Under the European Climate Law[1], European Union (EU) Member States are working collectively to reach net zero – cutting greenhouse gas emissions as close to zero as possible – by 2050. As a first milestone, the EU is aiming to reduce net emissions by at least 55% by 2030, when compared to a 1990 baseline. The shipping industry is crucial to global trade, but it also contributes significantly to greenhouse gas emissions. To achieve the necessary emission reductions, the scope of the EU Emissions Trading System (ETS) has been expanded to include maritime transport emissions, effective January 1, 2024, with a two-year phase-in period.

Background and Goal Setting

Launched in 2005[2], the EU ETS is the world’s first international emissions trading system and currently stands as a major pillar of EU energy policy. The EU ETS applies in all 27 EU Member States and the European Free Trade Association countries (Iceland, Liechtenstein and Norway). In general, the EU ETS makes polluters pay for their greenhouse gas emissions, encouraging emitters to reduce their emissions and generating revenue to help finance the EU’s transition to net zero.

Cap and Trade

The EU ETS works on the ‘cap and trade’ principle; the system aims to incentivize emission reduction efforts by penalizing companies that exceed their allocated allowances and rewarding those that emit below their limits. A cap is set on the total amount of greenhouse gases that can be emitted by the installations, aircraft operators and ships covered by the system. The cap is expressed in emission allowances, where one allowance gives the right to emit one tonne of carbon dioxide equivalent. The cap is reduced annually in line with the EU’s climate target, ensuring that total emissions decrease over time.

Annually, companies must surrender sufficient allowances to fully account for their emissions in the preceding year, by reducing emissions to below their allocated allowances or purchasing allowances, otherwise heavy fines are imposed. Within the cap, a Shipping Company[3] can buy allowances in the primary market through auctions on the European Energy Exchange (EEX). There is also a secondary market in which allowances can be sold bilaterally or through various derivatives provided by financial institutions and on exchanges such as ICE, EEX and Nasdaq and on the over-the-counter market. If an installation or operator reduces its emissions, it can then choose to either keep the spare allowances to use in the future or sell them, noting that any allowances issued after 2013 do not expire.

Scope

Starting from January 1, 2024, the EU ETS will apply to vessels engaged in the commercial transportation of cargo or passengers above 5,000 gross tonnage. In 2027, offshore vessels above 5,000 gross tonnage will also come under its scope and there will be an evaluation on whether to include offshore vessels of 400 to 5000 gross tonnage in 2027.

The EU ETS covers emissions that can be measured, reported and verified with a high level of accuracy: carbon dioxide (CO2), nitrous oxide (N2O) and perfluorocarbons. As it relates to the shipping industry, CO2 will be covered in the initial 2024 reporting period, with both methane and N2O being covered beginning in the 2026 reporting period.

100% of emissions from ships performing voyages between EU ports as well as 100% of emissions from ships within an EU port (i.e., docked) will fall within the scope of the EU ETS. In addition, 50% of the emissions from ships performing voyages between an EU port and a non-EU port will fall within the scope of the EU ETS. In each case, this is regardless of the proportion of the voyage that occurs outside of the EU or the EEA’s territorial waters.

Following the 2025 reporting period, representing emissions from 2024, allowances equivalent to 40% of the emissions falling under the EU ETS must be surrendered. Following the 2026 reporting period (being 2025’s emissions) this increases to 70%, with this increasing to 100% the following year.

Under the EU ETS, the owner of a vessel is always responsible for compliance with the EU ETS mandate for that vessel. Each owner will be associated with the administering authority of an EU Member State.

For ships registered in the EU, the administering authority will be that EU Member State. For ships not registered in the EU, the EU Member State with the greatest estimated number of port calls from voyages performed by that ship in the last four monitoring years will serve as the administering authority. If a ship is not registered in an EU Member State and did not carry out any voyage falling within the preceding four monitoring years, the administering authority will be the EU Member State where that ship first arrives or starts its first voyage.

A shipowner is allowed to delegate this responsibility to a third party and the parties are expected to agree upon reimbursement arrangements for the costs arising from surrendering of allowances. If a shipowner does elect to delegate this responsibility, it must deliver documentary evidence of that delegation to the applicable administering authority.

Requirements and Associated Sanctions for Failure to Comply

The EU has determined that the monitoring and reporting of greenhouse gas emissions must be robust, transparent, consistent and accurate for the EU ETS to operate effectively. The annual procedure of monitoring, reporting and verification (MRV) and all of the associated processes is known as the “ETS compliance cycle.”

During the ETS compliance cycle, each Shipping Company covered by the EU ETS is required to have an approved monitoring plan for monitoring and reporting annual emissions. Further, on an annual basis, operators must submit an emissions report for each ship under their responsibility and an emissions report must be submitted at the company level as well. The data for a given year must be verified by an accredited verifier by March 31 of the following year. Once verified, owners must surrender the equivalent number of allowances by September 30 of that year. Accordingly, the first ETS allowances for shipping will be surrendered by September 30, 2025 for emissions reported for 2024.

All operators in the EU ETS must surrender annually the number of allowances corresponding to their emissions in the preceding year. For each tonne of emissions for which no allowance is surrendered in due time, there is a penalty of EUR 100 (adjusted in accordance with the European consumer price index). This penalty is in addition to the cost of surrendering the allowances due. Names of the penalized operators are also disclosed to the public. The severity of sanctions continues to escalate until, in a worst-case scenario, ships may be denied permission to trade, or may even be expelled, from the EU[4].

Considerations and Anticipated Challenges

The integration of the shipping industry into the EU ETS represents a significant milestone in the pursuit of a sustainable maritime sector: close collaboration with authorities, port operators and stakeholders necessary to comply with the EU ETS may lead to the development of more efficient vessels, the use of renewable energy sources and the adoption of other emission reduction strategies that benefit the entire industry.

For example, Shipping Companies may want to optimize vessel routes, reduce idle times and adopt slow steaming practices to align with emission reduction targets. These actions will require careful planning and coordination to maintain the efficiency and effectiveness of supply chain logistics. Shipping Companies which have already started adopting practices to aid the reduction of emissions will need to consider how the EU ETS requirement interacts with their existing frameworks. For example, emissions resulting from the combustion of sustainable biomass compliant with the sustainability criteria established by the Renewable Energy Directive[5] have an emission factor of zero under the ETS. However, if a company already offsets their emission through a different scheme, they will still have to report under the EU ETS Directive[6].

To stay within their allotted allowances, substantial capital investments will also likely be necessary for the eventual adoption of emission-reducing technologies and sustainable fuel alternatives.

As a marketplace being driven by supply and demand, there will be some unpredictability regarding the underlying price of the allowances, which Shipping Companies will have to absorb during the first stages of adoption by accounting for likely additional expenses, while they build familiarity with the compliance requirements and the market dynamics. Large shipping and logistics companies have already announced plans to pass the costs of the EU ETS as a surcharge applied to all bookings and incentivize customers to book on “eco” deliveries which use less-polluting fuels. Upcoming regulations like FuelEU Maritime[7] aimed at increasing the demand for and consistent use of renewable and low-carbon fuels and reducing the greenhouse gas emissions from the shipping sector, will focus specifically on the shift to low-carbon or renewable fuels, expected to take effect after 2025.

For the purposes of the legislation, and in line with MRV requirements, the Shipping Company will be the holder of the Document of Compliance (DOC). Shipping Companies will also need to work with their technical teams and management companies when considering the identity of the DOC holder to make sure that this does not present any logistical issues. For example, DOC holders are often management companies which may not be equipped for dealing with the business of buying and surrendering allowances for multiple owners during the same reporting period.

Given the multi-layered approach to vessel operation and the numerous parties involved, it is anticipated that the EU ETS cost arrangements will be addressed and documented by EU ETS specific contractual clauses which will need to be included in relevant documents such as sale and purchase agreements, charterparties and contracts of affreightment. Emissions will also play a more significant role when negotiating chartering arrangements as parties will need to agree upon an allocation of responsibility scheme for bearing the costs of compliance with the EU ETS. Baltic and International Maritime Council (BIMCO) has already produced an ‘ETS - Emissions Trading Scheme Allowances Clause for Time Charterparties’ which we anticipate will form the basis of negotiations between owners and charterers.

Next Steps

While the EU ETS for shipping begins on January 1, 2024, there are still many issues that are under consultation that will need to be monitored, such as:

• necessary rules, templates and methods to ensure the good functioning of the system;
• sector-specific rules and templates (for monitoring plans, emissions reports and reports at company level) in relevant implementing and delegated acts which are yet to be adopted by the end of 2023, to ensure uniform implementation of the EU ETS and MRV rules;
• adoption by the EEA countries, which is yet to be confirmed;
• contractual clauses to address reimbursement for costs arising from surrendering of allowances by charterers; and
• an attribution list concerning administering authorities.

As the new regime is implemented, stay tuned for updates from the Vedder Price team.