Following expiry of the Brexit transition period, a new UK Emissions Trading System (“UK ETS“) came into force on 1 January 2021 – replacing the UK’s participation in the existing EU Emissions Trading System (“EU ETS“). As one might expect, the UK ETS is almost identical to the EU ETS in many respects. However, despite initial signs that the UK ETS would be linked to the EU ETS, for the time being the two regimes remain distinct and will operate in parallel. In the context of aviation, this potentially creates greater complexity for aircraft operators in terms of compliance – with the UK ETS applying to outbound flights from the UK to the EEA and the EU ETS applying to inbound flights from the EEA to the UK. In this briefing, we consider the new UK ETS regime for aviation and how it compares with the existing EU ETS framework, as well as the interaction with the Carbon Offsetting and Reduction Scheme for International Aviation (“CORSIA“). We also consider any impact the UK ETS may have on aircraft lessors and financiers, noting in particular that the previous statutory right of UK regulators to detain and sell aircraft for failure to pay EU ETS penalties appears to have been removed under the UK ETS.

Introduction

Before looking at the new UK ETS regime and how this compares with the existing EU ETS framework, it is helpful to give some background in relation to the development of the EU ETS and how this applies to aviation.

The EU ETS

The EU ETS was established in 2005 pursuant to Directive 2003/87/EC (the “EU ETS Directive”), as part of the EU’s policy to combat climate change and reduce greenhouse gas emissions. In 2008, the EU decided to include aviation activities in the EU ETS pursuant to Directive 2008/101/EC.

Under the EU ETS, all airlines operating flights within the European Economic Area (EEA) (i.e. the EU member states plus Iceland, Liechtenstein and Norway) are required to monitor, report and verify their emissions, and to surrender allowances against those emissions. Each operator receives tradeable allowances covering a certain level of emissions from their flights per year (known as “free allocations”). The EU ETS is often described as a “cap and trade” scheme, as it sets an upper limit on total emissions that decreases over time.

The EU ETS applies to operators carrying out an “aviation activity” listed in Annex 1 of the EU ETS Directive, i.e. flights which depart from or arrive in an aerodrome situated in the territory of an EEA member state. However, certain flights are exempt from the EU ETS (e.g. military, search and rescue, humanitarian aid, emergency medical services and flights by aircraft with a certified MTOW of less than 5,700 kg).

Initially, the scope of the EU ETS covered all flights arriving at, and departing from, airports in the EEA. However, in order to support the development of CORSIA by ICAO, the EU has subsequently limited the scope of the EU ETS to intra-EEA flights only until 31 December 2023 (the EU’s decision to suspend the application of EU ETS for flights outside the EEA is often referred to as “stop the clock”).

Each operator is allocated to an administering state in the EEA for the purposes of monitoring compliance with the EU ETS. The list of operators and their administering states is published annually by the European Commission.[1] Each administering state then designates a competent authority responsible for the implementation of the EU ETS.[2]

The UK ETS

Following expiry of the Brexit transition period, the new UK ETS came into force on 1 January 2021 and replaced the UK’s participation in the existing EU ETS.[3] The UK ETS was established pursuant to the Greenhouse Gas Emissions Trading Scheme Order 2020 (the “Order“). The UK ETS currently operates in an almost identical fashion to the EU ETS and, at present, uses the same benchmarks for free allocations as the EU ETS (although there is the potential for divergence in the future).

The UK ETS applies to operators carrying out an “aviation activity” listed in Schedule 1 of the Order. Broadly speaking, this covers UK domestic flights as well as flights departing from the UK and arriving in the EEA,[4] although this is subject to certain minimum thresholds for aircraft operators to qualify.[5] The same categories of flights which are exempt under the EU ETS are also generally excluded under the UK ETS.[6]

Although both the UK and the EU committed to giving “serious consideration” to the prospect of linking their respective ETS schemes under the terms of the EU-UK Trade and Co-operation Agreement (the “TCA“),[7] for the time being the two systems remain distinct and will operate in parallel.[8] For aircraft operators, this means potentially greater complexity in terms of compliance – with the UK ETS applying to outbound flights from the UK to the EEA and the EU ETS applying to inbound flights from the EEA to the UK.

There are 4 different regulators responsible for monitoring compliance with the UK ETS, with qualifying aircraft operators being assigned to a regulator based on the location of their registered office or place of residence (each a “UK Regulator“):

• for England, the Environment Agency;
• for Wales, the Natural Resources Body for Wales;
• for Scotland, the Scottish Environment Protection Agency; and
• for Northern Ireland, the Department of Agriculture, Environment and Rural Affairsthrough the Northern Ireland Environment Agency.

From 2026 onwards, qualifying aircraft operators based outside the UK will be allocated a UK Regulator based on where they generate their highest proportion of emissions. In the meantime, the Environment Agency will act as the default regulator for new qualifying aircraft operators that do not have a registered office or place of residence in the UK.

Interaction between UK/EU ETS and CORSIA

In contrast to the UK/EU ETS, CORSIA is an “offsetting” scheme whereby emissions may increase only if they are compensated by offsets.[9] CORSIA aims to ensure that emissions from international aviation do not exceed 2019 levels (for the purposes of the initial pilot phase from 2021 to 2023)[10] by requiring airlines to offset the growth of their emissions. Participation in CORSIA is initially voluntary but will become mandatory from 2027. Currently there are 88 countries (including the UK, all EU member states and the US) which participate in the initial pilot phase of CORSIA.[11]

Unlike the UK/EU ETS, CORSIA only applies to international flights, as domestic flights are excluded from its scope. However, in the absence of harmonising legislation, there is still the potential for overlap with the UK/EU ETS given that CORSIA covers international flights within the EEA and flights between the UK and the EEA.

In July 2020, the European Commission issued a “roadmap” setting out the various policy options for implementing CORSIA in EU law through a revision of the existing EU ETS legislation. Following the conclusion of a public consultation, the Commission has stated that it plans to adopt a proposal for a Regulation to amend the EU ETS Directive in the second quarter of 2021.[12] Similarly, the UK is also currently planning to issue further draft secondary legislation in relation to its implementation of CORSIA next year, which will seek to address how CORSIA will interact with the UK ETS. The UK Government has stated that it expects the relevant legislation to come into force by spring 2022.[13]

It is important to note that, for the time being, the UK ETS, EU ETS and CORSIA regimes will all run in parallel, meaning that there is likely to be an even greater compliance burden placed on aircraft operators in navigating the various schemes (with a potential risk of overlapping obligations).

Impact on Aircraft Lessors and Financiers

Given that, as noted above, the UK ETS is almost identical to the EU ETS in many respects, it would initially seem that not much has changed when it comes to analysing potential risks from the perspective of aircraft lessors and financiers. However, there is one significant change in terms of the sanctions that can be imposed by UK Regulators in the event of non-compliance by an aircraft operator.

Whilst both the UK ETS and EU ETS allow regulators to levy significant fines for non-compliance by aircraft operators, a key difference is that under the previous EU ETS regime UK Regulators also had a statutory right to detain and, with leave of the court, sell any aircraft operated by (a) a “UK administered aircraft operator” (i.e. an operator which was regulated by the UK for the purposes of the EU ETS) which failed to pay an EU ETS penalty within 6 months of its due date or (b) an operator which was the subject of an operating ban under Article 16(10) of the EU ETS Directive. Significantly, this statutory right of detention and sale applied on a fleet-wide basis given that EU ETS penalties are levied against operators (rather than being attributable to specific aircraft).

Although there were certain exceptions where this statutory right did not apply (notably, if an aircraft lessor or financier had already terminated the lease relating to the aircraft in question), this generally exposed aircraft lessors and financiers to a risk that an aircraft could be detained and potentially sold in the event of a lessee’s failure to pay EU ETS penalties within the prescribed time period. This risk was compounded by the fact that, pursuant to the terms of the UK’s ratification of the Cape Town Convention (“CTC“), liens for unpaid EU ETS penalties had priority over any registered international interests held by an aircraft lessor or financier under the CTC (e.g. international interests constituted by a lease or mortgage in respect of the aircraft in question).[14]

However, in a move that will be welcomed by aircraft lessors and financiers, the provisions giving rise to these statutory powers of detention and sale have now been removed under the UK ETS.[15] As a result, the only civil penalties that can be imposed on aircraft operator by UK Regulators for non-compliance with the UK ETS are fines (which may nevertheless be significant).

This can be contrasted with the position with respect to unpaid air navigation charges levied by Eurocontrol, whereby the UK Civil Aviation Authority still has a statutory right to detain and sell aircraft for outstanding air navigation charges relating to a particular aircraft (the so-called “tail lien”) or in respect of any aircraft in an operator’s fleet (the so-called “fleet lien”).[16] Furthermore, in the UK, liens for unpaid Eurocontrol charges still have priority over any registered international interests under the CTC.

Practical issues for Aircraft Lessors and Financiers

Notwithstanding that the statutory right of UK Regulators to detain and sell an aircraft in connection with the UK ETS has been revoked, from a practical perspective it is likely that aircraft lessors and financiers will still want to retain the ability to monitor an airline’s compliance with applicable ETS schemes (in much the same way as for Eurocontrol charges), given that any non-compliance could attract significant fines and could serve as an early warning sign of financial difficulties.

Consequently, we expect that creditors will continue to require that airline lessees/borrowers issue a letter (an “ETS Letter“) informing UK Regulators (as well as the relevant competent authorities under the EU ETS) of the lessor/financier’s interest in the aircraft. However, it should be noted that, in our experience, UK Regulators do not typically respond to or acknowledge receipt of an ETS Letter, although this may not be the case in other jurisdictions. Therefore, the practical effect of the ETS letter is essentially to put UK Regulators (or the relevant competent authority in the case of the EU ETS) “on notice” of the lessor/financier’s interest in the aircraft.

We also anticipate that aircraft lessors and financiers will want to ensure that appropriate undertakings are included in the relevant finance/lease documentation requiring the operator to (a) comply with all applicable ETS legislation, (b) promptly notify the lessor/financier if it is or becomes subject to either an operational ban or civil penalty under applicable ETS legislation and (c) pay when due any ETS penalties owing by it. Furthermore, creditors may also wish to consider including a specific Event of Default for non-compliance with ETS legislation or non-payment of ETS penalties (rather than relying on the general breach of obligations Event of Default).

Conclusion

Although the UK ETS is almost identical to the EU ETS in many respects, the fact that (at present) the two systems are not linked from the outset is likely to result in an increased compliance burden for qualifying aircraft operators. This may be further exacerbated by the potential risk of overlapping obligations between the UK/EU ETS and CORSIA until harmonising legislation is implemented. From an aircraft lessor and financier perspective, the removal of UK Regulators’ statutory right to detain and sell aircraft under the UK ETS is a welcome development (even though similar powers still exist in relation to Eurocontrol charges). Having said that, we expect that creditors will continue to adopt a cautious approach and will seek to retain existing contractual protections with a view to monitoring compliance by airline lessees/borrowers with applicable ETS legislation.

 

[1] https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32021R0662&from=EN

[2] https://ec.europa.eu/clima/sites/default/files/transport/aviation/docs/ca_contacts_en.pdf

[3] Pursuant to the transitional arrangements in Article 96(2) of the Brexit Withdrawal Agreement, operators must however continue to comply with their EU ETS obligations in relation to the 2020 scheme year, which ended on 30 April 2021.

[4] Flights between the UK and Gibraltar are also covered by the UK ETS.

[5] Pursuant to Article 7 of the Order, commercial air transport operators are exempt from the UK ETS if, during a scheme year, they operate (a) fewer than 243 “full scope” flights (i.e. flights departing from or arriving in the UK, Gibraltar or an EEA member state) in a 4-month period, for 3 consecutive 4-month periods, or (b) “full scope” flights with total annual emissions of less than 10,000 tonnes of CO₂.

[6] The list of “excluded flights” is set out in Schedule 1 of the Order.

[7] Article 7.3(6) of the TCA. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/948119/EU-UK_Trade_and_Cooperation_Agreement_24.12.2020.pdf

[8] By way of precedent, the EU and Switzerland recently agreed to link their respective ETS schemes pursuant to a Linking Agreement which came into force on 1 January 2020.

[9] https://www.icao.int/environmental-protection/CORSIA/Pages/default.aspx

[10] Originally, the CORSIA baseline was to be set using an average of 2019 and 2020 emissions. However, due to the effects of the Covid-19 pandemic, ICAO decided that 2020 emissions should be excluded from the baseline in order to avoid an inappropriate economic burden on the aviation industry. https://www.icao.int/Newsroom/Pages/ICAO-Council-agrees-to-the-safeguard-adjustment-for-CORSIA-in-light-of-COVID19-pandemic.aspx

[11] https://www.icao.int/environmental-protection/CORSIA/Documents/CORSIA_States_for_Chapter3_State_Pairs_Jul2020.pdf

[12] EU emissions trading system – updated rules for aviation (europa.eu)

[13] https://www.gov.uk/government/consultations/implementing-the-carbon-offsetting-and-reduction-scheme-for-international-aviation/implementing-the-carbon-offsetting-and-reduction-scheme-for-international-aviation-corsia

[14] Regulation 17 of The International Interests in Aircraft Equipment (Cape Town Convention) Regulations 2015.

[15] These statutory powers previously arose pursuant to section 39 and schedule 9 of The Greenhouse Gas Emissions Trading Scheme Regulations 2012, the UK implementing legislation for the EU ETS Directive. These provisions have now been repealed pursuant to the Greenhouse Gas Emissions Trading Scheme (Withdrawal Agreement) (EU Exit) Regulations 2020.

[16] These statutory powers arise pursuant to section 73(1) of the Transport Act 2000 and the Civil Aviation (Chargeable Air Services) (Detention and Sale of Aircraft for Eurocontrol) Regulations 2001.

Discover more

Our team has extensive experience with the above and related issues across the globe and can assist with developing a holistic strategy to navigate through the challenges posed by airline distress and strategically engage with financiers. Click here to contact a member of our team.