Industry Insight: Financing the Cost of ECA Compliance

Thursday June 26, 2014

Stricter regulations for vessel emissions coming into effect on January 1, 2015 will mean increased operational costs for all vessels operating within the Emission Control Areas (ECAs) of North America and Europe.

The new rules state that all vessels operating inside the ECA zones must use a marine fuel that has a maximum sulfur content of 0.10 percent by weight. In order to comply, ship owners that want to avoid having to switch to a more expensive lower-sulfur fuel must instead carry the upfront cost of investing in technology that provides an equivalent method of compliance.

Ship & Bunker recently spoke to Pace Ralli, the co-founder of Clean Marine Energy (CME), a new company that says it offers fresh thinking for ship owners to finance and manage their ECA compliance costs.

S&B: Why does the industry need Clean Marine Energy?

PR: Essentially, ship owners have three options to comply with with the 2015 ECA rules:

  1. Do nothing and switch to more expensive low sulfur fuel such as Marine Gas Oil (MGO);
  2. Invest in a liquified natural gas (LNG) conversion; or
  3. Invest in an exhaust scrubber system.

There have been a portion of ship owners, primarily in Europe, that have moved towards installing abatement technology, or a "scrubber", which "cleans" the sulfur from the exhaust gases of shipping's traditional fuel, Heavy Fuel Oil (HFO), while in North America conversion to using LNG is a more prominent option, given lower natural gas prices.

However, despite the imminent deadline, many ship owners are playing a game of "wait and see" before they make an investment decision. Many are waiting to see how the LNG supply infrastructure will build out, while the majority of ship owners will try to absorb the higher cost of paying for compliant distillate fuel, and assess how their competitors move so as not to lose competitive advantage.

This uncertainty and potential loss of competitive advantage is why CME has been established - to support ship owners by providing the upfront capital for converting their vessel to run on LNG or with a scrubber.

S&B: How does your financing proposition work?

PR: Under an Emission Control Service Agreement (ECSA) provided by CME, the ship owners (or other fuel payer, including charterers) agree to pay for what would have been burned on the vessel, the higher-cost distillate fuel, while the differential between the high-cost fuel price and the lower fuel cost of burning LNG or HFO (with scrubbing) enables the technology to be paid for by CME.

With CME providing the capital for a ship owner to convert, that ship owner will not have the additional financing on their balance sheet, enabling them to use their capital for other more customary, accretive investments.

This solution was initially developed for ships belonging to our affiliate company, Mid Ocean Marine in the US. Together we developed a solution to tackle the financial challenges of ship conversion. As such, the ECSA is a solution designed by ship owners for ship owners. We have taken the model that worked for us and made it available to the broader market.

Most importantly, by providing the upfront capital, CME shifts the performance risk of LNG conversion or scrubber installation from the ship owner on to the fund. Our mission is to significantly lower the barriers to ship owners taking action in face of increasing regulation. Not every ship owner will need CME, but we aim to help the early movers in the industry.

S&B: Can you explain more about how you see the differing suitability of LNG conversions and scrubbers for ship owners in North America and Europe?

PR: The value proposition of LNG is really clear in North America. With the abundance of cheap natural gas and the regulatory drivers of the ECA, ship-owners have real, immediate incentives to find a way to convert their vessels to run on LNG.

When a ship owner is making the decision between building a new ship or converting their existing assets, there are a few things to consider. The US, for example, is a special case because of the Jones Act, which stipulates that all vessels operating in territorial waters be built within the United States.

It is much more expensive to build in the US because of the limited shipyard capacity and the cost of US labour. In the US, higher replacement costs dictate that asset lives are much longer; in many cases it is more economical to convert an existing vessel than to replace that vessel with a newbuild. Whereas an owner of an international fleet may look to replace the vessel with a newbuild because it is more economical to build.

There are several challenges to converting a vessel. First of all, the supply and distribution infrastructure is in early stages of development and the rules and regulations around delivering LNG are still being finalised.  Although it is cheaper than building a new ship, it is still very expensive to convert your vessel. The up-front capital necessary to proceed with a conversion can be a barrier for many ship owners and it is that barrier that CME is aiming to eliminate.

LNG in Europe is more expensive than in the US, therefore the value proposition is different and payback times are slower - 5-12 years compared to 2-7 years in the US. Conversely, the payback for a scrubber installation for a ship owner operating 100% within an ECA in Europe could be as little as 2-5 years. Therefore, we see more traction with scrubber installations for ships operating within the Northern European ECA.

Ship owners in both regions are equally challenged and concerned with capital resource efficiency; while they may have access to ample capital, it is their fiduciary duty to use that capital for the most accretive projects possible. Therefore, other projects for quicker paybacks will be competing for that capital, and ship owners will be more likely to invest in more customary, revenue-producing projects (versus ones for just ECA compliance). Indeed, there is also a strong rationale for short payback that enables the ship owners or fuel payer to reap 100% of the benefit of burning lower cost LNG or HFO sooner rather than later, providing a competitive advantage over competitors, increasing the vessel asset value and commanding higher charter rates.

S&B: Using LNG as a marine fuel is still a very new concept. From your perspective, what are the latest developments for LNG bunkers in North America?

PR: Export facilities: CME is supportive of the establishment of LNG export facilities because we believe they are going to be an integral part of the infrastructure that is needed to distribute the gas domestically. However we are focused on distributing our gas to vessels in US ports meaning we do not need an export permit. We are not focusing on that now.

The development of those export facilities are important to us for a few different reasons:

Mainly, it is to do with the regulations around LNG, more specifically the transfer of LNG, ship-to-ship transfer and land-to-ship transfer. These are issues that are being dealt with by the export facilities and therefore they are helping the regulatory environment evolve.

Secondly, these export facilities are going to be very important because of their excess yield. Meaning that they are going to have LNG that they will not be able to export and they are going to look to market domestically. CME plans to partner with the export facilities to help them sell their excess yield gas. There are currently four approved export facilities in the US, but many more in the queue, and several lined up in Canada.

Small-scale liquefaction plants: We believe small and mid-scale liquefaction plants will eventually be the foundation of infrastructure for marine fueling in the US. It is going to be a combination of these small-scale plants that will be scattered throughout the strategic ports. There are several projects developing in ports around the US to distribute natural gas from those small-scale liquefaction plants, from 100,000 gallons to 500,000 gallons per day.

CME is assisting ship owners in strategic ports across the US; from the Gulf, northeast, Mississippi River, Great Lakes to the west coast. All those ports have ship-owners that are considering conversion and we are offering our financing to help accelerate the emergence of LNG in those markets. We will be partnering with the best-in-class operators from a supply and distribution standpoint in each of those ports, to guarantee supply and delivery to converted vessels. We've seen over 20 small-scale projects that are being planned and permitted for LNG supply, and know of at least 12 companies that are offering the logistics of LNG delivery.

S&B: You said scrubbers were currently looking more attractive for European ship owners, but there has also been heavy funding for LNG bunkering infrastructure development there. What are the latest developments?

PR: While our immediate focus in Europe is centered around scrubbing, CME is also working with partners to provide solutions that support the conversion of vessels operating in European ECAs to LNG, as well as looking at how CME can support the building of LNG infrastructure in Europe.

While there are an estimated 3,000 vessels operating in European ECAs for at least 60% of their operations, around only 100 scrubber units have been sold, with first movers primarily being the European ferry market. Ferries are generally owned and operated by companies paying for their own bunker fuel and therefore will feel the pain of higher fuel costs initiated by the 2015 ECAs directly. Other vessel types largely operating in ECAs include short sea tankers, container feeder vessels, smaller cruise vessels. Some transatlantic Ro-Ro vessel owners may also be considering conversion given the time they will spend in North American and European ECAs.

CME has partnered with PricewaterhouseCoopers and maritime law firm Norton Rose Fulbright in Europe to provide a comprehensive support network or finance, project management, contractual and legal counsel for ship owners installing scrubber and entering into an ECSA with CME.

S&B: Why wouldn't ship owners just pay for the scrubber or LNG conversion themselves?

PR: We enable vessels to be converted now, at no cost to the ship owners, in exchange for a portion of the future fuel cost savings. This allows the fuel payer to instead use their own capital for other more customary, accretive or revenue producing investments. While a ship owner may have sufficient access to capital, our bespoke solutions helps ship owners with capital resource efficiency, using a classic capex to opex model, and is designed to fit any ship within the parameters of any timeframe to minimize the cost of conversion. As previously mentioned, this provides the ship owners or fuel payer with several advantages, including having no additional debt on the balance sheet, a competitive advantage over competitors, increasing the vessel asset value and the ability to command higher charter rates.

S&B: How do you see LNG developing as a marine fuel?

PR:  There are so many factors that will determine how quickly LNG is adopted for marine fuelling, such as commodity price, supply infrastructure, global economy, financial positions of ship owners, and technology evolution; forecasting the global fleet would therefore be overstating our ability to see into the future. While we cannot predict how quickly it will happen, we can bet that it will happen.

One thing you cannot stop is evolution, and natural gas is indisputably the next natural step in the future of low-emissions fuelling - not just for shipping but many forms of high horsepower applications. Any ship built between now and 2020 will be at least considered for dual-fuel, and we would be willing to bet that in 2020 the number of LNG fuelled ships will be at least an order of magnitude greater than the number of LNG fuelled vessels in the global fleet today.

A recent simulation model established by DNV GL revealed that between 10 and 15 per cent of the new buildings delivered up to 2020 will have the capacity for burning LNG as fuel. This equates to about 1,000 ships. Larger vessels will benefit more from using LNG than smaller vessels.

Furthermore, a gas-fueled engine can be justified if a ship spends about 30 per cent of its sailing time in ECAs. In 2020, the number of ships using LNG will increase significantly with the introduction of a global sulfur limit, which is mainly where CME has it focus. For scrubbing the opportunity, and therefore the need for finance that does not burden the shipping industry, is equally significant.

A recent report from FGE, Outlook for Marine Bunkers and Fuel Oil to 2035 Study concluded: "Around $25bn is projected to be invested in on-board scrubbing facilities over the next 15 years, as the post-ECA environment should establish the economic viability of this technology". CME's goal is to install scrubber technology on 50 ships and convert another 50 ships to LNG.

S&B: Just how important of a role do you think LNG and scrubbing technology will have for ship owners in the future?

PR: We see LNG and scrubbing as a large and important part of the marine fuelling future. Where CME is really going to add value to the market is to bring that future closer, meaning we are going to help to more rapidly convert ship owners' fleets to run on LNG and install scrubbers. It is going to take time but we can bring it more quickly to the forefront by using innovative financing solutions to accelerate cost-effective ways of reducing emissions. Ship owners have a window of opportunity to act as early movers and lead the shipping industry into the next era of low-emissions shipping. Our focus is to assist these early movers and our vision is to be a leader in ECA compliance financing, to provide the most value to ship owners during this challenging, yet exciting time.