Ahead of the implementation of the International Maritime Organization’s (IMO) 0.5 per cent cap on sulphur content in shipping fuel on January 1, 2020, shipowners are increasingly exploring how they can finance the retrofitting of scrubbers on their ships, particularly those with sizable fleets. At the same time, banks are anticipating a move towards increased legislation and regulation in the area of sustainable finance to reduce the environmental impact of the industries they support, and a number of banks have already pledged support for Green shipping.
Currently, Annex VI of the IMO MARPOL Convention (agreed in 2008) requires all ships trading outside of sulphur Emission Control Areas or ECAs for short (not to be confused with Export Credit Agencies, also referred to later in this article) to use fuel with a sulphur content not exceeding 3.5 per cent.
In April this year, the IMO’s Marine Environment Protection Committee (or MEPC for short) confirmed that a 0.50 per cent limit on sulphur in fuel oil on board ships (outside designated emission control areas or ECAs, where the limit is 0.10 per cent) will come into effect on January 1, 2020 (the ‘IMO 2020 rules).
The exception would be for ships fitted with an approved “equivalent arrangement” to meet the sulphur limit – such as an exhaust gas cleaning system (EGCS) or so-called “scrubber” – which are already permitted under regulation 4.1 of MARPOL Annex VI. These arrangements can be used with “heavy” high sulphur fuel oil, as an EGCS cleans the emissions and therefore can be accepted as being at least as effective at meeting the required sulphur limit. Additionally, ships undertaking research trials of emission reduction and control technology can be exempted under regulation 3.2 of MARPOL Annex VI. For any ship without an approved equivalent arrangement, the effect of the draft amendment, which would enter into force on March 1, 2020, would be that the sulphur content of any fuel oil used or carried for use on board shall not exceed 0.50 per cent.1
In light of the upcoming IMO 2020 rules, owners and operators have no choice other than to consider installing scrubbers on their ships, to enable them to continue to burn heavy fuel oil with limited changes to current bunkering arrangements. Huge numbers of ships will be required to install scrubbers (some estimates run into the thousands) with something like 20 per cent of the global fleet retrofitted with scrubbers in the next seven years2. However, given the relatively high capital outlay and complexities surrounding the financing of scrubbers, there is an urgent need for scrubber finance solutions. This article will look at some of those potential solutions and the related issues.
Scrubber finance (where a willing financier can be found) is less of a concern where a ship is unencumbered at the outset (i.e. it is not subject to a mortgage to secure a bank loan or finance lease) and there are no restrictions on what an owner can (or cannot) do to the ship. However, where the ship is subject to a mortgage (to secure a bank loan) or a bareboat charter (in the form of a finance lease), restrictions in any number of those finance documents may limit (or completely bar) stand-alone scrubber finance, without the relevant financiers’ consent. It is worth remembering here that consent may be hard, or indeed impossible, to obtain (for any number of reasons, including limits on maximum facility size, loan to value covenants, etc.) unless a solution acceptable to all of the interested parties can be found.
In some cases, a finance lessor (particularly if that finance lessor will also handle the installation) will just increase its funding under the finance lease, to cover the cost of the scrubbers. That is a relatively easy “fix” with an addendum to the original finance lease, to address the increase in funding and loss as a result of the downtime – estimates of up to two weeks layup during which the ship may be off-hire (with access to heavy equipment for the installation of a scrubber tower tanks, pumps, instruments, wiring and piping which form the EGCS comprising the scrubber)3. It is probable that more than one party in the chain will have to compensate for time lost during the installation period.
Where the ship is also subject to a mortgage (given by either a shipowner to its lender in a straight ship finance loan or a loan supported by an Export Credit Agency, or by a lease financier (as owner) to its own creditor/lender) there are more complex issues to consider. Briefly, any mortgagee (or finance lessor) will consider it difficult to depart from the general principle that once equipment is installed, it will (more often than not) form part of the ship itself. By analogy, as soon as the scrubbers are installed, they form part of the ship and, therefore, are (or should be) subject to the owner’s mortgage. If the financier of the ship (as mortgagee) is not the same party as the scrubber financier, then the ship financier will have benefitted (in that the value of the ship subject to the mortgage is higher) to the scrubber financier’s detriment – in that the scrubber financier will be unsecured (where the scrubber now forms part of the ship and therefore is subject to the mortgage) and loses any proprietary claim (the scrubber financier will rank behind the ship financier unless some form of subordination of rights or other solution can be found).
It is possible that in certain jurisdictions, a scrubber financier’s rights (or liens given in its favour) may be recognised, but this will very much depend on the flag of the ship and place of arrest and sale (or court-approved sale, depending on enforcement procedures in that jurisdiction). This will give little (or no) comfort to the scrubber financier, particularly as ships are constantly on the move and pass through any number of different jurisdictions during the course of a voyage. As a matter of English law, it is unlikely that claims in relation to installed scrubbers will generate a maritime lien in favour of the scrubber financier. As a scrubber financier will not wish to research every relevant jurisdiction, other options will have to be considered.
Title to the scrubbers retained by scrubber financier
One option is to have the scrubber financier retain title to the scrubbers and lease them to the owner (whether hire purchase i.e. a finance lease structure or sale-and-leaseback with a put option). There, the scrubber financier should (arguably) retain title assuming the lease is correctly documented and the equipment constituting the scrubbers is sufficiently identifiable so that it isn’t co-mingled with (and therefore becomes part of) the ship itself. However, similar to a retention of title clause, if the owner defaults on payments to the scrubber financier, the scrubbers would be very difficult (and more than likely very expensive) to remove from the ship and recover by the scrubber financier (with the intention of re-sale to cover the original financing costs). There is also the question of re-sale value – once the EGCS has been removed from a ship, how easy (and cost effective) would it be for the manufacturer to reinstall it in another ship? If it is simply scrap metal, then this may not be a viable or indeed cost effective method of keeping the scrubber financier whole.
By using a finance lease-type structure to finance the scrubbers, if the mortgagee of the ship (or indeed another lien holder) seeks to arrest and enforce against the ship (so that the ship is either sold through an Admiralty court process or by means of a private sale in the case of Panama, for example), the scrubber financier may (assuming the finance lease is recognised) still have the ability to take injunctive action to postpone a sale of the ship and either arrange for the scrubbers to be returned, or come to some arrangement with the ship’s lenders so that it receives some payment from the mortgagee to cover its loss. This isn’t very protective of a scrubber financier’s position, but does potentially give the scrubber financier the right to a seat at the table where the owner is insolvent and its assets are being disposed of to settle the claims of creditors. However, this may not work in all jurisdictions, particularly Chapter 11 insolvency in the US, where the court may re-categorise a finance lease as a loan and find that title vests with the owner (as lessee) and not the lessor.
Increase and sub-participation of existing loan facility
Where the shipowner has the ability to increase the amount of an existing facility (whether a green-shoe or perhaps a revolving credit facility), it may be possible for a scrubber financier to provide the capital (by way of debt) to purchase the scrubbers through a sub-participation of existing loans. This would give the scrubber financier a first priority security position (albeit on a pari-passu basis), although it is unlikely a loan financier of the hull would agree to that without some contractual subordination on the part of the scrubber financier (as the cost of the scrubbers (and therefore the scrubber financier’s exposure) is exponentially lower than the hull financier’s risk profile).
Given that the scrubbers will be treated as part of the ship and, therefore, subject to the mortgage, and on the assumption that the ship will increase in value as a result of installation of the scrubbers, a more palatable solution may be a contractual agreement between the scrubber financier and financiers of the ship for a place in the security proceeds waterfall (under the loan agreement). This would provide the least disruption to any existing hull financing - basically it would be a contractual agreement with the security trustee (or mortgagee, acting on behalf of itself and the other hull financiers) that upon receipt of security proceeds (ordinarily as a result of enforcement action against the vessel), either the scrubber financier would share in the proceeds or it would be paid out of the excess (once the hull financiers have been made whole). In order to ensure that this arrangement continues to work in an insolvency of the owner, the owner could assign the benefit of any receivables it would be paid at the bottom of the waterfall (its equity of redemption) in favour of the scrubber financier. This mechanism does not give the scrubber financier control over any enforcement of security (unless it insists on voting rights) but is a simple way of giving it a second priority security position.
Scrubber financing by existing charterer
If a scrubber financier is actually the charterer of the ships, it may be simplest to include an additional set-off right in the charters (which is non-ship specific, i.e. it can be set off against any ship) for defaults under any of the scrubber loans or, alternatively, a discount to the charter rate. This is likely to require lender consent, but may be the simplest way of providing some comfort in relation to the repayment of the scrubber loans.
Where the scrubber financier decides on a retention of title clause or a finance lease structure, it may be possible to agree a put option with the owner’s financiers. If the owner defaults on its payments, the financiers pay off the debt owed to the scrubber financier and, in return, the owner gets title to the scrubbers (which would be sold as part of the ship to repay the owner’s debt to the hull financiers). This is only likely to work where the financiers are not willing to fund the cost of the scrubbers but the increase in value of the ship as result of their installation is significant.
In the short to medium term, we are likely to see a whole host of new scrubber finance products come to the market. It remains to be seen how existing lenders and finance lessors will accept these financial products into their existing security packages – whether by second ranking mortgages, second tier placing in cash waterfalls, or by some form of subordination. The market will ultimately decide what is (or is not) acceptable.