On 5 April 2023 the long-awaited draft amendment to Delegated Act EU 2021/2139 including draft technical screening criteria in Annex 1 (the Draft Delegated Act) was published by the European Commission heralding the inclusion of aviation as a transitional activity within the EU Taxonomy Regulation. Following consultation, the draft was then updated on 13 June 2023 and published as part of the European Commission’s sustainable finance framework. We set out below what is currently proposed, why it matters and what the consequences are likely to be for aircraft finance and leasing transactions.
What is the EU Taxonomy Regulation?
The EU Taxonomy Regulation was borne out of a recognition that private capital would need to be mobilised and incentivised to support transition to a low carbon economy. To encourage investor confidence that investments will have the desired positive environmental impact, the EU Taxonomy Regulation establishes a classification system for environmentally sustainable activities. It does this by setting out in Article 9 of the EU Taxonomy Regulation a number of environmental objectives.
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems.
It then provides that economic activities can be included within the EU Taxonomy if they:
- make a substantial contribution to one or more of these environmental objectives,
- do no significant harm to any of the other environmental objectives,
- are carried on in compliance with certain safeguards (such as compliance with certain international human rights and labour standards), and
- comply with the technical screening criteria set out in delegated legislation pursuant to the EU Taxonomy Regulation.
Of the objectives listed above, the European Commission recognises that the aviation industry has the potential to play a significant role in reducing carbon emissions and thus could, in future, make a substantial contribution to climate change mitigation. However, at present the ability of the industry to make such progress is technologically constrained. Although manufacturers have done much over the years to produce more fuel-efficient engines, aircraft remain powered by kerosene jet-fuel and this is likely to remain the case for some time to come – particularly for the vast majority of commercial widebody aircraft.
However, economic activities in sectors such as aviation where low carbon alternative technology is not yet economically feasible may still be considered as making a substantial contribution to climate change mitigation for the purposes of the EU Taxonomy Regulation provided that the activity:
- has greenhouse gas emissions levels which correspond to the best performance in the sector;
- does not hamper the development and deployment of low carbon alternatives; and
- does not lead to a lock in of carbon intensive assets over the economic lifetime of those assets.
In general, the economic activity concerned must be something which supports transition to a climate neutral economy and the phasing out of the use of fossil fuels consistent with the overall Paris Agreement goal of limiting the temperature increase to 1.5% of pre-industrial levels. The Draft Delegated Act proposes technical criteria to determine which kind of aviation-related economic activity would constitute a transitional activity for the purposes of the EU Taxonomy Regulation.
Why does this matter?
In addition to providing greater clarity as to what projects can be described as sustainable, the EU Taxonomy also performs a regulatory function.
CSRD – the corporate sustainability reporting directive
The recent corporate sustainability reporting directive (CSRD), which entered into force in the EU on 5 January 2023, has expanded the ambit of entities required to provide certain non-financial information as part of their annual reporting. As such, this requirement will now apply to (amongst others):
- all companies listed within the EU (including listed public interest SMEs),
- unlisted large EU undertakings, and
- certain non-EU companies where their securities are admitted to trading on an EU regulated market, they have EU subsidiaries that are large undertakings or public interest SMEs or EU branches which generate substantial turnover.
Pursuant to the EU Taxonomy Regulation and as part of their non-financial reporting, those entities will be required to disclose:
(a) the proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable; and
(b) the proportion of their capital expenditure and the proportion of their operating expenditure,
in each case related to assets or processes associated with economic activities that qualify as environmentally sustainable. Environmental sustainability is to be assessed by reference to the EU Taxonomy Regulation.
GAR – Green Asset Ratio
In addition, the European Commission and European Banking Authority (EBA) are aiming to encourage financial institutions to finance sustainable activities through the disclosure of a Green Asset Ratio (GAR).
Following the EBA’s technical advice, the European Commission’s delegated act on taxonomy-aligned disclosures for financial and non-financial undertaking requires financial institutions to disclose their GAR to show the extent to which the assets financed and invested are in taxonomy-aligned economic activities (including loans and advances, debt securities, equities and repossessed collaterals) as a proportion of total covered assets.
The GAR will lead to greater transparency around what financial institutions are financing, which may result in investors applying pressure on them to shift their loan books towards exposures to companies that are involved in taxonomy-aligned sustainable economic activities. The GAR may therefore have the effect of encouraging financial institutions to tighten credit supply and increase loan rates offered to companies involved in activities that are not taxonomy-aligned. There is also the possibility of the GAR evolving in future to require financial institutions to hold additional capital against exposures to non-green activities to take account of the sustainability risks. More generally, there is the potential for inclusion of ESG risks into Pillar 2 prudential requirements, which allow supervisors to require financial institutions to hold additional capital against additional risks (and this could include ESG risks in future).
What does the Draft Delegated Act say?
Annex 1 to the Draft Delegated Act designates the following aviation activities as potentially falling within the EU Taxonomy Regulation on the basis that they could (if the technical screening criteria are satisfied) make a substantial contribution to climate change mitigation:
- Manufacturing of aircraft
- Leasing of aircraft
- Passenger and freight air transport
- Air transport ground handling operations
We summarise the proposed technical screening criteria for each activity below in so far as they relate to aircraft financing and leasing.
Leasing of aircraft – Para 6.18
What type of transaction does this section apply to? - Annex 1 Para 6.18 describes this as the renting and leasing of aircraft and aircraft parts and equipment. The description is then supplemented by a reference to a NACE Code (which is a classification system for economic activities used in the EU.) The Draft Delegated Act refers to the activities falling within this section by reference to NACE Code 77.35 which encompasses operating leasing aircraft “without operator” – in other words dry operating leasing. It would also apply to operating leases of engines.
Many aircraft financings are structured using a lease, and it is unclear whether finance leases would fall within this section or under the more general “passenger and freight air transport” category in Para 6.19 which is discussed further below. This is because guidance to the NACE Codes Revision 2 expressly excludes finance leases from the ambit of NACE Code 77.35. It should also be noted that the NACE codes were updated in February 2023 and further guidance on the recent revision is awaited.
What aircraft does this section apply to? –
“aircraft with zero direct (tailpipe) CO2 emissions” - Paragraph 6.18 then goes on to provide that “aircraft with zero direct (tailpipe) CO2 emissions” fall within this section as making a substantial contribution to climate change mitigation. This means that leasing new technology aircraft, for example, potentially hydrogen or battery-powered aircraft, would be classified as an environmentally sustainable economic activity for the purposes of the EU Taxonomy Regulation. Such a transaction would not need to satisfy the further criteria for a “transitional activity” outlined below.
A transitional activity? - However, the section also recognises that zero CO2 emitting aircraft are yet to be in commercial operation. As such it proposes that aircraft leasing could also constitute a transitional activity if alternative criteria are fulfilled. To reflect and encourage technical improvements to reduce emissions, these criteria evolve and tighten over time and are as follows:
Best Performance in Sector – Until 31 December 2027 the EU Taxonomy requires the aircraft to have a certified metric value of CO2 emissions which is a defined percentage (based on the maximum take-off weight of the aircraft) below the ICAO New Type limit. At the time of writing only A330-841 and A330-941 are listed on the EASA CO2 database and appear to have the required certification. However, the draft technical criteria also allow for aircraft to be included which are declared by the manufacturer to meet the required threshold, provided that certification is then obtained within 3 years of the date that the Draft Delegated Act comes into force.
Replacement Ratio? – The Draft Delegated Act provides that “the share of Taxonomy compliance of eligible aircraft may be limited by a replacement ratio”. This replacement ratio is to be calculated by determining the proportion of aircraft permanently withdrawn from use to the number of aircraft delivered by reference to the global fleet over a preceding 10-year period and using independently verified data available from independent data providers. This means that when preparing the data needed by reference to KPIs for non-financial reporting such as turnover relating to aligned activities, the relevant figure for the applicable lease transaction would be limited by the ratio unless the transaction in question is one to which the replacement ratio does not apply.
Disposal - For aircraft delivered after the date on which the Draft Delegated Act comes into force, a non-compliant aircraft having at least 80% of the maximum take-off weight of the compliant aircraft, must also either be permanently withdrawn from use or permanently withdrawn from the fleet within six months of delivery of the compliant aircraft in order for the operating lease transaction to be taxonomy compliant.
Permanent withdrawal from use appears to mean that the non-compliant aircraft is permanently removed from service in the global fleet. The replacement ratio will not apply to the operating lease transaction in question in such circumstances.
Permanent withdrawal from the fleet is not defined but appears to be a lesser standard and could potentially encompass a sale of the relevant non-compliant aircraft to a third party. Such a transaction would be taxonomy compliant, but the replacement ratio would still apply.
In addition, in order to demonstrate that the relevant withdrawn non-compliant aircraft was genuinely operational as part of the relevant fleet (and not just purchased to satisfy the requirements of this section) the non-compliant aircraft must “have remained in the fleet within at least 12 months prior to its withdrawal” (which we assume means that the aircraft should have been part of the relevant fleet for at least 12 months prior to its removal) and should have a proof of airworthiness dating back less than 6 months prior to the delivery of the compliant aircraft.
Sustainable Aviation Fuel (SAF) – From 1 January 2028 to 31 December 2032, in addition to complying with the foregoing criteria, the relevant aircraft would also need to be certified to run on 100% blend of sustainable aviation fuels.
Furthermore, from 1 January 2030 the aircraft must be operated with 15% SAF, increasing by 2% annually thereafter. This share of SAF is to be calculated by dividing the total quantity of SAF purchased at fleet level by the total amount of aviation fuel used by the compliant aircraft, then multiplied by one hundred. This calculation is helpful, as earlier iterations of the technical screening criteria had suggested that some kind of evidence of the physical flow of SAF to the aircraft in question would need to be demonstrated.
Do No Significant Harm – The requirement that the transaction does not involve significant harm to any of the other environmental objectives set forth in the EU Taxonomy Regulation applies to all leasing transactions which would fall within this section. Of particular note is that the aircraft must comply with certain noise levels assessed by reference to Annex 16 of the Chicago Convention. Some commentators noted that the earlier draft of this condition would have adversely impacted the inclusion within the EU Taxonomy of transactions involving freighter aircraft; however, in the more recent Draft Delegated Act of 13 June 2023, this comment appears to have been addressed. In addition, given the replacement ratio and incentive to remove non-compliant aircraft permanently from use, any decommissioning of an aircraft must comply with EU waste regulation principles.
Passenger and Freight Air Transport – Para 6.19
What type of transaction does this section apply to? - This is a more general category which encompasses the “purchase, financing and operation of aircraft including the transport of passengers and goods”.
The section expressly excludes leasing of the type referred to in paragraph 6.18 (i.e. operating leasing). Instead, it refers to NACE Codes H51.1 and H51.21 which relate to “the renting of air transport equipment with operator” i.e. wet leasing. However, despite the reference to the “financing of aircraft”, the section does not specifically reference NACE Code 64.91 relating to finance leasing.
As noted previously this raises the question of which category applies to finance leases of aircraft (assuming that it is intended for them to be included within the ambit of EU Taxonomy). Given the reference to “financing” in this section and that the references to NACE codes are not deemed to be exclusive of the activities which fall within section 6.19, it would seem logical that section 6.19 should apply to finance leasing. However, it would be better if this could be confirmed by the European Commission.
What aircraft does this section apply to? – Generally, the criteria for transactions falling within this section are the same as for operating leasing. However, there are some differences.
Application of Criteria - Criteria such as the need for a taxonomy compliant aircraft to meet a threshold below the ICAO CO2 emissions threshold are expressed to apply until 31 December 2029 (rather than 31 December 2027 as seems to apply to operating leasing).
Additional Criterion - In this section there is an additional criterion for aircraft operated with a minimum share of sustainable aviation fuel starting from 5% in 2022 and increasing by 2% annually thereafter. Although not entirely clear, this criterion would appear to allow the wet leasing or financing of an aircraft which does not meet the threshold below the ICAO CO2 emissions standard to constitute a transitional activity if operated using the required percentage of SAF. In addition, as a standalone criterion, it seems that the replacement ratio and requirement to withdraw a non-compliant aircraft from use or the relevant fleet may not apply to such a transaction.
What aircraft are definitely excluded from the EU Taxonomy Regulation?
The EU Taxonomy Regulation generally excludes the leasing or financing of aircraft which are “produced for private or commercial business aviation” from being a transitional activity. Note that “private or commercial business aviation” is not defined and appears to be a purposive test rather than a test based on, say, the number of persons the aircraft is designed to carry. As such, it appears that an aircraft which would otherwise meet the criteria regarding taxonomy compliance would be excluded if it was to be used for private or commercial business aviation. Only if the relevant aircraft had zero direct (tailpipe) CO2 emissions could the leasing or financing of an aircraft produced for private or commercial business aviation fall within the EU Taxonomy Regulation as a sustainable activity.
The inclusion of aviation within the EU Taxonomy is to be welcomed – if aviation leasing and finance were excluded then that could operate as a hindrance to the industry being able to attract the funds that it needs to transition away from fossil fuels towards more fuel efficient and sustainable technology.
Nonetheless, in order for the technical screening criteria to be effective, they need to be clear and the current Draft Delegated Act does raise questions of interpretation. For example:
Clarity on Classification – Aircraft finance and leasing transactions employ a range of financing techniques and further guidance is needed as to how the categories should apply in practice. In particular, given the extensive use of finance leasing within aircraft finance structures, confirmation as to which set of criteria should apply to finance leasing would be welcome. For the most part, the technical screening criteria for paragraphs 6.18 and 6.19 are identical. However, as noted above, there are some important differences.
Replacement Ratio – It is not clear who will be calculating this and based on what data. The Draft Delegated Act only refers to “verified data available from independent data providers”. Previous iterations of the proposed technical screening criteria for aviation mentioned that information from data providers such as Cirium could be used. Given that this is intended to be calculated by reference to the global fleet of aircraft, presumably the calculation will be performed and published centrally by the European Commission or an EU agency such as EASA.
Withdrawal from Use and Withdrawal from the Fleet – It will need to be established how permanent withdrawal from use is to be established and verified – particularly given the interplay between this criterion and the “do no significant harm” criteria relating to transition to a circular economy. Any parting-out of an aircraft which has been permanently withdrawn from service would need to be carried out in compliance with relevant EU waste regulation.
This requirement could also have unintended consequences. As part of any re-fleeting exercise, an airline would typically look to dispose of aircraft which are being replaced as part of any new order – for example by selling the aircraft out of its fleet. If instead the airline scraps the aircraft, this reduces the flow into the second-hand market of more fuel-efficient aircraft (given that not all aircraft operators are able to afford new ex-manufacturer aircraft). It also has a potentially detrimental effect on residual values and airline revenue streams.
In addition, clarity would be welcome as to what constitutes withdrawal from the fleet (in particular, whose fleet is applicable here in the context of a lease). In general, the six-month period creates an arbitrary deadline for the completion of transactions relating to the disposal of aircraft which could give rise to additional commercial pressures in practice.
Requirement for Reporting Standards - In the responses to the current consultation, many industry participants raise the need for definitions and data sources to be clarified. For example, when discussing operating leases what is meant by the term “fleet” – the fleet of the lessor, the fleet of the lessee or the worldwide fleet? In addition, there is a need for some kind of audit guidance to be developed to support the application of the technical criteria.
What to do now?
The consultation period for comment on the Draft Technical Screening Criteria has now ended and it is anticipated that the Delegated Act may be finalised and passed later this year.
It is not a legal requirement that an aviation finance or leasing transaction should comply with the criteria set out in the EU Taxonomy, but it is obviously helpful if it does so, as this may facilitate better access to financing and will also assist with non-financial reporting. Industry participants should therefore consider the following:
New Orders – In any new order of aircraft, airlines and lessors may wish to ask relevant manufacturers questions about the compliance of any new aircraft with the ICAO CO2 standard and seek evidence that the aircraft would produce emissions below the required threshold for compliance.
Disposal – In any re-fleeting project, it may be necessary to plan at an early stage the programme for retirement and disposal particularly given the time periods set out in the Draft Delegated Act. Airlines will need to think about the way that disposal should occur bearing in mind the need to comply with “do no significant harm” criteria.
Contractual Criteria – In order to monitor compliance with criteria established in the Delegated Act, lessors and financiers will need to consider what further information or assurances they may need to receive from airlines – for example regarding the use of SAF and how this may be verified. Airlines will want to plan for anticipated information requests with a view to using existing available information as much as possible to reduce the administrative burden.
Monitor Future Developments – Although the draft technical screening criteria appear to be nearing finalisation, the use of taxonomy alignment in EU regulation is expanding, particularly in the area of non-financial reporting. It is therefore important to monitor developments in this area. The inclusion of aviation within the EU Taxonomy is a positive step for the industry. Given that the period for consultation on the Draft Delegated Act has ended, industry participants should focus attention on how the criteria are implemented in practice, particularly on the development of any reporting standards, to try to ensure that guidance is clear and practical.
In conclusion, this is an increasingly important aspect of the aviation industry, and we will keep you updated on developments in this area.
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