In the second two articles discussing the new FuelEU Maritime Regulation (Regulation (EU) 2023/1805) (the Regulations), we consider how those responsible can avoid penalties, the different issues faced by managers, owners and charterers and how these issues can be overcome. We also provide a brief overview of how the Regulations will impact LNG fuelled vessels.
Avoiding penalties
As well as banking, discussed in our previous article, there are other options open to the Document of Compliance (DoC) holder to avoid penalties under the Regulations.
Borrowing – Article 20
In order to avoid the penalties and minimise financial exposure, a vessel in a deficit may choose to borrow an advance surplus from their allowance in the next reporting period. While this may prima facie seem like an easy decision, it does in itself contain a penalty in that interest is charged on the borrowing. The borrowed amount will be multiplied by 1.1 before it is subtracted from the next reporting period balance. Further, there is a restriction on the amount that can be borrowed, being 2% of the compliance surplus and a vessel is not entitled to borrow for more than two consecutive years.
Pooling – Article 21
Pooling of GHG intensity is a second option; pooling adds a bit more flexibility, as a vessel in a compliance deficit may choose to pool with other vessels so that the overall compliance balance average of the emissions of the vessels in the pool is compliant. Essentially, the overperforming vessels offset the underperforming vessels.
The pooled vessels do not need to be owned by the same company. However, the conditions are that the fleet as a whole must be in a surplus and a vessel cannot be entered into more than one pool in a reporting period (other than for sub-pooling for the Renewable Fuel of Non-Biological Origin – RFNBO – sub target).
When deciding whether or not they wish to pool their vessel, owners/managers should consider the cost/benefit of deficient and surplus vessels. Regard must also be given to whether the vessel has chosen to bank or pool their surplus/deficit. A vessel that has made use of the borrowing provision is unable to be entered into a pool for that reporting year. However, a pooled vessel in a surplus may still opt to bank some of their compliance surplus so long as the overall pool will also remain in a surplus.
A company must notify the verifier of its intention to include a ship’s balance sheet in a pool by April of the verification period after the reporting period. Following which, they must then register this intention with the FuelEU database and stipulate the allocation of the total pool compliance.
An issue which we expect to see arise from pooling is what is to be done if a vessel does not achieve its anticipated emissions level resulting in the whole pool’s performance becoming compliance deficient. As such, there is the evident need for cautiously drafted pooling arrangements.
LNG
Evidently, the amount of GHG produced by a vessel is determined by the fuel which it consumes. Although VLSFO and MGO fuelled vessels are predicted to be non-compliant from the start, LNG in comparison is one fuel type that is expected to initially be compliant. This is attributed to its low reference value of around 82.1g CO2 e/MJ (with the possibility of that reducing further for some vessels dependant on their engine technology).
In a study conducted by Sea-LNG, it is considered that LNG in its fossil fuel form will be able to remain compliant for bunkering use under the Regulations until 2039. Taking this into consideration, LNG fuelled vessels are currently a great asset to have in a pooling arrangement due to their compliance surplus.
In order to prolong its compliance timeframe, an LNG vessel may choose to bank some of its previous surplus and therefore dependant on its earlier efficiency, may be able to survive subsequent reporting periods.
Notably, 2039 is anticipated to be the threshold for LNG vessels on their own (or only LNG ships pooled together) to be compliant. Accordingly, the longevity of their compliance would diminish if they were pooled with vessels burning ordinary hydrocarbon fuel, as the LNG vessels would no longer have a sufficient surplus to counteract those in a deficit. Essentially, over time, the vessels with a positive compliance surplus will cease to be the providers in the pool arrangement and will instead become those in a deficit requiring assistance. 2035 is a rough estimate of the date in which an LNG, VLSFO/MGO pooling arrangement would no longer meet the FuelEU pooling requirements.
We anticipate that after 2040, LNG fuelled vessels will become the undercompliant vessels and will need to be pooled with green fuel (or another compliant fuel available at the time) vessels so that the LNG vessels may benefit from the surplus. Alternatively, in order to avoid financial penalties, LNG vessels may have to transition to alternative fuels to meet the 31% reduction factor and remain compliant. This could require vessel modification and/or engine upgrade.
How to avoid issues posed by FuelEU
Companies are advised to gauge what they anticipate their FuelEU costs to be so that they can determine what their mitigation options are alongside what can be done with their outstanding balances.
Parties involved in maritime transportation have conflicting interests so will be affected in different ways by these Regulations. Some of the disputes we expect to see relate to the allocation of the non-compliance penalty.
Since the Regulations themselves do not assist with transferring the burden of fines/actual costs from owner/manager/DoC holder to the actual polluter, aka the charterer, the only way in which this can be done is via carefully worded clauses in their respective contracts.
Managers’ perspective
Despite a manager being an external third party, if they are the holder of the DoC, they will find themselves liable for the vessel’s under-compliance. A ship manager does not have a contractual relationship with the charterer. Therefore, in order to protect his interest, the manager will seek to make the owner liable for any penalty/costs associated with the Regulations. The relationship between the owner and the manager is governed by the ship management agreement, under which the manager may negotiate the inclusion of an indemnity in their favour.
Owner’s perspective
A shipowner under a time charter will also have limited control over a vessel’s emissions. Accordingly, they will not be comfortable with bearing the risk of the vessel’s under-compliance and instead will want to pass this to the charterer. An owner may find themselves liable for the costs either due to the fact they are the DoC holder, or because they have included a provision (such as the one discussed above) within their ship management agreement. Regardless, the owner is unlikely to be willing to remain responsible for the costs.
Many charterparty forms already include a general indemnity protecting owners by requiring charterers to cover any voyage related costs (e.g. Baltime, Clause 4). While it is possible that an owner could rely on this general indemnity as a means of recouping an under-compliance penalty, such clauses were established prior to the Regulations and therefore did not have them in mind at the time of drafting. Consequently, while it may be a possibility to claim the penalty costs under the general indemnity, it is in fact not a guarantee. Therefore, a prudent owner should ensure he is fully protected by a suitably worded charterparty clause.
Similarly, as the verification period only takes place every five years, in many cases, the charterparty will have long concluded before the penalty is calculated. Accordingly, any such costs could be left for the owner’s account for a prolonged period.
Charterer’s perspective
It is the charterer who is responsible for bunkering the vessel and the charterparty will often stipulate the grade of fuel that is to be supplied to the vessel throughout the charter period. In some cases, the clause stipulating the type of fuel to be used will be very restrictive and could in fact lead to the vessel being in a compliance deficit. As such, many of these clauses would benefit from being redrafted to allow for alternative fuels, in addition to the usual fuels, to be used. Making such an amendment to ensure as wide options as possible for the provision of fuels would give charterers a better chance of not being in breach of the Regulations. However, it is likely that many owners will be reluctant to include a clause that is too widely drafted due to the above discussed risks of incompatible fuels and the damage they can cause. Negotiations will need to take place to ensure that a clause is drafted with enough flexibility to allow for charterers to meet the requirements of the Regulations with their fuel choices but with enough protection to owners to ensure that the chosen fuel will not cause damage to their vessel.
With that being said, if a charterer has taken steps to ensure that the vessel is compliant, such as purchasing alternative potentially more expensive fuel, they are not going to want the DoC holder or owners to reap the benefits of the surplus.
Further, since the vessels’ emissions can be affected by many things including the engine/technology, charterers will not want to agree to a clause that holds them firmly liable for the penalty in case the under-compliance is caused as a result of something that the owners are responsible for, such as poor engine functionality. If this were the case, charterers would expect owners to be liable/cover the costs. Such a situation demonstrates how crucial it is to ensure the correct negotiations take place and a well drafted provision is included within the charterparty.
Charterparty clauses
Due to an owner having limited control under a time charter and yet the liability under the Regulations, it is in the owners’ interest to ensure that an express provision is incorporated into the charterparty for owners’ protection and to avoid any unnecessary disputes.
A suggested charterparty clause may require charterers to ensure the compliance balance is positive for each reporting period. However, owners would not have a means of enforcing this requirement and so it may not be the most appropriate.
A more suitable clause may instead require charterers to reimburse owners for the estimated FuelEU penalty at the end of each reporting period. Alternatively, to avoid a build-up in costs and dependant on risk appetite, owners may prefer to do this on a monthly basis. Crucially, this would need to highlight that the estimate given is the “Owners’ best estimate”. If monthly reimbursement was the preferred method, the clause could be drafted in a way that would allow charterers to recoup some of the funds if there were surpluses in future months. The balance could either be added or deducted from hire.
Due to the requirements under the MRV, owners are likely to already be monitoring GHG data and charterers will usually be recording information to observe the vessel’s performance. As such, monthly reporting and reimbursement is certainly a viable option for reducing the risk of owners receiving a very big penalty at the end of the year.
A method of enforcement could be built in allowing owners to suspend performance if payment is not made. A clause of this nature would balance both charterers’ and owners’ interests.
Comment
Ultimately, the Regulations are likely to lead to new avenues of disputes between charterers and owners. As has been highlighted throughout this article, the only way of avoiding such disputes is by reviewing the charterparties governing voyages within the scope of the Regulations and ensuring that there are well drafted clauses that carefully take into consideration all potential areas of conflict.
In the event of any query arising out of this article or from the Regulations generally, please contact the authors or your usual contact at Hill Dickinson LLP.
Please see part 1 here.
For further information, please contact:
Beth Bradley, Partner, Hill Dickinson
beth.bradley@hilldickinson.com
