A. Introduction

On 20^th December 2006, the Commission adopted a proposal for legislation to include aviation in the EU Emissions Trading Scheme (ETS). This proposal is now subject to co-decision by the European Parliament and the Council.

However, on 23^rd January 2008, the European Commission also released a proposal to amend the existing EU ETS Directive itself, as part of the “Climate Action and Renewable Energy Package”.

This means that today the aviation sector faces a dual legislative track to reduce its contribution to climate change.

The 38 airline members of the International Air Carrier Association (IACA) have repeatedly stated that the inclusion of the aviation sector in the EU ETS could be the most cost-effective instrument for reduction in aircraft emissions if it is well designed, affordable and includes the following parameters:

• It covers only CO2 emissions and does not include a multiplier
• It is non-discriminatory
• It allows growth for the aviation sector
• It is based an open trading system linked to existing ETS market
• It is manageable for all airlines in the scheme.

B. IACA rejects full auctioning

The amendment of the existing EU ETS Directive recently proposed by the European Commission fails to fulfil the above conditions, in particular the changes that relate to the auctioning level.

IACA members are extremely concerned by the prospect of a 100% auctioning level by 2020.IACA estimates that under such design the aviation sector will have to foot a yearly bill which will reach €11 billion euro in the year 2020^[1].

IACA believes that is it time for the regulators to assess seriously the ability of airlines to pass this huge additional cost through to their customers.

Cost pass-through rate in the airline sector

The ability of airlines to transfer these cost to their passengers through an increase of ticket price is the key consideration as it determines to what extent the cost of buying allowances will impact the airlines profitability.

The European Commission?s impact assessment[2] accompany the proposal to include aviation in the EU-ETS stated, without any demonstration, that airlines would be able to pass these costs of allowances in full to their customers.

This assumption does not stand up when confronted with the reality of the air transport market:

1.There is no perfect competition in the airline sector

Perfect competition is the prerequisite for a full cost pass-through.In the airline sector, despite the liberalisation, the competition situation is a mix of oligopoly, duopoly and sometimes monopoly situations.

2.30% of EU airports are congested

At congested airports, where the supply is limited due to an unavailability of slots, airlines are unable to raise their fares.In the case of a cost increase, the number of passengers and the price will, therefore, remain unchanged. This means that the profit will be reduced.

According to a study conducted by Mott MacDonald[3] for the European Commission,up to 50% of EU airports will be congested by 2025.

3.Fixed costs are not passed-through

According to economic theory, part of the cost of a flight resulting from buying a CO₂ allowance cannot be considered as a variable cost but should be seen as an increase in the fixed costs.Therefore, it cannot be passed-through to customers.

In conclusion, the genuine ability of airlines to pass through the costs of allowances will vary according to their business model, exposure to competition and their position in the market.The Ernst & Young study[4] estimates that only one-third of the costs will be passed-through to the airlines passengers.

Impact on airlines profitability

If airlines are able to pass-though one third of the costs of allowances, it means that they have to absorb two-third of those costs

The airlines' profitability will be impacted by a dual effect:

• for the portion of the costs transferred to the passengers, airlines will face a reduction in demand and, therefore, a loss of revenues due to the price sensitivity of their passengers. This is particularly true for IACA airlines operating in the leisure market.
• the profit margin will be reduced through the absorption of two-thirds of the allowances costs.
• The consequences for a low margin industry would be at best the inability to invest in fleet renewal and in the worse cases, bankruptcies.

The cost of the scheme in 2020 with 100% auctioning, estimated at €11 billion, must be put in perspective with the level of the total profit of the airline sector in 2007 estimated at $5 billion (€3.2 billion)[5].

IACA urges the regulators not to underestimate the consequences on the European economy and more specifically on regional connectivity and development that such a radical restructuring of the airline sector would entail.

No auctioning does not mean a 'free ride'!

IACA wishes to underline that even a limited percentage of auctioning for aviation will come at significant cost, as the sector will still have to buy its entire growth beyond the capped baseline.

For example, in the year 2020 a zero auctioning rate would still mean that 222 million tons of CO₂ which is more than half of aviation emissions, needs to be purchased from the other ETS sectors. The cost of covering the sector?s growth will then amount to €6.6 billion (at an optimistic rate of €30 per allowance).