Auctioning of Emissions Allowances Under EU’s Cap-and-Trade Regime: Impact on the Civil Aviation Sector
The purpose of this client alert is to unfold the main legal and economic implications for enforcing the aviation provisions of the Emissions Trading Scheme Directive (‘ETS Directive’)1 to airlines established outside of the European Economic Area (‘EEA’) and in particular in the US. The European Union (‘EU’) has decided to be proactive in establishing a cap-and-trade system that is tailored to the aviation sector absent any consensus in the international community. A lawsuit is now ongoing before the High Court of England and Wales (‘High Court’) and, by extension, the Court of Justice of the EU (‘CJEU’). Although the Advocate General assigned to the preliminary ruling case has already pronounced in favor of the legality of the EU ETS aviation provisions, it remains to be seen whether the CJEU itself will follow her legal reasoning and decide that this scheme in no way is extra-territorial and fully complies with relevant rules of public international law. A major economic consideration will be whether airlines will be able to pass over the increased compliance costs onto final consumers without causing a significant shift in demand for airlines tickets. The civil aviation sector represents about 10% of the GHG emissions falling within the scope of the ETS, which implies that around 4000 aircraft operators either taking off from or landing in the EU will be affected by it.2
II. Overview of the ETS Regime
The ETS Directive, which establishes a Greenhouse Gas (‘GHG’) Emissions Trading Scheme (‘EU ETS’) for the EEA (i.e., the 27 EU Member States plus Norway, Iceland and Liechtenstein), represents a central instrument for reaching EU’s 20% GHGs reduction target. The Directive, as last amended in 2009,3 sets auctioning (via a common platform or certain Member States’ individual platforms) as the principal method of allocating emissions allowances4 in the third trading period (2013-2020),5 subject to certain transitional regimes, thus replacing free allocation of emissions allowances generally followed in the first (2005-2007) and second (2008-2012) trading periods. Only those activities designated in the Annex I to the ETS Directive are subject to EU ETS. Most of these activities release only carbon dioxide but some of them, in addition, also release nitrous oxide (i.e., production of nitric acid; production of adipic acid; and production of glyoxal and glyoxylic acid) or perfluorocarbons (i.e., production of primary aluminium).
III. Impact of the Revised ETS Directive Upon the Aviation Sector
Aircraft operators enjoy a special regulatory treatment under the EU ETS as a result of the entry into force of Directive 2008/101/EC amending the original ETS Directive.6 Their subjection to the ETS will become effective as of 1 January 2012.7
These operators are covered by the EU ETS only to the extent that their aircrafts take off from or land on an EEA-based airport, regardless of their place of establishment.8 Calculation of the number of GHGs emissions released by aircraft operators will be based on the entire journey to or from an EEA airport, and not just on the distance travelled by the aircraft over the EEA territory.
The civil aviation sector shall be allocated allowances corresponding to 97% of its historical emissions between 1 January 2012 and 31 December 2012, 15% of which shall be auctioned and 85% of which distributed for free.9 From 1 January 2013 and for 8 years thereafter, the civil aviation sector shall be allocated a quantity of allowances corresponding to 95% of its historical emissions to be multiplied by the number of years that have run within the period,10 15% of which are to be auctioned, 82% of which are to be distributed for free and 3% of which are to be placed in a special reserve for new entrants and fast growing airlines.11 The historical aviation emissions have been set at: 219,476,343 tons of CO2.12 Member States are to invest the proceeds of the auctioning revenue in climate change initiatives in the EU and in third countries, in particular in projects designed to reduce GHG emissions.13
It will be up to the Member States to formally allocate free allowances to aircraft operators by multiplying technical benchmarks by the operators’ respective 2010 tonne-kilometre data. In its Decision of 26 September 2011, the European Commission agreed on 0,00068 allowances per tonne-kilometre as the 2012 benchmark for determining free emissions allowances for aircraft operators. The benchmark for the period between 1 January 2013 and 31 December 2020 was set to be 0,00064 allowances per tonne-kilometre.14
The rationale behind the scheme is that, having been allocated a certain number of emissions allowances for free, aircraft operators have to surrender a number of allowances to the national competent authority which correspond to the level of their emissions. Should they estimate that the allowances granted to them for free are not sufficient to cover the total number of allowances they need to surrender to the national competent authority, they have the option between purchasing new allowances on the market (e.g., from other trading sectors) and reducing their level of emissions by investing in energy-efficient or green technologies.
Exemption for the Defense Industry
The ETS Directive provides for a number of exemptions from its scheme (e.g., customs and police flights, search and rescue flights, humanitarian flights, emergency medical service flights, etc..). Of particular significance is the Directive’s exclusion of military flights from its scope provided that they are performed by military aircrafts, and “are directly related to the conduct of military activities”.15 However, such exemption does not extend to military flights performed by civil registered aircrafts or to civil flights performed by military aircrafts.16 As a result, defence ministries worldwide will have to rethink their cargo flights when performed by civil registered aircrafts to and/or from an EEA-based airport (which may typically happen in case of a refuel). As a consequence of the enforcement of the ETS to the aviation sector, those civil registered aircrafts may consider refueling or establishing a logistic hub outside of the EEA in order to remain competitive in the context of their involvement in a defense procurement process.
In the context of national litigation involving on the one hand The Air Transport Association of America, American Airlines, Continental Airlines and United Airlines (the claimants) and, on the other, the Secretary of State for Energy and Climate Change (the defendant) before the High Court, the validity of the EU ETS aviation provisions was questioned to the extent that they regulate air activities carried out outside of the EEA. The High Court referred the invalidity question to the CJEU for a preliminary ruling.17 The claimants argue that such provisions produce an extra-territorial effect that is contrary not only to international customary law (e.g., principle of national sovereignty, and freedom to fly over the high seas) but also to international agreements (e.g., Chicago Convention, Open Skies Agreement, and the Kyoto Protocol). They also claim that such a GHGs reduction scheme ought to have been decided upon through the conclusion of a global agreement rather than a unilateral act by the EU.
On October 6, 2011, the CJEU’s Advocate General (Mrs. Kokott) delivered her (non-binding) legal opinion on the admissibility and merits of the preliminary ruling request.18 In a first stage, (i) she ascertained whether the EU was bound by the international treaties and customary law principles invoked by the claimants and, where this was the case, (ii) she assessed whether the nature and the broad logic of the international treaties and/or customary law principles are susceptible of conferring individual rights and, where this was the case, (iii) she determined whether the content of the invoked provisions is unconditional and sufficiently precise. According to Advocate General Kokott, amongst all international law rules referred to by the claimants, only Article 7 and the second sentence of Article 15(3) of the EU-US Open Skies Agreement satisfy all three conditions and could thus be directly relied upon by the claimants as a superior norms for reviewing the validity of the challenged EU act (i.e., the ETS Directive’s aviation provisions). On the merits, the Advocate General concluded that both provisions did not affect the validity of the ETS Directive. Responding to the allegation that the EU institutions breached Article 15(3) of the EU-US Open Skies Agreement, the Advocate General posited that the EU ETS does not amount to “charges for the arrival or departure of aircrafts”. Even if international customary law were directly applicable in the EU legal system, the EU ETS aviation provisions would still not be deemed extra-territorial and in breach of public international law: it is not uncommon for a State or even an international organization to account for extraneous factors in the exercise of its sovereignty or functional competence, even when these factors are localized over the high sea or in third country. This is precisely the case when a State adopts the principle of universality of income for calculating a person’s tax basis. Considering the entire length of the flight for the purpose of applying the EU ETS to all airlines departing from or landing at an EEA-based airport would only reflect the proportionality and ‘polluter pays’ principles according to Mrs. Kokott.
Reactions and Possible Counter-Measures
On September 30, 2011, that is one week before Advocate General’s opinion was published, 21 countries (e.g., USA, Canada, Brazil, Peru, South Africa, Saudi Arabia, Russia, China, Singapore and Thailand) issued a joint declaration by which they objected to the applicability of EU ETS to non-EEA aircraft operators on the ground that the Directive’s aviation provisions would be contrary to the Chicago Convention and to WTO rules, amongst others.19 On November 2, 2011, the International Civil Aviation Organization (‘ICAO’) Governing Council adopted a working paper strongly inviting the EU to exclude non-EU aircraft operators from the scope of the EU ETS.20 As a result of ICAO’s positioning and in light of the CJEU’s future judgment, there is the danger that EU governments will be torn between two irreconcilable interpretations of the Chicago Convention.
Meanwhile, unilateral actions by individual countries are taking place. China, for instance, has recently blocked the order of 10 Airbus superjumbo aircrafts which were intended for Hong Kong Airlines.21 In addition, the US House of Representatives approved a bill to prohibit US air carriers from complying with the ETS Directive,22 claiming that its provisions on airlines are inconsistent with well established international law and practice, and directly infringe upon US’ national sovereignty. This Bill is now to be examined by the Senate.
Economic Consequences for the Aviation Industry
The implementation of the ETS Directive, as it currently stands, will clearly result in considerable extra costs for all civil (incl. cargo) airlines flying from or to an EEA airport, some of them claiming that the total compliance costs would rise up to several hundred millions Euro. However, studies have pointed to different impact assessments. According to a European Commission’s study, the impact on the aviation sector would be modest, contingent upon the number of competitors on each route, efficiency levels (including fuel hedging strategies) and the types of customers catered for. All or at least a significant proportion of the ETS costs could indeed be passed on to customers with a slight influence over prospective demand.23 Other studies, by contrast, have contested the European Commission’s assumptions, and stated instead that such a transfer of costs to customers would not exceed one third of the extra allowance costs.24
As a result, in order to prevent any financial penalties (the excess emissions penalty shall be 100 Euro for each tonne of carbon dioxide equivalent emitted for which the aircraft operator has not surrendered allowances and the amount of exceeded allowances shall be deducted from the airline’s allocated allowances for the following calendar year)25 or even an operating ban throughout the EEA,26 airlines may have to rethink the use of their fleet: only the most fuel efficient aircrafts may have to be used to fly to or from any EEA airport. In addition, aircraft operators may consider exploiting a hub located in the vicinity of but technically outside of the EEA zone, from where short-haul flights requiring less fuel are run towards various EEA final destinations.27 Such hub relocation would however also generate serious costs (e.g., traffic rights, slots acquisition) and cause serious inconvenience for consumers: the combination of stopover flights would, in certain cases, release higher carbon emissions than direct flights, and not every air passenger would necessarily be willing to make a stopover outside of the EEA in the face of available direct flights.
In light of the Advocate General’s legal opinion, two categories of situations need to be envisaged in order to better assess litigation prospects. First, let us assume that the CJEU will adopt a position radically opposite to that expressed by the Advocate General and thus find the ETS aviation provisions to be invalid (a scenario which is highly speculative albeit not inconceivable). In this case, the challenged provisions would be merely discarded for the purpose of the national dispute before the High Court: they would not be annulled in the sense of being retroactively removed from the text of the Directive. This is because the invalidity judgment would have been delivered as a result of a preliminary ruling request and not of an annulment action.28 Having said that, national courts in future cases could in practice rely on such invalidity judgment to refuse to refer a new preliminary ruling request to the CJEU and thus to declare themselves these provisions invalid for the purpose of their own litigation.29 One CJEU invalidity judgment could de facto have a precedential effect on the domestic courts of various Member States provided that the EU legal issue at stake before them is identical to that adjudicated upon by the CJEU. This hypothetical situation, in the medium run, could urge the EU institutions to amend Directive 2003/87/EC in the face of widespread inapplicability of its ETS aviation provisions to parties involved in national disputes. If we assume by contrast that the CJEU will endorse Advocate General’s legal opinion, the ETS aviation provisions would remain applicable in all Member States, and no national court would be in a position to find them invalid.30 Of course, aircraft operators would not be prevented from formally challenging the ETS aviation provisions again in any Member State’s court, in which case the domestic court would enjoy discretion as to whether to refer the preliminary ruling request to the CJEU (unless it adjudicates in last resort, in which case it would have to refer).31 The CJEU in the face of a new challenge to the validity of the ETS aviation provisions could deliver a succinct judgment merely referring back to the substance of its first judgment or (less likely in practice) reconsider the legal issue on the basis of new developments under EU and/or international law.
The main long term solution to address the difficulties raised by the high costs of releasing carbon emissions would be for aerospace companies to invest in green and energy-efficient technologies. Several of them have already emphasized the importance of research and development in low fuel-consuming airplanes.
The adoption of an agreement at a global level is preferable to a unilateral EU-tailored cap-and-trade regime so as to avoid the imposition of any countermeasures by third States and the creation of distortions of competition between those aircraft operators which operate via an EEA-based airport and those which do not. EU’s proactive ETS regime can of course have the effect of encouraging other States to adopt a tax or a national cap-and-trade system with a view to reducing carbon emissions released by commercial aircraft operators in the atmosphere, which is a good thing in and of itself. However, the risk is that non-EEA-based aircraft operators find themselves subject to two different legal regimes for the same international flight, which would make them less competitive than EEA-based aircraft operators.
1Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, 2003 OJ L 275/32, available here.
2Commission Press Release, Brussels 7 March 2011 IP/11/259, available here.
3Directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community, 2009 OJ L 140/63.
4One allowance entitles its holder to emit one tonne of carbon dioxide equivalent for a specific period.
5A minimum of 50% emissions allowances are estimated to be traded on the ETS as of 2013.
6Directive 2008/101/EC of the European Parliament and of the Council of 19 November 2008 amending Directive 2003/87/EC so as to include aviation activities in the scheme for greenhouse gas emission allowance trading within the Community, 2009 OJ L 8/3, available here.
7Annex I of the ETS Directive, point 6.
9ETS Directive, Article 3c(1).
10ETS Directive, Article 3c(2).
11ETS Directive, Article 3d(1)-(2).
12The historical aviation emissions have been set at: 219,476,343 tonnes of CO2. See Commission Decision (2011/149/EU) of 7 March 2011 on historical aviation emissions pursuant to Article 3c(4) of Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowance trading within the Community 2011 OJ L 61/42 available here.
13Article 3d(4) of the ETS Directive.
14Commission Decision of 26 September 2011 on benchmarks to allocate greenhouse gas emission allowances free of charge to aircraft operators pursuant to Article 3e of Directive 2003/87/EC of the European Parliament and of the Council, 2011 OJ L 252/20, Article 1.
15ETS Directive, Annex I.
16Commission Decision of 8 June 2009 on the detailed interpretation of the aviation activities listed in Annex I to Directive 2003/87/EC of the European Parliament and of the Council, 2009 OJ L 149/69, available here.
17Case C-366/10, The Queen on the application of (1) the Air Transport Association of America, Inc.; (2) American Airlines; (3) Continental Airlines, Inc.; (4) United Airlines v. The Secretary of State for Energy and Climate Change.
19Press Information Bureau Government of India (Ministry of Civil Aviation), “International meeting of ICAO Council and Non-EU Member States on Inclusion of Aviation in EU-ETS held”, September 30, 2011, available here.
21P. Clark, “China blocks billion-dollar Airbus order”, Financial Times June 24, 2011.
23Commission Staff Working Document SEC 2006/1684 dated December 20, 2006, Accompanying document to the Proposal for a Directive of the European Parliament and the Council amending Directive 2003/87/EC so as to include aviation activities in the scheme for greenhouse gas emission allowance trading within the Community - Impact Assessment of the inclusion of aviation activities in the scheme for greenhouse gas emission allowance trading within the Community, page 30-31.
24For example: Ernst & Young, 2007. “Analysis of the EC Proposal to Include Aviation Activities in the Emissions Trading Scheme,” Executive Summary, Ernst & Young, New York (2007), 5.
25ETS Directive, Article 16(3).
26ETS Directive, Article 16(5).
27Lufthansa for example has raised the idea of partially relocating its hub operations from Frankfurt and Munich to Zurich, which is still located in the heart of Europe, but outside the EEA.
28Contrast Article 267 with Article 263 of the Treaty on the Functioning of the European Union (TFEU).
29For a supporting authority, see Case 66/80 International Chemical Corporation v. Amministrazione delle Finanze dello Stato  ECR 1191, para. 13-15.
30As a general rule, the EU Courts have the monopoly to declare EU acts invalid on the ground that they are in breach of a superior rule of EU law: Case 314/85 Firma Foto-Frost v. Hauptzollamt Lubeck-Ost  ECR 4199, para. 13-20.
31Article 267 TFEU.