The start of 2019 has been marked by headlines highlighting the impact that Brexit is having on (amongst many other things) UK airlines. Regional airlines have been particularly affected by the uncertainty created by Brexit and this uncertainty was cited as a key reason for Flybmi’s recent decision to file for administration. One issue highlighted in Flybmi’s demise was the increase in carbon costs arising from the European Commission’s decision to exclude UK airlines from full participation in the EU Emissions Trading Scheme from 1 January 2019.

What is the EU Emissions Trading Scheme?

The EU Emissions Trading Scheme (the “EU ETS”) is a ‘cap and trade scheme’ used to reduce greenhouse gases (GHGs). The scheme aims to create an artificially managed market for carbon to encourage reductions. The system uses allowances as ‘currency’, with one allowance granting the ability to emit one tonne of carbon. Trading is facilitated by a cap on the amount of allowances that are released yearly, both those allocated for free or auctioned by Member State administrators, and those then sold on the secondary market. Emission allowances issued under the EU ETS are held in the Union Registry. The EU ETS encourages a reduction in carbon by allowing operators to sell unused allowances, and requiring those who exceed their free allowance to buy more to cover their carbon emissions. Airlines are also required to monitor, record and verify their emissions.

A moratorium placed on non-EU flight emissions from 2013, which was extended to 2023, means that only flights between airports in the European Economic Area (the “EEA”) are required to monitor and pay under the system. If a flight leaves or arrives from a State outside the EEA, the EU ETS requirements do not apply.

Brexit Concerns

In 2017, following the UK’s decision to leave the EU, the European Commission expressed concern that that UK’s decision could undermine the integrity of the EU emissions trading system in the period prior to and immediately following withdrawal. This was because the deadlines for submitting verified emissions reports and surrendering allowances for 2018 and 2019 were scheduled to fall after the UK’s exit from the EU. The concern was that, with no regulations in place to enforce compliance after the withdrawal, UK participants, knowing they would not be required to surrender the allowances at a later date, would be able trade their full allowances ahead of withdrawal. The European Commission was concerned that this would lead to a potential excess of allowances flooding the carbon market. To address this risk arrangements were put in place which brought the submission date for the 2018 year forward to 15 March 2019. These arrangements did not however address the period from 1 January 2019 to 29 March 2019 (the proposed Brexit withdrawal date).

Changes on 1 January 2019

As an interim measure, and in the context of a lack of progress with the Brexit negotiations, the European Commission announced on 19 December 2018 that, with effect from 1 January 2019, the UK’s access to the Union Registry would be partially suspended. As a result of this suspension the UK has been unable to auction, or issue for free, any allowances, or exchange international credits into allowances for the first quarter of 2019. Although the suspension has meant that airline operators do not need to surrender allowances for the period of suspension it has also meant airline operators have not been able to access 2019 allowances to off-set obligations that accrued in 2018. It is likely that the carbon price spikes referred to by Flybmi was caused by the reduction in allowances available for trading on the market from 1 January 2019 coupled with an increase in demand from those with no allowances. The impact of the price increase would have been further compounded by the fact the fact the airline would not have been able to access the allowances it typically would have expected to receive.

What will happen next will be determined by whether there is an orderly withdrawal from the EU or a ‘No Deal’ Brexit.

An orderly withdrawal

If the current version of the withdrawal agreement with the EU presented by Theresa May (the “Withdrawal Agreement”) is eventually agreed, and ratified, the suspension of the UK’s access to the Union Registry will be lifted and the UK will remain within the EU ETS during the implementation period (set to be until at least December 2020). Allowances will be reallocated across the remainder of the 2019 year and adjustments will be made to reflect the liabilities under the scheme that would have accrued since the start of 2019. The net effect of these adjustments is that airline operators should be in the same position when it comes to settle 2019 obligations as they would have been had the suspension not occurred.

The UK has signalled in the Withdrawal Agreement its intention to implement a system of “at least the same effectiveness and scope” as the EU ETS scheme. The Government has also stated its intention to continue reduction emissions using carbon pricing and the EU have remained open to creating links to compatible systems internationally. This leaves the UK with several potential options identified by the Government: to join the EU ETS scheme itself, create a compatible UK ETS system that reflects the EU’s system, setting up a standalone UK ETS, or reverting to a carbon tax. Whether the Withdrawal Agreement eventually passes, or another agreement is drawn up, the intention of both parties to create a compatible system seems unlikely to change.

In the event of a ‘No Deal’ Brexit the UK would automatically leave the EU ETS and UK operators will no longer be able to access their current Union Registry accounts. Flights within the UK will not be covered by the EU ETS and UK operators will also benefit from the derogation on flights leaving or entering a Non-EEA state.

UK operators who wish to access their Union Registry accounts, to continue trading allowances will have to open an account in another Member State’s registry and UK operators who are permitted to continue to fly intra-EU flights covered by the EU ETS will be allocated new administrators, in a list already published by the European Commission.

In a ‘No Deal’ Brexit scenario the Government intends to implement a Carbon Emissions Tax. This new system is expected to include, as under the EU ETS, a continued requirement to monitor, report and verify.

Impact of Continued Suspension of Allowances

It is unclear how the suspension on UK auctioning and allowances will be dealt with during any Article 50 extension period. If the Withdrawal Agreement is not approved next week and Brexit is only delayed until 12 April it is unlikely that the position will change i.e. our expectation is that the suspension will remain in place. If however the withdrawal agreement is approved and Brexit is delayed until 22 May, it is conceivable that the suspension will be lifted as there will be a road map for the UK’s continued participation in the EU ETS over the short term.

Consequences of a failure to meet EU ETS obligations

The UK currently implements a regime of civil penalties for failing to provide enough allowances or failing to pay money owed, including fines. Beyond this, UK operators currently also face the risk of an operating ban and/or aircraft being detained and sold if their EU ETS obligations are not discharged. This risk of detention and/or a forced sale is of particular relevance to aircraft lessors who lease aircraft which are operated on intra-EU flights. During this time of disrupted access to allowances it is more important than ever that lessors use the monitoring tools available to them to check that 2018 EU ETS liabilities of UK airlines were cleared on 15 March 2019.

In the event of a ‘No Deal’ Brexit enforcement remedies will be provided in accompanying regulations to the Carbon Emissions Tax. It is likely that the enforcement mechanisms currently used (including the ability to detain and sell aircraft) will continue in any system that aims to be similar in “effectiveness and scope”