- European airlines will feel the pinch of carbon price regulations more acutely than their international rivals over the next few years, but the region's stronger carriers should be able to pass much of the cost to travellers.
- The aviation sector's decarbonization ambition relies heavily on replacing fossil fuels with sustainable aviation fuels (SAF), which come with significant related costs.
- Stricter environmental regulations could pressure the credit quality of weaker European airlines, which may find it more challenging to employ strategies that reduce carbon-related costs.
Regulatory costs directly linked to carbon emissions are increasing on many domestic and international flights, adding expenses designed to incentivise efforts to limit global warming. Yet not all carriers are equally impacted. Europe's regulations are both stricter and more expensive than elsewhere, meaning that airlines ferrying travelers within the region pay more for burning fossil fuels than those operating beyond its borders.
The additional costs underpin the EU's strategy to speed the adoption of technology and operational initiatives that reduce emissions and use pricing to encourage consumers toward lower-carbon alternatives. That mirrors the region's playbook in other sectors, and particularly those with hard-to-abate emissions.
S&P Global Ratings expects this approach will weigh on European airline's operating costs, and could put pressure on some carrier's credit quality, particularly if they are unable to pass escalating costs onto customers. Weaker airlines (particularly those with already above average operating costs, and ageing, or less fuel-efficient fleets) may find it more difficult to employ strategies that reduce carbon-related costs.
Flying's Carbon Footprint
Aviation accounts for about 2.5% of global CO2 emissions and 3.8% of emissions in the EU, according to the European Environmental Agency. The contribution is small compared to some sectors, including power (40%) and industry (16%) (see chart 1). But airline emissions tend to attract criticism because they are often viewed as discretionary and exclusive--about 80% of all flights are taken by 20% of the global population, while the top 2% of travellers account for 40% of all flights, according to the International Council On Clean Transportation (ICCT). Sector emissions are forecast to increase. The ICCT predicts that commercial flights' carbon emissions could triple by 2050, though it also suggests they could be as much as 85% below that forecast due to technological advances and demand management.
The International Air Transport Association (IATA), an airline trade body, forecasts average growth in air passenger volumes of above 3% per year out to 2040, supported by the long-term trend toward rising wealth, particularly in Asia.
We think decarbonisation is challenging for airlines, even without traffic growth. Planes currently have no cost-effective alternative to fossil fuels. And investment in low-carbon and no-carbon power sources, and CO2-reducing technology, is costly and thus risky, especially given the long investment lead-times. Manufacturers none-the-less continue to make improvements in aircraft design, with each new generation of planes typically delivering a 15%-20% reduction in fuel usage. Aircraft now entering service will, however, remain operational for at least two decades. That means new aircraft technologies implemented within the next ten years will play a key role in delivering net zero carbon emissions by 2050.
The motivation for reducing fuel usage has long been related to cost savings. Fuel is an airline's biggest expense, along with employees, so reducing consumption has been a key earnings driver. As fleets expand and older planes are replaced, we expect fuel efficiency gains across the industry to continue at a minimum of 1.5% per annum (as measured by per seat mile, or available seat kilometres--the main measures of an airline's capacity).
Carbon Regulations Can Incentivize Innovation
Carbon regulation costs vary significantly depending on geography and jurisdiction. The greatest costs are faced by operations within the European Economic Area (which includes EU member states plus Iceland, Liechtenstein, and Norway), the U.K., and Switzerland. The decarbonization target for much of that group is set out in the European Green Deal, which seeks a 90% reduction in emissions by transport (air, road, and maritime) by 2050, compared to 1990. And the main policy tool to achieve that is the EU's Emissions Trading System (EU ETS).
Beyond those borders, carbon-related costs range between negligible and none. That lighter touch also applies to international flights to countries beyond the EEA, U.K., or Switzerland.
Airline Emissions Regulatory Regimes
The world's two most consequential carbon regulations are the U.N.-sponsored International Civil Aviation Organization's (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation, known as CORSIA, and the EU's Emissions Trading System, or EU ETS.
- The market-based mechanism covers international routes (which represent about 60% of airlines' total CO2 emissions), but excludes domestic journeys. Its pilot phase began in 2021 and will run to the end of 2023.
- An emissions baseline, set at the level of 2019, is being used during the pilot phase. That baseline will then fall to 85% of 2019 emissions.
- Offset obligations are triggered when emissions on international routes between participating countries exceed the baseline. At that point an airline's individual emissions are used to calculate their obligation over the base level.
- Offsets can be met by purchasing qualifying carbon credits from designated environmental projects or by using CORSIA qualifying SAF. Offsets are currently the much cheaper option, but some commentators have criticised variations in the quality of projects, and their ability to reduce absolute CO2 levels.
- We think CORSIA's targets fall short of what is necessary for air travel to reach net zero emissions by 2050.
- A market-based mechanism launched in 2005 to restrict emissions growth in the power- and heavy-industrial sectors. It was expanded to airlines in 2012 and includes Scope 1 emissions from flights within the European Economic Area and from the EU's outermost regions, such as the islands of France, Spain, and Portugal.
- Carriers receive tradeable emissions allowances, with the total amount set annually by the European Commission and reducing (currently by 2.2%) each year.
- Allowances must be purchased for emissions that exceed a company's allotment, while permitted emissions not used can be rolled forward to cover future obligations or sold via a process known as carbon trading. The scheme also offers credits for the use of SAF.
- The geographic scope is limited to intra-EEA flights (and covered by similar schemes in the U.K. and Switzerland). We understand the scheme's scope is subject to further review in 2026, with any widening in scope at least partly dependent on the perceived success of CORSIA. We assume that the two schemes won't overlap, although we note that the future interplay between them is uncertain.
Plotting The Course To Net Zero
The upshot of Europe's more onerous carbon emission regulation is that pressure is on the region's airlines to reduce their net carbon output. We expect carbon offsets will initially be their primary tool, eventually ceding that position to SAF (see chart 2).
There will be no single solution capable of delivering net zero emissions by 2050--a goal shared by various airlines and related trade groups, but not mandated by any regulation. That will require a combination of factors over the coming decades, not the least of which will be break-through technologies, with sustainable fuels currently assumed to be the primary contributor to net zero by 2050. Of course, since these technologies (and their supply chains) require further development, the nature and impact of those innovations are difficult to quantify currently.
European Regulators Will Maintain Pressure On Emissions
The EU's decarbonization roadmap, "Fit for 55", aims to reduce carbon emissions by 2030 to a maximum of 55% of 1990 levels. For European airlines, that is likely to mean the end of free carbon allowances by 2026 (in a phased approach starting in 2024), coupled with minimum SAF requirements for all planes departing European airports. The EU's proposed ReFuelEU Aviation Regulation suggests SAF should account for 6% of aviation fuel by 2030. It could also usher in the end of aviation kerosene's European tax exemption (with exemptions for SAF).
"Fit for 55" could also dictate that airlines operating in the EU must source at least 90% of their aviation fuel from EU airports. This seems designed to stop airlines skirting the initiative by refuelling at airports not covered by the regulation. We also note that the UK is set to introduce its own minimum SAF usage rules (set at 10% of jet fuel by 2030).
It is important to acknowledge the uncertainty surrounding future regulation and thus costs. Reform of the EU ETS is being negotiated among the EU Parliament, the European Council, and the European Commission, which could result in changes to the current proposals. Nevertheless, our base-case forecast assumes that airlines' free carbon allowances will be phased out, resulting in a significant hike in (currently modest) carbon costs for most European airlines in the next three to four years.
Carbon offset prices also remain uncertain, but are likely to rise, along with regulatory pressures. That is reflected in the price of EU ETS carbon allowances, which remain volatile but have climbed (predominantly since 2020) to about €90 per metric ton, from an average of below €10/ton over the decade prior to 2020. Our rated European airlines (see table 1) that are exposed to the EU ETS should experience a material increase in carbon costs over the next few years. By comparison, the rest of our rated portfolio of airlines, (see table 2 and 3 in the appendix, and including the Turkish headquartered airlines in table 1) can expect only modest CO2-related costs under current (mostly CORSIA) regulations.
|EMEA Airline Ratings|
|Entity||Headquarters||ICR as of April 3, 2023||Difference compared with Feb. 1, 2020 (notches lower)|
Ryanair Holdings PLC
British Airways PLC
International Consolidated Airlines Group S.A.
Deutsche Lufthansa AG
Transportes Aereos Portugueses, SGPS, S.A.
Pegasus Hava Tasimaciligi A.S.
Turk Hava Yollari A.O.
Air Baltic Corp AS
|EMEA--Europe, Middle East, Africa. ICR--Issuer credit rating. N/A--Not applicable. Source: S&P Global Ratings.|
Estimating Ticket Price Changes
Assuming that free EU ETS carbon allowances are phased out (likely by 2026) and that airlines can pass on regulatory levies to customers, the impact of carbon costs on ticket prices can be crudely estimated.
For example, a one-way London to Barcelona flight creates an estimated 0.2 tonnes of CO2 per passenger. Applying an EU ETS price of €90 per metric ton, those emissions will add about €18 to the ticket price. Given an estimated price of about €60 for the trip, the regulatory burden appears significant but manageable.
By comparison, a ticket from Paris to Athens would incur almost €33 in emissions-linked costs, based on its 0.37 tonnes of carbon per passenger. And, if the EU ETS scheme was extended to international flights (which we view as unlikely), the cost of a London to New York trip could rise by about €90 per ticket.
The price of carbon is, however, volatile. If it increased by 50%, the voyage to Barcelona would incur €27 of extra costs, which is almost half the ticket price.
Reducing The CO2 Cost Burden
We expect that an airline's ability to pass carbon costs onto passengers will be an increasingly important competitive advantage. That should play into the hands of our strongest rated airlines, whose route-network efficiency, pricing, brand strength, and market dynamics afford them the option to raise ticket prices (albeit with a time lag to costs). That advantage was evident when they asked travellers to absorb recent inflation, notably of fuel and labour costs. Ticket price increases appear to have been widely accepted, partly due to post-pandemic, pent-up demand and high household savings. Further fare hikes, linked to rising CO2 costs, will also rely on continued strong demand, which is in line with our current base-case. That could, however, be tested if the economy weakens beyond our expectations and weighs on air traffic growth.
SAF appear key to the aviation sector's carbon reduction ambitions but are costly and large scale production will be challenging. Most jet engines can already use SAF blended into jet kerosene, and in rapidly increasing proportions due to technological changes to engines. Yet SAF production costs currently run at several times that of traditional jet fuel, while supply is extremely limited. SAF prices are currently about two to three times that of jet fuel, according to S&P Commodity Insights. IATA noted that SAF production was estimated to have tripled in 2022 to 300 million litres (79 million U.S. gallons), though jet fuel consumption in the U.S. alone averages about 60 million U.S. gallons per day.
Increasing production is complicated. Land used to create SAF at the necessary volume would likely come at the cost of other essentials, notably food, and could lead to deforestation. Those pressures will be exacerbated by competition for land from other bio-fuels, such as renewable diesel--though longer-term, most ground vehicles will likely be electric.
Efforts to develop synthetic fuels are also underway. Yet their use remains niche, according to the International Civil Aviation Organization, which cited scaling up production, cost competitiveness, and the need for infrastructure support among the challenges to synthetic fuels' large-scale development and deployment.
Electric aircraft engines are unlikely to play a role in reducing the CO2 cost burden for the foreseeable future. There will also be break-throughs in greener aircraft designs, fuel and emissions reducing technology, and carbon capture technology. The form and impact of the resultant benefits are difficult, and perhaps impossible, to quantify currently. Yet we can forecast where breakthroughs might come from, and where they likely won't. Electric engines, for example, could be used in relatively small and short-range aircraft, but will likely have limited applications in larger, longer-haul flights, according to the Air Transport Action Group.
Hydrogen powered flights avoid many electric engine pitfalls (including weighty batteries), but deployment of the technology remains distant and expensive. Rapid growth in hydrogen use would also test production constraints, particularly with regards to green electricity supply in hydrogen production.
Efficient networks, better route management, and improvements to air traffic control will also play a role in reducing carbon-related costs. Planes that fly direct routes and climb and descend at optimal fuel-efficiency speeds can reduce emissions by as much as 10%, according to Airbus. Meanwhile, airlines that operate flights at fuller capacities (high load factors) minimize their per-passenger carbon footprint. We expect that increased carbon-related costs will incentivize airlines to drop less profitable, routes.
Unfortunately, the EU's costlier carbon levies could also have a negative effect on network management and emissions, by incentivizing operators to fly to destinations outside of the EEA (plus the U.K. and Switzerland) that are exempt from EU ETS' charges. Long-haul flights (over 4,000 kilometres) account for half of the CO2 emitted by flights departing Europe, but only 6% of total flights, according to Eurocontrol, a European air traffic management group.
Stronger European Airlines Should Cope Best With Rising CO2 Costs
Our ratings reflect uncertainties due to the pace of development of climate-related technologies, market developments, and regulatory and policy initiatives. Our Global Industry Risk Assessment for Transportation Cyclical industries (which includes airlines) is 'High risk' or '5' and is currently the only corporate sector at such a high level. Environmental factors are a moderately negative consideration for the airline industry, as captured in our Environmental, Social, and Governance (ESG) credit indicator scores.
While European airlines' profits, competitive positions, and cash flows are all broadly vulnerable to the EU's accelerated reduction of greenhouse gas emissions, some airlines are more exposed than others. That notably includes short-haul carriers, which have the greatest proportion of operations within the EEA (and Iceland, Lichtenstein, Norway, the U.K., and Switzerland).
Additional regulatory costs in Europe's highly competitive, highly cyclical, capital-intensive airline market could serve to differentiate aircraft operators. We view our strongest rated airlines as best positioned to cope with such costs, without materially weakening their credit quality. On the other hand, rising costs will be a greater burden to airlines with already weaker margins, which may also find it more difficult to pass increased costs to customers.
We believe that could contribute to a widening of the performance gap between Europe's strongest few airlines and the weaker majority, with the latter potentially finding themselves under pressure to consolidate or facing default. If that removes competition and capacity from the European market, it could provide a further boost to the region's strongest airlines, so long as air travel continues to resist economic pressures.
|North American Airline Ratings|
|Entity||Headquarters||ICR as of April 3, 2023|
|Southwest Airlines Co.||United States||BBB/Stable|
|Delta Air Lines Inc.||United States||BB/Positive|
|Alaska Air Group Inc.||United States||BB/Stable|
|Rand Parent LLC||United States||BB-/Stable|
|United Airlines Holdings, Inc||United States||BB-/Stable|
|Allegiant Travel Company||United States||B+/Stable|
|JetBlue Airways Corporation||United States||B+/Negative|
|Spirit Airlines Inc.||United States||B/Stable|
|American Airlines Group Inc.||United States||B-/Positive|
|Hawaiian Holdings Inc.||United States||B-/Stable|
|WestJet Airlines Ltd.||Canada||B-/Stable|
|Western Global Airlines Inc.||United States||CCC/Negative|
|ICR--Issuer credit rating. Source: S&P Global Ratings.|
|Latin American Airline Ratings|
|Entity||Headquarters||ICR as of April 3, 2023|
|Avianca Group International, Ltd.||Colombia||B-/Stable|
|Grupo Aeromexico, S.A.B. de C.V.||Mexico||B-/Stable|
|LATAM Airlines Group S.A.||Chile||B-/Stable|
|Gol Linhas Aereas Inteligentes S.A.||Brazil||CCC+/Positive|
|ICR--Issuer credit rating. Source: S&P Global Ratings.|
- Europe's Remarkable Air Passenger Traffic Recovery Faces A Trickier 2023, Nov. 21, 2022
- Decarbonizing Cement Part Two: Companies Could See Pressure On Ratings As The EU Firms Up Carbon Rules, Oct. 27, 2022
- Decarbonizing Cement Part One: How EU Cement Makers Are Reducing Emissions While Building Business Resilience, Oct. 27, 2022
Writer: Paul Whitfield
This report does not constitute a rating action.
|Primary Credit Analysts:||Rachel J Gerrish, CA, London + 44 20 7176 6680;|
|Pierre Georges, Paris + 33 14 420 6735;|
|Izabela Listowska, Frankfurt + 49 693 399 9127;|
|Jarrett Bilous, Toronto + 1 (416) 507 2593;|
|Secondary Contact:||Stuart M Clements, London + 44 20 7176 7012;|
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