Minimising volatility for the airline industry

Inclusion of the aviation industry in the EU_ETS scheme.

Executive summary

In the current market environment there are many factors causing volatility in the Income Statement – political, economic, financial and industry specific factors that to try to manage some of this volatility or report it in a sensible manner is the objective of many treasurers. The aim of the EU Emissions Trading Scheme (EU-ETS), tarted on 1st January 2005, is to reduce emissions in a cost effective manner allowing companies to trade emission allowances and thereby determine how and where they reduce emissions. Following legislation in 2009 the aviation industry is now included. From 1st January 2012 all airlines flying to and from the European Union are required to match their carbon emissions with carbon credits. Although each airline receives an allowance on an annual basis this is unlikely to match actual emissions incurred and hence the airline will be exposed to this very volatile commodity.

Although aviation only accounts for approximately 2% of the world’s greenhouse gas emissions it has the fastest growth factor across all sectors, primarily as air travel is becoming cheaper and more popular. It is stated that someone flying from London to New York and back generates roughly the same level of emissions as the average person in the EU does by heating their home for a whole year. Hence the scrutiny from the world that is now very focused on making our planet greener.

This publication is the first in a three part series through which we will explore:

Part I – What is the issue?
Part II – The accounting implications and considerations, and
Part III – A case study from an airline ragarding their emissions hedging

The facts

All airline companies flying into or from the EU or in fact through the EU are required to surrender one allowance for every tonne of CO2  emitted. Therefore even non-EU airlines may be affected. Airline operators are required to monitor yearly emissions on a per flight basis. This information must be verified and submitted to the relevant authority by 31 March of the following calendar year. By 30 April the allowances need to be surrendered. The intention is to induce airlines to emit less carbon by upgrading their fleets or becoming more efficient.

This will not affect all airlines equally; in fact some of the smaller airlines operating only short-haul flights may be detrimentally affected as specific emissions are proportionally higher on shorter distances. In addition those flights that have higher occupancy rates in the baseline period (2010) are likely receive a greater number of free allowances so the performance in 2010 was critical in the determination of free allowances. In addition aircraft operators who have invested in more modern fleets may have substantial advantage as these aircraft have been designed to be kinder to the environment. Only those flights made entirely outside of the EU as well as some flights to remote regions, training flights or military flights will either not be covered or be exempt by the scheme.

Options available

If airlines fail to comply with the EU-ETS there are hefty penalties, sometimes in the region of EUR 100 per missing allowance. This penalty fee does not negate the need to still purchase shortfall allowances or sell excess allowances and this will be at the spot price which may be an unfavourable price thus causing volatility in the income statement. In addition an operating ban may be imposed on the aircraft operator.

So companies want to ensure that they are in control of this new regulation as there are operational, legal, tax and accounting implications.

From a risk management perspective this additional cost for emissions allowances introduces another commodity price risk in the airline’s business model. Therefore companies may start to consider entering into forward contracts to hedge forecasted overages of emissions certificates they think they will need to procure that will go above the carbon credits given to them for a particular year or to sell any excess allowances. Entering into this market requires detailed know-how of carbon markets and suitable market models. As illustrated below there has been significant volatility in these markets.

ICE ECX EUA 1st contract each period

ICE ECX EUA 1st contract each period

All data obtained from Reuters.

Companies may choose to enter into physically settled contracts or cash settled contracts. For cash settled contracts, companies would be buying OTC derivatives to customise positions that are benchmarked against exchange prices (similar to other OTC products). Expectations are that most companies would tend towards physically settled derivatives, however there is the option to use cash settled derivatives to hedge their price risk when they buy EUA/EUAA/CER [Refer to Glossary below] on the spot/auction markets in the future.

In respect of the former contracts that are physically settled these will likely meet the own use exemption in International Accounting Standards 39: Financial Instruments: Recognition and Measurement paragraph 5:

<i>This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.</i>

In respect of the latter case where companies enter into cash settled derivatives or where they taint their portfolio of physically settled contracts, the instrument will be required to be held on balance sheet at fair value with fair value movements being posted to profit and loss. As such many companies may look to hedge account in order to reduce the volatility in the income statement.

The three most fundamental challenges corporates will face are maintaining a reliable inventory system of the carbon credits, producing an efficient and effective Monitoring Plan and the collection of reliable market data and tools to be used in the pricing of the derivative instruments and performing of hedge effectiveness calculations (assuming hedge accounting is applied).

Example

The scenario below illustrates the impact of hedge accounting versus not hedge accounting.

Scenario

On 31st March 2011 Airline ABC prepares its plan for 2012 and forecasts they will have a shortfall of 50,000MT of emissions each month from 31 March 2012 until 31 December 2012. As a result of the policy to not be exposed to the variability in the EUA price, airline ABC enters into a commodity swap to pay fixed and receive floating EUA index for each month from March 2012 until December 2012. The company designates this as a cash flow hedge relationship and has chosen to use the hypothetical derivative method for assessing the effectiveness.

Assume that the company was able to obtain a derivative that almost exactly matched the underlying exposure and all the hedging requirements were met, the retrospective assessment indicates that the hedge is almost perfectly effective.

example

The results of the company hedging its emissions exposure is as follows:

example

This indicates that as the company has elected to apply hedge accounting EUR2,244,880 has been posted to equity in the calendar year. Without hedge accounting this entire amount would have been posted to profit and loss causing significant volatility.

Concluding remarks

Some decisions will need to be made by the airlines regarding the hedging policy as well as operational factors should be taken into account to manage the inventory and comply with regulatory, legal and tax requirements. Taking a step back from the detail there are still some hurdles to overcome. There has been intense opposition to this law over the last six months. During a meeting in Moscow on 23 February 2012 governments opposed to this levy agreed a limited package of counter-measures. This is marginally better than what was originally thought would happen where these countries would lodge a case against the EU. The opposition comes to the rules imposed and the fact that for almost 14 years the International Civil Aviation Organisation (ICAO) has been trying to get an agreement but has failed to do so. However some countries have taken stronger action, such as China which has banned its airlines from taking part in the scheme – however this could lead to them being fined or barred from European airspace.

Despite all this opposition there is nothing to indicate that this scheme will be suspended, despite ongoing efforts from all parties to develop a solution appropriate for all parties involved. Therefore it would be worth companies investing in the research required to set up the appropriate desks within the business to manage this from an operational, accounting, legal and tax perspective.

The question for the man on the street is, is this an additional charge to be passed on to the customers? Expectations are that this ruling would add $2-$3 per transatlantic flight so not a huge burden however it adds to everything else passengers are being charged including increased fuel charges, baggage allowances, speedy boarding and seat selection to name but a few.

In the next part to this series we will be discussing the accounting challenges and considerations with Deloitte and the third series will cover the practical application of the hedge accounting for emissions.

Glossary

  EUA EAA CER
Full Name European Union Allowance European Airline Allowance, (also called EUAA and aEUA) Certified Emission Reduction
Description
  • A ‘certificate to pollute’
  • One EUA equals one metric tonne of CO2 equivalent
  • Total number issued per year corresponds to the total cap
  • One EAA equals one metric tonne of CO2e
  • Only for use by the aviation industry
  • Total issued equals the amount of the emissions cap for the aviation sector
  • Also equals one metric tonne of CO2e, but offsets are generated from an emissions reduction project, versus from a compliance obligation
  • Projects are located in Kyoto signatory countries who do not have reduction targets

About the author

Jacqui Drew joined Reval at the end of 2011 as a Solution Consultant and as part of our elite team of Subject Matter Experts. Jacqui specializes in the valuation, hedge accounting and risk management modules of Reval. Prior to this, Jacqui was a Senior Manager at Deloitte where she managed the audit support function in relation to the valuation of derivative financial instruments and the application of hedge accounting. There, Jacqui managed a team of over 80 financial instrument specialists across the UK. She was actively involved in advising clients on valuation and hedge accounting issues, presenting at seminars and conferences and delivering training internally and externally on financial instruments in all asset classes.

Jacqui can be reached at Jacqui.Drew@Reval.com

About Reval

Reval is a global provider of an all-in-one Software-as-a-Service solution for enterprise Treasury and Risk Management. Its award-winning SaaS platform delivers deep and broad visibility into cash, liquidity and risk for finance, treasury and accounting groups, worldwide. With Reval’s integrated, straight-through processing workflow of front-to- back office functions, companies can optimize operational efficiency, security, control and compliance across the enterprise.

Reval’s unique combination of deep domain expertise and comprehensive functionality provides companies with the means to compete confidently in a complex and dynamic market environment. Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific.

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