In this second edition of our Countdown newsletter series on IMO, we dive into flexible compliance mechanisms under consideration for a goal-based fuel standard (GFS). Member States are discussing these mechanisms as part of the proposed mid-term measures (MTM) at the 17th Intersessional Working Group on Reduction of GHG Emissions from Ships (ISWG-GHG 17). Here we explain what flexible compliance means, how it works, its potential impacts on the transition to sustainable marine fuels, and what we can learn from its use in other policies, such as FuelEU.

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• Flexibility is a set of policy tools under consideration as part of a GFS which allow ships to bank and trade surplus compliance.

• Trading surplus units can create an incentive for ships to use sustainable marine fuels. It also offers ships unable to meet the target an alternative to paying non-compliance fees, known as remedial units.

• The Comprehensive Impact Assessment of the MTMs on the global fleet found that flexibility can lower cost per tonne of GHG reduction by roughly 6%, lowering the total cost of the transition.

• Flexibility comes with trade-offs, such as less revenue from remedial units to use for reinvestment as well as geographical concentration of sustainable fuel use.

• Member States can build on lessons learned by governments in the EU, Brazil, California, and the Netherlands, amongst others. These countries have implemented fuel standards with trading to drive the uptake of sustainable fuels.

The GFS aims to progressively limit the “GHG Fuel Intensity” — the mass of GHG emissions per unit of energy used on board a ship. Flexibility is one element being considered as part of a GFS (see figure below).

Each element must be carefully designed to ensure a GFS is effective. For example, if the GHG reduction pathway is too “flat” or the remedial unit cost is too low, ships could simply pay a bit more and continue using fossil fuels. Conversely, a well-designed GFS can incentivize the adoption of sustainable marine fuels and technologies, aligning the sector with the 2023 GHG Strategy's decarbonization goals.

In this context, ‘flexibility’ describes flexible compliance mechanisms that would allow ships to be over or under the GHG fuel intensity target in a given year while using banking and trading to remain in compliance.

Banking allows ships that reduce their emissions intensity below the target to carry forward surplus units into future compliance periods.

Banking can smooth out fluctuations in the cost of compliance over time, allowing companies to manage their emission reduction strategies more efficiently. However, banking can also weaken the regulation’s ability to cut GHG emissions, so careful policy design is critical.

This dilemma was demonstrated in the early years of the EU Emissions Trading System (ETS), when unlimited banking led to stockpiling cheap credits, which kept the price of emission allowances low. This was later addressed through the Market Stability Reserve, which adjusts the supply of allowances based on how many are being held by companies to ensure the ETS price signals remain strong. In a GFS, Member States should consider how to avoid stockpiling in the early years when the cost to reduce emissions intensity is expected to be low for ships with access to drop-in biofuels.

Trading allows ships with a GHG fuel intensity below the limit to exchange surplus compliance with non-compliant ships, generating revenue from the excess. This rewards ships for using lower GHG-intensity fuels while also giving those unable to access sustainable fuels an alternative to paying for remedial units.

The simplified example in the figure below illustrates how trading enables mutually beneficial trades that incentivize investing in and using sustainable fuels. It shows how, under certain assumptions, trading can lower emissions and “abatement costs” - the cost ships pay to reduce one tonne of GHG. Understanding these abatement costs is key to evaluating the financial feasibility of meeting the IMO’s decarbonization goals.

As shown by the figure, without trading:

• Vessel 1 uses only fossil fuels and is forced to pay for remedial units, here set at the purely illustrative cost of $300 USD each.
  

• Vessel 2 blends in biofuel to meet compliance but faces a high cost due to limited availability of this fuel.
  

• Vessel 3 is a dual-fuel vessel that has access to e-fuels. Without trading, the dual-fuel vessel only uses enough to meet the limit, here set at 70 tCOeq/mil MJ (we converted from the more familiar “gCOeq/MJ” to alleviate some of the mental math).
  
  

With trading:

• Vessel 1 and 2 can both lower their costs of compliance by purchasing comparatively cheaper surplus units (SU) from vessel 3, the dual-fuel vessel.
  

• In response, vessel 3 increases the amount of e-fuel it uses over the year. We assume here that e-fuel has scaled to the point where supply is less constrained and surplus volumes can be bunkered.
  

The example shows how trading can spread the benefits of low abatement cost across a fleet and incentivize companies with access to sustainable fuels to use more of it.

Our example aligns with the findings of the Comprehensive Impact Assessment (CIA) of the MTMs on the global fleet, prepared by DNV. Their report shows that flexibility can reduce the total cost per tonne of GHG reduction from 2023 to 2050 by roughly 6%. It notes that flexibility can support ships that are unable to use or access sustainable fuels by allowing them to purchase surplus units from ships more readily able to use them.

For simplicity, in our example we considered a GFS with flexibility in isolation. However, the proposals under discussion suggest combining a GFS with GHG pricing. Adding a price on each unit of GHG or rewarding sustainable marine fuels through a “feebate” would further incentivize emission reductions and could support a just & equitable transition. We will explore this critical topic in future editions of Countdown.

While flexible compliance for a fuel standard on a global level would be novel, many of its potential features are already being tested by FuelEU Maritime. Here are some of the advantages of flexibility that we highlighted in our Countdown to FuelEU series — as well as some of the challenges that could be addressed through thoughtful policy design.

• Flexibility creates incentives to use sustainable fuels through the trading mechanism called ‘pooling’. Our analysis showed that FuelEU pooling can create a business case for dual-fuel vessels sailing to the EU.

• A high cost for noncompliance is a strong incentive to use sustainable marine fuels and technologies. The cost of remedial units, or ‘penalties’ in FuelEU, is over $700 USD per tonne of GHG for HFO. This is close to three times the abatement cost of blending biofuel at $250 USD (based on 2024 Rotterdam delivered prices). The penalty is also higher than the abatement cost of some advanced sustainable fuels.

• Decentralized pooling is complex – and may lead to inefficiencies. FuelEU relies on companies setting up their own pooling arrangements without a centralized marketplace for buying and selling surplus units. This creates flexibility in how companies exchange surplus but makes it difficult for buyers and sellers to find each other, leading to less-than-optimal pricing of surplus units. For example, a small pool populated mostly by companies that urgently need surplus would result in higher prices than an open market.

• Arranging pools comes with significant transaction costs including legal, financial, and operational costs that can be a burden, especially for smaller firms.

Companies need a degree of predictability around future costs and revenues to invest confidently. Early feedback from stakeholders indicates bilateral trading arrangements in the FuelEU may lead to more volatile pricing due to uncertainties regarding the legal and financial framework.

Looking ahead to the IMO, Member States should consider a centralized platform that creates an open market for companies to buy and sell surplus credits. This may address some of the challenges seen in FuelEU pooling and thereby lower transaction costs and create certainty that drives uptake of sustainable fuels. This could work alongside the ability for ships to trade within fleets or bilaterally.

In addition to considering the effects of trading in FuelEU, IMO Member States can build on evidence and know-how from existing national and subnational policy in designing an effective GFS. The figure below summarizes how trading has been incorporated into fuel standards in the US, the Netherlands, and Brazil. Member States can build on evidence from these countries and others to create flexible compliance mechanisms that reward ships which go beyond GFS targets, reducing overall compliance costs, accelerating uptake, and rewarding innovation.

As with any policy, there can be trade-offs from including trading as part of flexible compliance.

One concern may be that trading can create geographic differences in uptake, and potentially concentrate emissions in specific regions. Fortunately, the impact on air quality from fuel choice is expected to be minimal due to existing limits as well as expected pollutants from alternative fuels. Nevertheless, monitoring will be important as new fuels become more widespread.

Trading might also reduce remedial unit payments that otherwise would be recycled to Member States facing urgent challenges from climate change and potentially disproportionate costs from the MTMs. That should be balanced against the benefits of reducing the overall costs of the transition and driving the adoption of sustainable fuels. Lowering the cost of the transition can help smaller firms that lack access to sustainable fuels and technologies and countries that pay comparatively more for shipping. Finally, sustainable fuel production can benefit countries with the lowest cost of production, which could enable industrial development in emerging markets and lower-income countries. We’ll turn to the critical topic of shipping costs and the impact of the transition in greater depth in a future newsletter.

As Member States engage in critical IMO negotiations, they should consider flexibility as part of the discussions of a GFS. Our analysis indicates that incorporating trading into a GFS framework can drive a cost-effective transition to sustainable marine fuels, while expanding access to the decarbonization benefits of these fuels to more ships across the global fleet.

• Watch the recording of our recent IMO MTM webinar, featuring a conversation between ISWG-GHG Chair Sveinung Oftedal and our CEO, Bo Cerup-Simonsen and high-level panel discussion amongst industry veterans from across the value chain.

• Watch the recording of our FuelEU webinar, including presentations from the Center and European Union officials on how to leverage FuelEU to decarbonize.

• Evaluate regulatory impact on fuel cost gaps: Game out the cost gap between a range of sustainable and fossil fuels with our Fuel Cost Calculator to check if proposed regulations can bridge the gap.