EU carbon levy: try to avoid air turbulences

On March 12 the CEOs of Airbus and of eight other European aviation and airline companies urged the leaders of France, Germany, Spain and the UK to solve a dispute with the US, China, India, Russia and 23 other countries over the inclusion of foreign airlines in the European Emission Trading Scheme (ETS) that was extended to the air industry on January 1, 2012. The European CEOs warned that the dispute could lead to foreign retaliation in the form of suspensions or cancellations of orders for European aircrafts that would cost jobs to Europe. The fear of a trade war between the EU and its foreign partners had already been aired the week before by the head of the International Air Transport Association (IATA) who called on the EU to defer the application of its scheme until 2013, when a global approach to airline emissions could be adopted by the next general assembly of the International Civil Aviation Organization (ICAO), an intergovernmental body that decides on aviation rules.

So far the EU has rejected the accusation that its unilateral action on airline emission will result in a trade war. The EU argues instead that its action is necessary to reach a global agreement at the ICAO, which it pursued in vein before and to which it remains fully committed as the first-best solution to a global problem. This position is backed by a group of 26 US economists, including five Nobel Prize winners, who wrote to President Obama on March 14, asking him to support the EU's efforts to set a price for carbon emission by the aviation sector.

The matter has been brewing for some time. In November 2008 the European Parliament and the European Council adopted a directive extending ETS to aviation. The European legislation mandates that all emissions incurred by flights that depart from or arrive in Europe be subject to the European Emission Trading System as of January 2012. According to the new rule, airline companies have to surrender one EU Emission Allowance for each ton of CO₂ their planes emit not only inside Europe but also on the way to or from Europe. For this purpose, 209 million additional Emission Allowances will be issued each year between 2012 and 2020 (which increases the size of the total ETS allowances by about 10%). Initially 85% of these allowances (currently priced at about €7 each) will be handed out to the aviation companies at no cost.

There have been two major sources of criticisms to the EU approach. On the one hand, many argue that unilateral action is ill-suited to solve a fundamentally global problem. Several arguments are put forward. First, it is alleged that unilateral action by the EU contrasts with its obligation of “shared but differentiated responsibility”, which has been accepted by all countries in global climate negotiations. This obligation dictates that developed countries should do more than emerging and developing countries to reduce emissions because they are responsible for the largest share of the stock of CO2 emissions. The EU legislation, indeed, treats developed and developing countries alike. Second, it is argued that the EU rules apply to flights that may be largely outside Europe, which might be considered as an infringement of international law. Third, there is criticism that the EU is seeking to collect revenue from activities outside Europe for its own financial benefit. And fourthly, it is alleged that the inclusion of international aviation in the ETS is only but the first step towards carbon border tax adjustments, which would be introduced on EU imports of goods produced outside the EU with more carbon-intensive technologies than those used in the EU due to different carbon emission legislation. Those criticisms come mainly from foreign governments or from trade economists and practitioners who fear that unilateral EU action is detrimental to international cooperation.  

The other source of criticism is the aviation industry which argues that the introduction of ETS is costing them money and is creating distortions.  The inclusion of aviation in the ETS has indeed a number of distorting effects. First, it favors high cost airlines over low frills carriers as customers are much less price-sensitive in the former than in the latter. Second, the free allocation of allowances to companies risks freezing market shares in favor of incumbent airlines since allowances are allocated on the basis of past activities. An airline wanting to grow in Europe therefore has to buy more allowances – thus facing higher costs – than incumbent operators. Third, the unilateral European legislation might encourage stop-overs just outside EU borders. For instance flying to Beijing via Dubai might become cheaper than flying to Beijing directly, as in the first case only the emissions incurred on the way to Dubai are taken into account. And fourthly, the airline industry might see a risk for its extraordinary privilege since currently it pays no taxes on kerosene for international flights. A global consensus on emission trading might pave the way for the global introduction of a kerosene tax, which could turn out to be a much larger financial blow to the airline industry than a relatively small carbon price.

In short, there is ample reason for opposition to the EU action from both foreign countries as well as from the airline industry. However, there is also good news for those who feel that EU action is necessary as a way to ensure that the aviation sector is properly taxed for its carbon emission. The first is that a tax on kerosene might be seen as beneficial for all energy importing countries. Even countries like China or the US might eventually be interested in collecting a tax that shifts some of the wealth from energy exporters to energy importers. The second is that the EU has ample time left to find a compromise. While aviation has been included in the ETS as of January 2012, companies will only have to surrender allowances starting in April 2013. The third piece of good news is that there is flexibility in the negotiation position of the EU. Important issues have not yet been decided. Most importantly, the EU has not yet specified what it will do with the revenue from the auctioning of the allowances and which type of carbon emission abatement scheme by non-EU countries it would accept in order to exclude their airlines from the ETS.

The best outcome would be if the EU unilateral action lifted the deadlock that has prevailed so far at the ICAO and enabled its general assembly to reach a global agreement at its next general assembly in 2013. Getting there might be a bit bumpy but seems doable. As a strong defender of the multilateral system the EU should use unilateral action with care.  It should offer to share some of the revenue generated from selling aviation allowances with developing countries to help them reduce their carbon emissions. It should also resist further retaliating measures if large emerging countries choose to retaliate against EU action in the aviation sector in order to demonstrate that they have sufficient muscle to stand against future EU (or US) unilateral carbon border adjustment taxes being levied on their exports.