, it will be mandatory to surrender allowances covering:

1. 50% of the verified emissions for voyages which enter or depart the EU;
2. 100% of the verified emissions for voyages between ports in the EU and produced by ships at berth in a port within the EU.

(c)    Phase-in
Pursuant to Article 3gb of the revised ETS Directive, a Shipping Company shall be liable to surrender allowances in respect of carbon dioxide emissions as follows: 

1. 40% of verified emissions reported for 2024 (i.e. 20% of verified emissions for voyages into or out of the EU); 
2. 70% of verified emissions reported for 2025 (i.e. 35% of verified emissions for voyages into or out of the EU); 
3. 100% of verified emissions reported for 2026 and each year thereafter (i.e. 50% of verified emissions for voyages into or out of the EU). 
4. From and including 2026, allowances in respect of 100% of verified emissions of methane and nitrous oxide emissions (i.e. 50% of the total verified emissions for voyages into or out of the EU) must also be surrendered.

(d)    Availability of allowances
The EU wide allowances for shipping will be 79 million but this will reduce year on year by 4.2%. There is no proposal to allow for the free allocation of allowances to Shipping Companies and it presently appears these will be issued at auction only.

Any entity can hold allowances and these are to be recorded in the Union Registry.  Allowances will be valid indefinitely but cannot be surrendered against emissions produced in earlier (non-maritime) phases of the ETS.

(e)    Penalties
The ETS Directive requires Member States to implement rules on penalties applicable to infringement in national law.  Specifically, Members States must:

1. publish the names of Shipping Companies that are in breach of their obligations to surrender allowances.
2. make Shipping Companies which do not surrender allowances as obliged by 30 September in the following year liable to pay an excess emissions penalty of EUR 100 for each tonne of carbon dioxide emitted beyond the allowances surrendered. The Shipping Company must also surrender allowances in respect of those excess emissions when submitting allowances for the following year. Pursuant to Article 16(4), the penalty of EUR 100 is index-linked and subject to increases. 
3. without prejudice to the rules applicable where a ship is in distress, where a Shipping Company has failed to comply with the obligation to surrender allowances for two or more consecutive years, the competent authority of the Member State of the port of entry may issue an expulsion order to that Shipping Company, and all Member States except the flag state (if a Member State) shall refuse entry of the ships of that Shipping Company to any of their ports until the Shipping Company fulfils its obligations. 
4. Where a ship of the Shipping Company enters or is found within the flag state (if a Member State), the Member State shall detain the ship until the Shipping Company fulfils its obligations. The Member State shall inform the European Commission, EMSA and other Member States of the detention order and those States shall take the same measures as following the issue of an expulsion order, i.e. shall deny the ships of the Shipping Company entry to their ports.

Why is this relevant?

The extension of the EU ETS to maritime will impose a new cost on shipping that takes place in the EU. The additional cost is one that will lead to discussions concerning charterparty arrangements so that the costs can be passed down/shared between the parties engaged in shipping into/ between ports in the EU.

Against that background, a number of clauses are available to consider for inclusion in charterparties, including the BIMCO’s ETS Emissions Trading Scheme Allowances Clause for Time Charterparties. 

The BIMCO clause encourages both parties to the charterparty to cooperate and collaborate, with the party responsible for fuel also being responsible for emissions trading allowances. The shipowner must monitor emissions and provide the relevant ship emissions data and the basis of the calculation. The charterer then transfers the corresponding allowance to the shipowner on a monthly basis. The BIMCO clause also deals with the adjustment of allowances due to off-hire events and what happens if the charterer fails to transfer sufficient emission allowances.

BIMCO is also working on a clause addressing Emission Trading Scheme Allowances in the context of ship management agreements. This has been fast-tracked for adoption on the ground that the industry needs it urgently. Additionally, an Emission Scheme Surcharge Clause for Voyage Charter Parties is being developed and is intended to apply to any emission scheme. BIMCO expects these two clauses to be presented for adoption before the new year.

Although there many ways in which suitable clauses can be drafted, the suitability of any particular clause will depend on a number of commercial factors. In particular, the following questions will all be highly relevant to deciding which clause to use (whether a BIMCO clause or a bespoke version): 

• who will be acquiring the allowances; 
• how they will be acquired (all in one go at the beginning of each auction year, spread out during the year, at the end of each auction year/prior to the date for surrender); 
• how to calculate the allowances/frequency of calculation; 
• how to share data to enable verification of the calculation; 
• whether a commercial ship manager is involved and, if so;
• whether this is a service they can offer (with any necessary amendments to the management contract). 

Related legislation

The EU ETS scheme is part of the EU’s Fit for 55, a set of proposals in July 2021 that were intended to update EU law with the aim of reducing GHGs by 55% by 2030. Part of Fit for 55 is the FuelEU Maritime Initiative, which was announced in March 2023. This is a proposed Regulation that aims to reduce GHGs from the shipping sector by promoting the use of cleaner fuels and energy.

The International Maritime Organisation (IMO) has also undertaken various initiatives to reduce GHGs. Some of these have taken the form of amendments to MARPOL Annex VI. These include the adoption of mandatory: energy efficiency regulations for ships; Data Collection System; and calculation of Energy Efficiency Existing Ship Index (EEXI) and annual operational Carbon Intensity Indication (CII) and CII rating. The IMO is also reportedly considering various market-based measures, including a global emissions trading scheme, to regulate GHG emissions from ships.

Comment

Given that owners have had to report emissions under the EU MRV Directive for a few years, they will have potentially developed capabilities in this regard. Nonetheless, the EU ETS presents owners with many challenges. 

The trade press reports that charterers have so far been reluctant to rewrite existing charterparties, either with bespoke clauses or by incorporating the BIMCO ETS Allowances Clause. This hinders owners from shifting the burden of compliance costs onto actual users. Owners are expected to try and hedge their potential exposure in a similar way to Freight Forward Agreements (FFAs).

In October 2023, three major container lines issued an EU ETS surcharge calculation for their customers using the Clean Cargo Emission Calculation Methodology. This deals with average emission factors based on a standardised utilisation roundtrip. The lines are expected to release the actual surcharges that will be levied as a result of the EU ETS at least 30 days before the regulation comes into effect.

However, it has also been suggested that major European oil and trading groups that have been in the carbon market for years may propose that they take responsibility for emissions compliance when chartering vessels in return for more favourable charter rates.

It will be interesting to see what further industry developments emerge before 1 January 2024.