Managing FuelEU Opportunities in the LNG Sector

As the first FuelEU Maritime¹ (FuelEU) reporting period draws to a close, market uncertainty remains across the sectors over which party should be entitled to manage FuelEU compliance balances under time charters and how this translates into the FuelEU pooling landscape. Building on our previous article², this article highlights the key issues and explores strategies that LNG operators can develop to mitigate risk and potentially monetise the compliance benefits available.

LNG’s Treatment under FuelEU

FuelEU seeks to encourage the transition from fossil to lower-carbon fuels by imposing greenhouse gas (GHG) intensity limits on fuels used onboard ships on voyages to / from the EU and during time spent at EU ports. Under-compliance against GHG intensity limits (Deficit) risks financial cost (a FuelEU Penalty) unless neutralised through FuelEU flexibility mechanisms such as borrowing, banking and pooling that can be used to achieve compliance, even if a vessel has generated a Deficit.

In the short term, LNG is a less GHG intense fuel, and, for LNG Carriers, fossil LNG boil off can generate over-compliance (Surplus) depending on main engine type, methane slip and liquid fuel consumption. As the GHG intensity limit becomes stricter every 5 years, fuels which are initially compliant may become non-compliant. Care must therefore be taken in long term charters which stretch beyond 2035 because, as the GHG intensity limit tightens, Surplus may transform into Deficit.

FuelEU Strategy Implications

FuelEU is more than a simple compliance question or liability to dispute along the contractual chain; it provides flexibility for risk management and cost minimisation across fleets. Net compliance can offer revenue generation opportunities, making effective risk management and a clear FuelEU strategy essential, especially where companies operate in different sectors.

The first step for an LNG operator is to assess whether their LNG fleets operate on long term (more than 5 years) and short term (less than 5 years) charters and across multiple sectors.

Given fossil LNG’s treatment in the first 5 years, FuelEU Penalties are unlikely to apply; instead, vessels will probably generate a Surplus, which can be used to generate revenue through pooling and also presents long-term fleet planning opportunities for achieving fleet-wide compliance at minimal cost.

The exposure to FuelEU Penalties after 2030 means LNG operators may consider long term risk mitigation steps including:

• banking Surplus from LNG vessels between 2025 to 2030 (or later if they remain compliant) for use beyond 2030, when the fleet is non-compliant (n.b. it is possible to pool with a second vessel and bank to the second vessel’s compliance balance);
• generating Surplus onboard vessels through methods other than fossil LNG consumption from chartered vessels and using that vessel to reduce the Deficit of other vessels in the fleet; and / or
• securing access to Surplus generated onboard third-party vessels, i.e. through pooling.

To benefit from the options above, an LNG operator must control the vessel’s compliance balance, and have authority to instruct the vessel’s compliance entity to record actions and compliance balance details in the FuelEU Database. Typically, a chain of contractual obligations from operator to shipowner to ship manager secures this outcome for LNG operators, but there are further contractual options which may provide additional comfort.

Surplus Anchor Vessels

As identified above, one approach to risk mitigation across a fleet of vessels is to use a single over-compliant vessel as an anchor vessel which can be pooled with the under-compliant vessels in the fleet to generate a net Surplus (Surplus Anchor Vessels). 

Prior to 2030, for LNG operators operating cross-sector, LNG carriers can be Surplus Anchor Vessels.

After 2030 or 2035, consumption of fossil LNG is unlikely to create Surplus Anchor Vessels and these could be created in the LNG sector by:

• ordering newbuild dual-fuel LNG vessels capable of consuming Renewable Fuels of Non-Biological Origin (RFNBOs) that will generate significant Surplus; or
• supplying lower carbon fuels (i.e. biofuels and biomethane) to existing LNG Carriers to generate additional Surplus, if both possible and economical.

Subject to engine compatibility and availability, liquid biofuels can be deployed on existing vessels, making them potentially the most cost-effective mid-term solution. However, FuelEU sets out criteria for “sustainable” bunker stems, and those that don’t meet all requirements will be treated equivalent to the least favourable fossil fuel for that fuel type, generating zero benefit under FuelEU. 

Revenue Generation or Deficit Mitigation through Pooling

Pooling is a cost-effective way to reduce Deficit compared to paying the FuelEU Penalty. Charterers with control of a Surplus Anchor Vessel can change their FuelEU compliance profiles, reducing fleet-wide exposure to FuelEU Penalties and / or potentially generating additional revenue by selling Surplus to third parties. Pricing Surplus is a key factor though and there is currently no market benchmark, but it will only be a matter of time before this happens.

Regulatory requirements for pooling

Article 21 of FuelEU outlines limited regulatory requirements for pooling:

• each year a vessel can only be allocated to one pool.
• each pool must have a single pool verifier.
• the total pooled compliance balance for the pool must be positive, although individual vessels can exit the pool with a Deficit so long as they have reduced their Deficit through pooling.
• no vessels in the pool can borrow in the reporting period.
• pooling outcomes need to be registered in the FuelEU Database by the applicable compliance entity – i.e. intention to pool, allocated compliance balance, pool verifier etc.
• the pool verifier must verify the pooled compliance balances and register this in the FuelEU Database.

This leaves considerable flexibility for pooling contract terms and parties eligible to participate. Aside from registration of the required details, the compliance entity does not need to be involved in the commercial arrangements for pooling.

Pooling Arrangements

For any operator, securing intra-group compliance and minimising group compliance costs should be the primary objective. Surplus Anchor Vessels can mitigate costs across LNG fleets by establishing internal pooling arrangements where Surplus Anchor Vessels transfer Surplus to reduce or eliminate other vessels’ Deficit. These arrangements depend on fleet performance and require relevant compliance entities to pool selected vessels.

If operators generate sufficient Surplus within the LNG fleet, they can add a profit generation function to the pooling arrangement, selling Surplus to third parties.

In the short term, this internal pooling is less relevant for LNG fleets expected to generate a fleet-wide Surplus, with charterers instead focussing on profit generation.

Various types of arrangements are available on the market for sellers of Surplus, including simple bilateral sale and purchase contracts for Surplus, or sales through third parties, either brokers or platforms offering to pool large numbers of entities. 

Individual LNG charterers may be uniquely placed to sell Surplus direct to Deficit customers:

• a stable and predictable supply of Surplus may exist if fleet vessels regularly trade within the EU; and
• a ready customer base of Surplus buyers may exist where shipowners operate in sectors less likely to generate Surplus.

Alternatively, transactions can be facilitated via third parties, typically arranged via external brokers using a ‘match-making’ platform to connect Surplus and Deficit vessels. There is a developing market for FuelEU pooling services and the exact contractual arrangements and levels of risk would depend on the terms of the chosen pool.

Summary

Pre-planning is essential to stay ahead in the new FuelEU marketplace. Operators of LNG vessels should take advantage of this by becoming match ready now because first movers generate rewards. However, this requires putting in place a robust contractual framework which, at the same time, earmarks potential risks and exposures arising out of the FuelEU landscape. At HFW, we have experience of setting up or facilitating all types of pooling arrangements and pooling going concerns. Whilst these tend to vary depending on commercial set-ups and preferences, pragmatic and tailor-made solutions are always achievable. So please feel free to contact the authors below if you would like to learn more about this.

Footnotes:

1. Regulation (EU) 2023/1805 of the European Parliament and of the Council of 13 September 2023 on the use of renewable and low-carbon fuels in maritime transport, and amending Directive 2009/16/EC.
2. What will FuelEU mean for the LNG sector? | HFW