Paring the carbon footprint of airlines

Aviation is one of the fastest growing emitters of greenhouse gases (GHG) and the second-largest source of emissions in the transportation sector after road transport, contributing 15.7%. It accounts for 2-3% of global and 3.7% of energy-related carbon dioxide (CO2) emissions in the European Union, according to the European Commission¹ (EC). And this is only set to worsen. The International Civil Aviation Organization (ICAO)² estimates that by 2040, international aviation emissions could rise by up to 150% compared with 2020.
 

To be sure, countries are enacting laws to cut down GHG emissions, with aviation also falling under their ambit. The EU has put in place an emission trading system (ETS), which is a cap-and-trade mechanism that specifies the permitted emissions for industries and their trading. It is a key step in its commitment to lower GHG emissions 55% by 2030 (vs 1990). Under ETS, companies receive free emission allowances annually; those in excess are to be paid for through auction purchases or through trade among entities, the absence of which leads to hefty fines/penalties.

Aviation ETS becoming more stringent

The EU, however, is becoming more stringent when it comes to emissions. In April 2023, the EU parliament agreed on to reform the ETS for the aviation industry, deciding to gradually phase out free allowances by 2026 (25% by 2024, 50% by 2025, and 100% by 2026). However, 20 million emission allowances will be distributed as incentive from 2024 to 2030 to aircraft operators moving to sustainable aviation fuels (SAF).

Compliance is mandatory for all aircraft operators operating cargo and passenger flights within the European Economic Area (EEA) and for flights departing to Switzerland and the United Kingdom.

In June 2018, the ICAO adopted the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), a global market-based measure for aviation emissions, whereby aircraft operators will offset any growth in CO₂ emissions above 2020 levels. The EU ETS would be extended to all flights departing from the EU if the airline does not apply CORSIA from 2027.

However, this has been opposed globally since it can lead to significant compliance costs.

Phase-out of emission allowances to hit margins

The complete phasing out of free allowances will have a profound impact on aviation companies since these emissions will then have to be offset through purchased allowances, which currently trade at ~€70/ton of CO₂³. 

Airlines can make either of two difficult choices - bear these costs and take a hit to their bottom line or pass these costs on to end-consumers, which will depend on prevalent pricing, the competitive position of the airline and consumer willingness to pay such fees on the routes flown. In case the costs of these allowances are passed on to consumers, the average ticket price on the London-Paris route, for instance, is likely to rise 18% (considering per passenger emissions of 0.250 ton of Co2⁴). 

The impact on airline companies will depend on their average fleet age as well, considering older fleets tend to generate higher emissions because of fuel inefficiencies. Therefore, companies having a newer fleet would have a higher operating margin on account of lower maintenance costs and higher fuel efficiencies, and going forward, lower allowance purchases as well.

This is evident from the table above, with Ryan Air and Pegasus having the highest operating margins in line with their lower fleet age.

In the near to medium term, this scenario is difficult to reverse for companies operating older fleet. This is considering the high capex requirements and operational challenges associated with aircraft deliveries due to a substantial order backlog at the world’s largest aircraft manufacturers, Airbus and Boeing.

Modernise fleet, increased SAF use, tackle emissions

Airlines need to mitigate the quantum of emissions through replacement of their older fleet with newer ones or with the use of SAF.

Higher price and production capacity constraints of SAF: Though increased use of SAF is likely to be the way forward, it is fraught with challenges in terms of pricing and scaling up production. According to the International Air Transport Association, SAF could contribute ~65% of the reduction in emissions needed by the aviation sector to reach net zero in 2050⁵.

That said, according to the European Aviation Environmental Report, the current SAF supply remains at ~0.05% of the total aviation fuel used in the EU, which signifies a significant challenge with respect to scaling up production. Moreover, the average price of SAF is ~2.5x higher than that of conventional fuel. While it can be lowered through economies of scale, it is currently a farfetched proposition.

Fleet modernization will call for heightened capital expenditure requirement: The prospect of replacing the fleet in the near-to-medium term is marred with challenges since it entails high capex, which may strain an airline company’s cash flow.

Sustainability-linked loans can help bridge funding gap

What is the proposed flight path? Aviation being a hard-to abate sector, it is relatively difficult to transition to net-zero with currently available technology given cost constraints. Hence, sustainable financing will play a critical role in incentivizing aviation players to pursue fleet improvements.

Banks with sustainability initiatives and processes in place will be able to accommodate the rising demand for sustainability-linked loans (SLLs). The EC is also considering proposals around granting lighter capital treatment to sustainable debt. However, financial institutions need to convince regulators regarding the genuineness of their sustainability-linked financing to safeguard themselves from the accusation of greenwashing.

SLLs, bond issuances rising, but still at nascence

According to the World Economic Forum, the aviation sector needs to invest ~$185 billion annually to achieve net-zero emissions by 2050⁶,  which is 2.4 times the current investment of passenger airlines. The issuance of SLLs has trended upward in recent years and is expected to grow.⁷ For example, CDB Aviation, the Irish subsidiary of CDB Leasing, as part of its goal to develop sustainability-linked leases and other innovative sustainable finance products for the aviation industry, issued a combined $1.23 billion sustainability-linked term loans in December 2023 and April 2024, aiming at reducing CO2 intensity, latest-generation aircraft fleet share and other social causes.

SLL issuance necessitates greater scrutiny by lenders

In this milieu, financial institutions will play a crucial role to facilitate the growth of green alternatives and support the airlines in their journey towards decarbonization. Simultaneously, lending in a debt-heavy, capital-intensive sector triggers constant monitoring of the financial health of the airlines.

Though aviation companies have recovered well from the pandemic, their balance sheets still show a huge dependency on external funds. Cumulative free cash flows (FCF), pre-dividend for the top eight European airlines as discussed above, amounts to 11.7 billion euro as against the total outstanding debt obligations of 71.8 billion euro.

With heightened compliance costs pertaining to emission allowances and increased capex requirements related to flight upgradations and SAF-related investments, airline FCF is likely to come under pressure going forward. Banks and financial institutions are likely to play a cardinal role in ensuring the continued availability of funds to prevent any potential cash flow mismatches against maturing debt.

Amidst an increase in SLL issuances, timely monitoring of key performance indicators (KPIs) such as gross global Scope 1 emissions, emissions per passenger and tonnage, the percentage of SAF used and proportion of new aircraft in the fleet mix becomes imperative. Besides, borrowers are also expected to publicly report information relating to their sustainability performance targets (SPT), given the rising interest among regulators, shareholders and other key stakeholders. Borrowers are also likely to obtain independent and external verification of their performance level against SPTs for each of the KPIs to ensure compliance with lender norms. Linking margins and fees of their SLL with the achievement of targets is likely to improve compliance.

Lowering emissions above the clouds will involve close coordination on the ground between lawmakers, regulators, financial institutions and last, but not the least, airline companies.
 

¹https://www.europarl.europa.eu/doceo/document/TA-9-2022-0230_EN.html
²ICAO is a UN agency which coordinates the principles and techniques of international air navigation and helps 193 countries to cooperate and ensure safe and orderly growth
³https://ember-climate.org/data/data-tools/carbon-price-viewer/
⁴https://www.clevel.co.uk/flight-carbon-calculator/
⁵https://www.iata.org/en/programs/environment/sustainable-aviation-fuels/
⁶https://www.weforum.org/publications/net-zero-industry-tracker-2023/in-full/aviation-industry-net-zero-tracker/#:~:text=The%20aviation%20industry%20faces%20a,the%20current%20passenger%20airline%20investments
⁷Source: https://www.ishkaglobal.com