Ship charterers face higher freight costs with ETS changes, but some could win out

Companies hiring ships to transport commodities are likely to face higher logistics costs with the EU's proposed inclusion of shipping in the Emissions Trading System (ETS). But the well prepared will benefit from the new regulatory regime once it is implemented in the coming years.

Later in 2022, the European Parliament, the Council of the EU, and the European Commission (EC) are due to hold tripartite negotiations to finalize how and when exactly maritime transportation will be pulled into the world's largest carbon market by liquidity.

While the proposed regulations put the onus to surrender emission allowances, or EUAs, on the "shipping companies" that take over the duties under the International Management Code for the Safe Operation of Ships and for Pollution Prevention, also known as the ISM Code, many industry participants expect the EU to make those registered in its Monitoring, Reporting and Verification (MRV) system responsible for this task in practice.

This is mainly due to practicalities—Brussels can spend less resources enforcing the new emission rules in an efficient way by targeting the companies already liable for the existing MRV regulations. And those assuming responsibilities under the ISM Code are often the ones that report in the MRV registry.

However, the situation is much more nuanced when it comes to who will carry the financial burden. The EU has been explicitly clear that it wants "polluters" to pay for emissions, and its current definition of "shipping companies" could cover shipowners, charterers, technical or even commercial managers.

"The [proposed] law, as it currently stands, does not restrict one party or the other from assuming ETS responsibilities," law firm Watson Farley & Williams Senior Associate Valentina Keys told Net-Zero Business Daily by S&P Global Commodity Insights. "This aspect has been purposefully created to be elastic."

"It is therefore left entirely up to the commercial parties to negotiate the most workable, fair, and practical way forward which would, ideally, allow for a joined-up approach with shared costs and shared responsibility," said Keys. "From speaking with various cargo owners … it is widely accepted by cargo owners that they will have to pay more for cargo shipments."

Antonello Zanfardino, a senior carbon analyst at French shipbroker BRS, said the entities that pay for the allowances may shift over time based on market forces, regardless of the regulatory design.

"It doesn't really matter which party has to buy the EUAs and which one has to surrender them, because the EUA is a transferable digital certificate. It's pretty easy to move from the charterer's account to the owner's account," Zanfardino said.

Evolving charter terms

There is growing consensus among market participants that charterers under time and bareboat charter contracts will be responsible for EUA costs, as they are in charge of procuring marine fuels—the main determinant of ship emissions.

"The one who will be paying for carbon units will be the same party who pays for the bunker fuel. To know exactly how many EUAs you need, you will need to know exactly how much fuel you burn, and which type of fuel you burn," Zanfardino said.

Alibra Shipping Director Giuseppe Rosano said the emissions allowance will become an element of cost for the charterers. "This will just be part of their accounting," he said.

Moreover, the charterers control trading routes and sailing speeds in those contracts. This means they—rather than the owners—will have the opportunity to minimize their CO2 emissions and fuel consumption by optimizing their voyages.

Rachel Hoyland and Beth Bradley, lawyers at Hill Dickinson, said cargo interests may prefer time charters if they "have the inclination and means" to be closely involved in voyage execution. "Where cargo interests lean towards being relatively 'hands off' … we anticipate that the EU ETS rules, and the issues arising, may be a further factor driving a preference for voyage charters," they said in an email.

Voyage charters are generally inclusive of bunker costs, and here two schools of thought have emerged over how to allocate the expenses on EUAs.

Commodity trading company Trafigura believes the EUA cost could be integrated into existing contract terms with an additional clause, as has been the case with the Additional War Risk Premium. "The cost will ultimately be paid by charterers, and this will push charterers to fix better consuming ships with owners who can focus on technical and operational measures aimed at optimizing consumption," the trading house said in an email.

Others reckon shipowners will take EUA prices into consideration when offering voyage charters—but charterers with existing positions in the European carbon market could have greater bargaining power.

Hugo Wilson from the carbon desk of brokerage Affinity (Shipping) said that charterers will need to consider the costs of freight, bunker, and emissions simultaneously. "They can definitely be more competitive if they've fixed a lower internal cost of carbon," Wilson said.

Platts, part of S&P Global, regularly publishes rate assessments for voyage charters in the dry and wet bulk markets.

The carbon advantages

Market participants expect European trading giants and oil majors to gain an advantage in the new regulatory regime as many of them have been trading in the emissions market for years and accumulated some EUAs.

With many small owners not familiar with trading rules, large charterers could offer to help pay for EUAs and receive lower rates in return, Alibra's Rosano said, adding: "If they have a surplus, they will earn more money."

Moreover, EUA prices are likely to increase in the long run because the EU plans to tighten emissions regulations, hoping to cut GHG emissions by 55% from 1990 levels by 2030. The EC has planned a 4.2% linear decrease in the number of EUAs auctioned annually as the ETS' coverage expands.

This means cargo interests long on EUAs currently could reap financial gains from future shipping deals that involve stops at European ports—if they know how to structure their deals in a smart way.

"European carbon is an incredibly liquid market, so you would never settle for less than the market price if you've got carbon on your books," Wilson said. "[Major] charterers are definitely in a position where they are more ahead of the game than the owners."

When the shipping market is tight, cargo interests that have locked in part of their margins with EUAs on hand can even afford to pay a bit extra to get the ships they want.

"If you have enough EUAs, you may be more competitive … you could be able to take ships that other charterers cannot afford to pay [for]," BRS' Zanfardino said.

Things could be trickier for smaller companies with less financial resources, or non-European businesses that have no other EUA requirement in their daily operations. Their business models often won't allow them to match what European majors have done.

"Unless you are buying 2 million-3 million EUAs per year, it doesn't financially make sense to set up a full carbon desk," Zanfardino said.

Partly because of this, a growing number of shipbrokers—including Clarksons, BRS, Affinity, and Simpson Spence Young—have set up carbon desks targeting the fledgling segment.

"Instead of internalizing [the work], which can be a huge cost for a company, especially a smaller one, my suggestion would be to work with the one or several trusted partners with a good track record that charge you a reasonable fee," Zanfardino said.

Future scenarios

Regardless of how the EUA costs are distributed, the overall freight costs for Europe-related trades are expected to rise as long as heavy fuel oil remains the typical marine fuel.

When the allowances traded above $100 in February, Norway-based analytics firm Siglar Carbon estimated the proposed ETS rules would lead to a 17% increase in Medium Range tanker rates, and 19% on the intermediate rate for the Riga-Amsterdam route, 10% on the MR rate for the Antwerp-New York route, and 15% on the VLCC rate for the US Gulf-UK Continent route.

Cargo interests could theoretically avoid trading in Europe to escape the ETS whenever possible. They could also add an extra port call outside of Europe to their voyages, or use a transshipment center, for lower compliance costs.

But there are expectations that such evasion will be limited as the shipping industry has shown more willingness to join the fight against climate change lately.

"Parties responsible for compliance might seek to impose new limitations on the trading of the vessel, such as limiting calls in the EU or changing the rotation of calls," Hoyland and Bradley wrote.

"However, rather than seeking to evade the application of the EU ETS, we expect that the majority of cost control provisions are likely to be aimed at reducing emissions," they said.

In the most optimistic scenario, the EU will become the breeding ground for low-, or even zero-emission vessels with the regulatory change—and that is exactly what Brussels aims to achieve.

Posted 02 June 2022 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.