John Pearson January 4 2023 Aircraft leasing community and carbon markets: part two Vedder Price PC | Aviation - International John Pearson Aviation Article 6: new dimension and opportunityKey features of Article 6 RulesIntegrating credits into leasesCommentWith sustainability at the centre of discourse within the aviation community in recent years and annual environmental, social and governance (ESG) reporting becoming more widespread for industry participants, market observers are applying increasing levels of scrutiny to detect and call out greenwashing, lack of true ambition and lack of impactful action and investment. This article, the second in a series of two,(1) sets out an approach that participants should consider.Article 6: new dimension and opportunityArticle 6 of the Paris Agreement recognises that some parties may "choose to pursue voluntary cooperation in the implementation of their nationally determined contributions to allow for higher ambition in their mitigation and adaptation actions and to promote sustainable development and environmental integrity". It goes on to set out three principal methods for implementing this "voluntary cooperation". The two methods that are most relevant to this article are:article 6.2 – cooperative approaches between parties or other entities that involve the use of internationally transferred mitigation outcomes (ITMOs). In simple terms, cooperative approaches will generally be bilateral or multilateral agreements between country parties to cooperate on the achievement of mitigation outcomes in the country that hosts the project activity. Effectively, it is one country financing a climate change mitigation project in another country in exchange for ITMOs that the financing country can then apply towards the targets set out in its own NDC. Article 6.2 also allows host countries to transfer ITMOs for use by non-governmental actors, including airlines under the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) (for further details, see "Aircraft leasing community and carbon markets: part one") or companies seeking to support a voluntary claim; andarticle 6.4 – a new mechanism which establishes the framework for the creation, transfer and use of unitised mitigation outcomes referred to as "A6.4ERs". An A6.4ER can be traded on what is effectively a new carbon market through a registry that is currently in its design phase with the supervisory body (a new entity established at United Nations level to oversee the article 6.4 mechanism). An A6.4ER may constitute an ITMO and be authorised for use as part of a cooperative approach under article 6.2.Key features of Article 6 RulesArticle 6.2 market mechanism and ITMOsThe Article 6 Rules set out that an ITMO must be a 2021-onward mitigation outcome that is "real, verified and additional" and may include an emissions reduction or removal (together with its co-benefits) but, until further clarity is provided on avoidance activities,(2) may not be an avoidance of emissions. Once transferred internationally, such a mitigation outcome will constitute an ITMO. A host country (being the country in which the activity that generates the mitigation outcome) has the right to decide whether the mitigation outcomes achieved within its jurisdiction are authorised for use towards:its own NDC or the NDC of another country (that of the buying/investing party); and/orinternational mitigation purposes; and/orfor other purposes.The terms "international mitigation purposes" and "other purposes" were deliberately left undefined to give countries the freedom to determine how they wish to leverage the benefits of the article 6.2 framework. However, most commentators understand that "international mitigation purposes" is intended to refer to schemes such as CORSIA and "other purposes" to, among other potential routes, the voluntary carbon market. Accordingly, a country with resources and/or an ambition to produce green hydrogen or sustainable aviation fuels could authorise these activities for other international mitigation purposes and generate ITMOs that could ultimately qualify for retirement under CORSIA. This could be considered a significant tool for contributing to a just transition in the Global South with the potential to unlock globally "in-demand" industries that will generate significant revenue streams for countries that are catching up on industrialisation, allowing them to reach their economic potential without continuing to extract fossil fuels.ITMOs should, in time, by a coveted carbon asset as compared to other types of credits that have existed in the market to date. There are extensive provisions in the Article 6 Rules that require a host country to make what is referred to as corresponding adjustments to its national emissions ledger on the sale or transfer of an ITMO, irrespective of the "use" for which the host country authorises a particular mitigation outcome. This is integral to the market as it ensures the prevention of double-counting (the scenario where a mitigation outcome is sold and a claim to that outcome is made both by the host country and the buying entity) and is why some analysts forecast that the value of ITMOs (including A6.4Ers) may, in time, prove to be significantly higher than the value of other credit-types.Article 6.4 market mechanism and A6.4ErsThe Article 6 Rules provide that, unlike with article 6.2, the article 6.4 mechanism is to be governed by the supervisory body whose role and function includes to:develop and approve methodologies and standardised baselines;register activities as article 6.4 activities, renew crediting periods and issue A6.4Ers;administer and maintain the registry for the mechanism; andpromote the consideration of human rights, apply robust social and environmental safeguards and develop tools and approaches for sustainable development.It is unclear what methodologies will be approved by the supervisory body,(3) but the expectation is that the supervisory body will consider both methodologies that currently exist within, and have been approved by, the many registries in the voluntary carbon market as well as the Kyoto-Protocol era's Clean Development Mechanism (CDM), as well as new activity types, including removals – which did not feature significantly under the CDM. Accordingly, the range of activities that may qualify is, if not unlimited (the inclusion of avoidance-based credits, for example,(4) remains under consideration), then very broad provided that certain requirements are met – methodologies must:encourage ambition over time;encourage broad participation;be real, transparent, conservative, credible and below business as usual;avoid leakage, where applicable;recognise suppressed demand;align to the long-term temperature goal of the Paris Agreement; andcontribute to reducing emissions in the host country, and align with its NDC and long-term low greenhouse gas (GHG) emission development strategy.Crucially, methodologies must also specify an approach to demonstrating additionality.It is expected that private sector participation in the article 6.4 mechanism will, together with progressive and necessary implementation of the mechanism by host countries, be key to driving and scaling this market.Interaction with voluntary carbon marketIt is not yet entirely clear how the article 6 market mechanisms and the current voluntary carbon market will interact, particularly if the former will subsume the latter or if the two will coexist. Standards such as Verra and Gold Standard intend to label credits on their registries that have been authorised for use under article 6, and the market expectation is that these credits will yield a premium price due to the requirement on host countries to make corresponding adjustments.(5)From a CORSIA perspective, guidance is awaited from the International Civil Aviation Organization on whether credits of 2021 (and subsequent) vintage will require a corresponding adjustment. If this is required, then the availability of CORSIA-eligible credits with a corresponding adjustment label may be limited until such time that the article 6 mechanisms are fully operationalised.Implications for private investment communityThe private investment community is expected to work with governments and project developers to encourage the roll-out and implementation of the article 6 mechanisms with haste. In the best-case scenario, these mechanisms will serve to provide critically needed finance to developing nations in the Global South that enable and unlock the types of nature-based and technological solutions that will, in time, pave the way for global industries to decarbonise their operations.In line with this financing, the aircraft leasing community could pool its resources to finance and advance projects in developing nations that will ultimately yield the solutions that the aviation industry needs to decarbonise. Examples include:projects that produce biochar(6); orthe scaling of production and processing of sustainable aviation fuel feedstocks.The market mechanisms exist. What is missing is resources, engagement, collaboration and application.Integrating credits into leases Lessors are increasingly including monitoring requirements in relation to EU Emissions Trading System and CORSIA in leases, and integrating arrangements relating to lessor-generated offsets will be a natural fit for some, over time. But in the near term, if lessors do enter into more projects to generate their own offsets, care must be taken not to restrict the transferability of a lease to a pool of similar lessors. At least initially, the provision of offsets as a lessor product will likely be offering to sit outside of leases and either terminate upon the assignment or novation of a lease, or continue notwithstanding that the leasing arrangement has passed to a new lessor.With time, and if the position of lessors generating their own offsets becomes more widespread, integration within lease agreements could become a more common lease feature. Financiers will then need to consider if it is appropriate to take security over the offsets generated by lessors, or source their own offsets for use following any enforcement action against a lessor, where the underlying lease remains intact.CommentThe aircraft leasing community has significant capital, both human and financial. It is well established and sophisticated with deep expertise in complex investment and leasing structures, including in developing countries.The industry has, therefore, the great potential to assist with the problem that aircraft present in the green transition – there are major technological constraints for rapid decarbonisation.The community has the opportunity to invest in and help develop the natural and technological resources needed to reach net zero, rather than relying on airlines and governments to lead this investment and development. Doing this while simultaneously solving a compliance problem for its airline customers should be a win-win.It is hoped that the tools and market mechanisms identified in this series of articles provide guidance to the industry on how to participate more effectively in the carbon markets and assist in the transition to net zero.For further information on this topic please contact John Pearson at Vedder Price LLP by telephone (+44 20 3667 2900) or email ([email protected]). The Vedder Price LLP website can be accessed at www.vedderprice.com.Lev Gantly, partner at Philip Lee LLP, assisted in the preparation of this article.Endnotes(1) For the first article in the series, see "Aircraft leasing community and carbon markets: part one".(2) At the 2022 United Nations Climate Change Conference, the Subsidiary Body for Scientific and Technological Advice was tasked with considering whether article 6.4 activities could include avoidance and conservation enhancement activities in its fifth session due to take place in November-December 2023.(3) It is expected that the supervisory body will issue guidance on methodologies for consideration by parties at the 2023 United Nations Climate Change Conference.(4) These include the definition of "removals", guidance on eligible methodologies and eligibility of avoidance-based project activities.(5) Both standards have also taken initial steps to bring their credits into compliance systems under the umbrella of article 6, through their eligibility for CORSIA as well as recognition under the Singaporean carbon tax regime.(6) A charcoal produced from plant matter and stored in the soil as a means of removing carbon dioxide from the atmosphere.