Carbon emissions from the aviation sector have a highly emotive and clearly visible profile compared to many other industries. During 2015, the aviation sector will emit approximately 757 million tons of carbon dioxide (CO₂),¹ representing between two and three percent of the world's anthropogenic carbon emissions,² just slightly less than the entire carbon footprint of major industrialized countries such as Canada, South Korea and Germany. Many climate change scientists believe that the effects of aviation CO₂ and other greenhouse gas emissions could be of a magnitude three or four times greater than calculated, by virtue of being deposited at high altitude and taking much longer to be absorbed by the Earth's ecosystems than they would if deposited at sea level.³

The White House has estimated the "social cost" of carbon emissions at $36 per metric ton.⁴ Based on this calculation, the annual cost to society resulting from current aviation CO₂ emissions is approximately $27 billion. At present, very little of this societal cost is paid for by the air transport industry. To date, only the European Union (EU) has enforced stringent aviation compliance measures under its Emissions Trading Scheme (EU ETS),⁵ whereby aircraft operators are legally required to account for their intra-European CO₂ emissions. Even under EU ETS, up to 85 percent of compliance costs are currently subsidized by the EU by way of free carbon allowances. Most other carbon-intensive industries regulated under EU ETS receive no such financial support or social impact relief. As a result, aviation emissions have become a highly charged global issue, with a critical crossroads approaching by the end of 2016.

Evolution of a Global Controversy

In order to meet its commitments under the Kyoto Protocol to the United Nations Framework Convention on Climate Change,⁶ the EU decided in 2008 to expand its flagship emissions trading scheme to include aviation activities.⁷ This triggered considerable international backlash against the EU for unilaterally regulating emissions occurring within other sovereign territories and within international air space. In response, the United States enacted the European Union Emissions Trading Scheme Prohibition Act of 2011 (similar to prohibitions by India and China against their airlines participating in EU ETS) and also led to the formation of a "Coalition of the Unwilling" comprised of over 20 countries that initially refused to comply with EU ETS and considered several potential countermeasures ranging from airspace overflight restrictions to Airbus order cancellations and boycotts.

EU bureaucrats failed to see the signs of such a backlash brewing, and by November 2012 were forced to hastily back down by enacting a temporary 12-month measure to "Stop the Clock" on international emissions until after the ICAO Assembly held in Autumn 2013. "Stop the Clock" reduced aviation emissions for flights commencing or terminating in Europe from a 100 percent compliance target to 40 percent compliance figure overnight. However, EU ETS remained in full force and effect for all intra-European flights, even for operators based outside the EU. Many European airlines, particularly low-cost carriers, saw this measure as penalizing European airlines by increasing their compliance costs relative to those of their international competitors.

The EU's intent had been to give ICAO time to devise a global aviation emissions reduction scheme that was equivalent to EU ETS measures and ready for implementation by 2020. If ICAO failed to devise such a scheme by the Autumn 2013 ICAO Assembly, the EU planned to revert to "full scope" EU ETS as originally enacted prior to the 2012 "Stop the Clock" decision. However, rather than come up with an alternative scheme to EU ETS, ICAO members used the 2013 Assembly to admonish the EU ETS and to give themselves another three years to decide what a global aviation emissions reduction scheme might look like, a process that at that stage had already taken 16 years.⁸ The EU once again was forced to concede, and in April 2014, the European Parliament voted to extend the "Stop the Clock" derogation to the next ICAO Triennial Assembly in Autumn 2016. The EU also enacted amendments to EU ETS to increase compliance thresholds and exclude many small aircraft operator emitters where the cost of enforcement vastly outweighed any potential noncompliance penalty recoveries.

A Patchwork Quilt of Administration and Enforcement

The framework of EU ETS was based on a bureaucratic European scheme designed for stationary installations such as power plants and steel mills. As such, many contend that it was not the best starting place for an aviation emissions scheme. EU ETS is politically complicated and technically cumbersome, only being fully understood in most parts by civil servants and a few accredited verifiers and specialist commodity traders. Unlike Eurocontrol, which is centrally administered and regulated, EU ETS compliance is delegated among the 28 EU member states plus Iceland, Norway and Lichtenstein (collectively, the EEA States). Each EEA State has transcribed the EU ETS Directives into its local laws differently, effectively creating 31 different variations of the emissions trading scheme. Administration under the scheme mostly has been delegated to non-aviation entities such as environmental agencies and even ministries for agriculture, fishing and forestry. Each EEA State has different administration requirements and local laws concerning enforcement. Many international airlines face confusion as to which regulatory authority is assigned to regulate them, with some authorities being far more helpful, organized and pragmatic than others. Non-EU aircraft operators are generally assigned to the regulator in the EU country to where they historically have had the greatest number of scheduled flights.

The three basic common denominators of compliance and enforcement under EU ETS are that: (1) covered operators must report their annual CO₂ emissions by March 31 of the following year, (2) sufficient allowances commensurate with each year's emissions must be surrendered by April 30 of the following year and (3) a statutory penalty of €100 per ton (or the local currency equivalent) is enforced for non compliance. Each EEA State also has the right to enforce local civil penalties for non-compliance in addition to EU ETS statutory penalties. Local penalties, if applicable, vary from state to state. For example, local penalties in the UK are capped at around £63,000, while in Spain each potential offense carries a maximum penalty of €2,000,000, which could have crippling financial implications for a single aircraft operator. As indicated above, there are also different levels of enforcement codified under the various EEA States' domestic laws. For example, under the UK's Greenhouse Gas Emissions Trading Regulations, the Civil Aviation Authority has the right of seizure, detention and sale of aircraft in the event of persistent EU ETS aviation noncompliance, whereas the authorities in most other EEA States do not.

Covered aircraft operators were effectively given a two-year compliance holiday after 2012, but were required to submit 2013 and 2014 emissions reports by March 31, 2015 and surrender sufficient emissions allowances by April 30, 2015. Aircraft operators failing to meet these deadlines are being sent enforcement notices and penalty calculations (based on Eurocontrol flight data) by the relevant regulatory authority. Each EEA State has its own appeal procedures, and in some countries it can take years to determine and adjudicate noncompliance.

EU Governments Begin Cracking the Whip

The UK, Germany, Belgium and the Netherlands proactively have issued penalty notices against European and international aircraft operators since 2014, and are currently pursuing enforcement measures. Civil penalty appeals brought by Jet Airways against the UK regulator, which could be considered a potential test case of EU ETS enforcement against international carriers, were dismissed in March and October 2015. In the latter appeal, Jet Airways unsuccessfully argued that force majeure compelled it to follow the Indian Government's mandate against EU ETS participation. It was found that Jet Airways was not bound under Indian law not to comply with EU ETS, political motivations notwithstanding, and that there was no external force compelling Jet Airways to make intra-EU flights. Jet Airways has since paid the statutory penalty. While all Chinese international airlines now appear to be compliant under EU ETS according to the European Union Transaction Log (EUTL), it remains unclear whether the EEA States have been instructed not to enforce statutory penalties against Chinese carriers in order to encourage compliance. Belgium recently levied a fine of €1,400,000 against Saudia⁹ for noncompliance in 2012 and, while the penalty may have been paid, the airline appears to be absent from the EUTL, thus potentially calling its compliance into question. The UK, Belgium and the Netherlands have published lists of noncompliant operators; however, it is understood that these lists are incomplete in that the names of a number of offenders have yet to be published due to ongoing investigations and appeals. In April 2014, the German authorities ordered 61 operators from Russia, the United States and other countries to pay fines totalling €2,700,000¹⁰ for breaching EU ETS regulations; however, the authorities declined to name the noncompliant operators.

Aircraft lessors and financiers should be concerned if their airline customers do not comply with EU ETS, and could feel compelled to repossess aircraft rather than risk being dragged into EU ETS enforcement proceedings (which could significantly jeopardize lessor and lender rights) and face exposure to fleet-wide liens that could give rise to aircraft detention and sale, much the way Eurocontrol liens may be enforced. While it is possible that EEA States may continue to administer a light touch so as not to antagonize the ICAO process toward a potential global emissions trading scheme, it also is unlikely that the increasingly strident political forces at work within the EU will allow this situation to continue indefinitely. In fact, aircraft operators constitute the only delinquent participants in EU ETS. The European Commission's Director-General for Climate Action has intimated that once diplomatic avenues to bring delinquent flag carriers into compliance are exhausted, then legal proceedings would commence.

To call the proposals being discussed in ICAO a "global" scheme is somewhat misleading, as the scheme will, if implemented, only cover emissions from international flights and not domestic flights. For example, fully 60 percent of all flights departing and arriving in the United States are domestic flights, and therefore would not be covered under the proposed ICAO scheme. The recent proposed endangerment finding by the U.S. Environmental Protection Agency (EPA) concerning aviation emissions has triggered a rulemaking process that ultimately could fill this gap, though it is too early to tell who will be bound by the EPA's final regulations (i.e., only U.S. domestic or also international operators), which aircraft models will be covered, and whether the EPA rules will be promulgated in time to dovetail with the ICAO process or stand on their own as yet another layer of complexity for operators forced to comply with differing standards around the globe.

Many industry insiders believe it is unlikely that a workable global emissions reduction scheme can be devised by the time of the next ICAO Assembly in Autumn 2016. The biggest hurdle is conflict between developed and developing nations over who should bear the greater proportion of compliance cost. It will be quite difficult to resolve the tension between the UN's principle of "Combined but Differentiating Responsibilities and Respective Capabilities" and the Chicago Convention's guiding principle of creating a level playing field regardless of State of domicile. Any proposals to operate a phased-in route-based system may antagonize the United States while potentially benefitting other countries, particularly those in the Middle East and Asia, which are rapidly making significant economic inroads into markets historically governed by bilateral aviation agreements.

The November 2015 Paris climate change convention is likely to pave a critical 2016 path forward for ICAO. There is growing concern within the aviation industry that time is rapidly running out and that ICAO needs to redouble its efforts to find unity and an agreement that will lead to aviation carbon neutrality from 2020 onwards. Meanwhile, the United States and China have both recently set ambitious national greenhouse gas reduction targets that may be difficult to achieve if they are to include international and domestic aviation activities. A question therefore remains whether any aspirational ICAO global emissions reduction scheme will be ambitious enough to contribute to limiting global temperature rises to within 2 degrees Celsius,¹¹ considering the meteoric increase in aviation activities and the current low price of oil.

What Aircraft Lessors and Financiers Should Be Doing Now

Lessors and financiers of aircraft operated by customers covered under EU ETS should be taking a proactive interest in EU ETS monitoring and reporting and ensuring contractual covenant compliance. If no agreement on a global emissions reduction scheme is reached at ICAO's next Assembly in Autumn 2016, then the EU may feel emboldened and legally obligated to reintroduce "full-scope" EU ETS covering all flights within, to and from the EU, regardless of origin, end point, operator domicile or aircraft registry. This could have wide-ranging consequences for aircraft operators and owners, including heightened risks of lease and loan defaults, imposition of significant monetary penalties and (in extreme cases) crippling operating bans and (of even graver concern) threats to possession and ownership. Absent clear and practical EU ETS compliance covenants in lease and loan agreements, aircraft lessors and financiers may find themselves in a difficult recovery position should the EU reintroduce "full-scope" EU ETS, as threatened. Aircraft lessors and financiers therefore should be closely following developments over the next 12 months, as a reversion to "full scope" EU ETS likely will result in further airline defaults. Proactive risk management is therefore advisable.

If you have questions regarding any of the topics discussed in this article, please contact Jordan R. Labkon at +1 (312) 609 7758 or your Vedder Price attorney with whom you have worked. In addition, Barry Moss (+44 20 3713 9515) and Andrew Pozniak (+41 22 548 19 97) of Avocet were contributing authors to this article.

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