CII : The New Pandora Box?
As we embark on 2023, the most anticipated (or not?) regulation that impacts shipping will be the Carbon Intensity Indicator (CII) via amendments to MARPOL Annex VI. The first annual reporting will be completed in 2023, with initial CII ratings given in 2024. Even before the end of 2022, we had observed several shipping interest groups coming out and questioning the effectiveness of such a formula. Whether such a well-intentioned but ill-conceived ‘mathematical prescription’ could achieve its ambition of significant carbon emissions reduction without factoring real-world challenges and responses? Would the road to carbon-neutral heaven lead us to a new Pandora’s Box, opening a can of commercial, legal, operational, and financial heartaches and heartburns? Even having an open discussion on the potential repercussions of this policy is unchartered territory. Hence, kindly understand if errors or omissions, if any, are made later in this topic. It’s a steep learning curve for all!
As a recap, the International Maritime Organization (IMO) has the target to reduce greenhouse gas emissions (GHG) to 50% by 2050 as compared to 2008 levels with the CII being lauded by policymakers as providing “important building blocks for IMO's future mid-term greenhouse gas reduction measures”.
According to the IMO, based on a ship’s CII, it will be rated A, B, C, D or E which represent the range of performance levels with A being superior and E being Inferior. The performance level will be recorded in a "Statement of Compliance" to be further elaborated in the ship's Ship Energy Efficiency Management Plan (SEEMP). A ship rated D for three consecutive years, or E for one year, will have to submit a corrective action plan to show how the required index of C or above will be achieved.
Commercial & Operational Pain Points?
The CII formula is basically the product of “Full Voyage Fuel Burned and Carbon Factor (depending on fuel type used)” divided by the product of “Summer Deadweight Ton (DWT) and Full Distance (both ballast and laden)”. The result is to calculate the amount of CO2 (grams) emitted per DWTnautical mile aka carbon intensity. At first glance, sharp eyes can immediately realize the counter-intuitive nature of this calculation’s denominator.
Firstly, deadweight ton is used in favor of cargo intake which meant there is no incentive for a vessel to take the additional effort to optimizes her operations to increase cargo intake or seek a larger parcel size since the vessel is basically treated as always fully laden for sake of calculation. In fact, ships might get penalized in their CII rating for loading more as they spent more time in port (which increased idle fuel consumption) and exposed to risks of longer port delays (stevedore damage/port strikes/bad weather etc).
Secondly, ballast legs, a proxy of fleet unproductivity, are not punished as it is included in the denominator that artificially lowers carbon intensity. Since ballast legs consume less fuel than laden legs and hence emit less emissions, this creates an incentive to ‘game’ the system to achieve a compliance rating near the end of the calendar year. Departing from its last discharge port, a non-compliant ‘D’ or ‘E’ rated ship can opt to load a further distanced cargo instead of a nearby one as the longer ballast distance in the former choice will be mathematically favored. Under this scenario, this could lead to a sub-optimal distribution of ships worldwide to meet transportation demand, increasing costs and time, a proposition that seems ill-timed when the global economic outlook is frosty. Hence, it can be argued that one of the likely outcomes might be a multi-tier market whereby less efficient ships will pivot towards long voyages, emitting more, while more efficient ships ply the shorter trades.
Looking at the numerator of the CII formula also poses considerable eyebrow-raising concerns. By design, the CII assumes that shipowner and/or the ship crew had full/near autonomy on every important element that can dictate on fuel consumption throughout the entirety of the voyage (ballast leg > load port waiting/operations > laden leg > disport waiting/operations) which obviously departs from operating realities. Adverse seagoing/faring conditions (typhoons, currents, piracy/military attacks etc), change in trade patterns (geopolitics, supply chain diversification, arbitrage trading strategies etc), port and canal congestion (3rd party bottlenecks, labor strikes, government mandates etc) and charterers orders (ability to direct ships to a wide redelivery range, Singapore to Japan etc).
Imagine if the CII had been implemented first during 2021. We had dry bulk ships laden with Australian coal were first denied entry to Chinese ports, followed by mandatory quarantine measures for port calls/crew changes in various major ports and finally unprecedented congestion in Chinese ports in Q3-21. It will not be a far stretch to assume that even the most eco-speed, technologically advanced ship would be a poor CII performer. In this alternate reality, would the IMO have to issue a blanket exemption to avoid this administrative headache as dry bulk owners appeal to ‘force majeure’?
In a recent presentation by a leading dry bulk operator, a ‘solution’ was mooted to avoid a ship’s CII rating being penalized by unnecessary long port idle time. The idea is once a ‘Notice of Readiness (NOR)’ is tendered, both owners and charterers would agree to allow the ship to start steaming in circles outside anchorage . Putting aside the ironic fact that this would generate more emissions (and costs), other operational issues could arise. When a vessel tenders its NOR upon arrival, it has a due diligence/obligation with regards to its seaworthiness, ‘tight and fit for the purpose or employment’, ready at the charterer’s disposal. What if the vessel post NOR tender and acceptance, starts steaming outside the ‘customary waiting areas’ and its “Readiness” status was comprised due to……unforeseen circumstances during said period. In this case, when it comes to laytime or hire calculation, who should bear the loss of time for the ship to regain its “Readiness” status? Not to mention, when a vessel is idling, it gives time for the crew to engage in crucial non-seafaring activities such as bunkering, supplies restocking, maintenance, cleaning, and general upkeep of the hull, rigging and equipment of a ship.
Bunkers specifications (conventional or non-conventional) would be of vital importance in calculating the carbon emissions. However, if ships receive off-specs fuel, that will obviously cause a great departure between the theoretical and actual amount of emissions. In this situation, should a ship retrospectively receive a CII re-rating during its incumbent trading year? If an owner is successful in its claim against the bunker supplier, that would in turn jeopardize its initial pristine CII rating? Do owners have to prove to the enforcement agent that they have done everything it could to mitigate the problem once it arises?
Policy & Legal Hurdles?
For any policy/law/regulation to be effective, we need to ensure there will be strict and fair enforcement and clear penalties for non-compliance. Otherwise, it will amount to a ‘paper tiger’. Usually, these are done by the Port State Control and Flag States. As of writing, there’s still reservation whether these entities have the adequate personnel and expertise to facilitate this new change. Would there be an uneven playing field for shipowners across different trading geographies? Moreover, a ship that obtained 2 consecutive years of ‘D’ rating, could strive for a ‘C’ rating in the 3rd year (via ‘gaming’ the system). Then it would avoid the ‘3 consecutive years ‘D’ rating’ condition for corrective action plan. The vessel could go on to trade in the 4th and 5th year at ‘D’ rating again. Rinse and repeat the same game plan on the 6th year. Similar concerns for a vessel who obtained an ‘E’ rating. Ship managers will be obliged to prepare a corrective action plan as part of an updated SEEMP III, have it approved and then implement it. If lightning strikes twice, and the vessel get a second consecutive E rating, the legal consequence is to repeat the corrective action plan, no further ramifications as mentioned by a DNV analyst.
While the IMO had commendably voiced out to governments, port authorities and other stakeholders to provide incentives to vessels rated as ‘A’ or ‘B’, the exact details and scope of such incentives remained elusive or vaguely defined.
When it comes to charterparties concerns, after a year-long attempt, BIMCO had released its own CII timecharter clause. However, it was evident that neither owners nor charterers are mutually satisfied. A quick look suggests that the main burden of the CII is assigned to the charterers, whereby owners have the right under subclause (g) (i,ii,iii) to intervene with voyage planning which contravene traditional commercial rights of the charterer to commercially direct the ship. In addition, vague wording(s) like ‘advance warning’, ‘reasonable likelihood’, ‘reasonably show’ used to determine and allocate the obligations, will no doubt generate vastly differing views on what constitute ‘reasonable’ or ‘acceptable’ until precedence had been established as per common law.
In the shipping industry, we still witness daily disputes regarding Bill of ladings and laytime despite relevant laws and case studies being in existence and refined over the past century. It seems reasonable to expect that a newly drafted clause is just the first step of a long and winding marathon. Practically speaking, perhaps commercial resolution might hinge on whether it’s a shipowners or charterers’ market? This is not a reproval of BIMCO who had the unenviable job to clause an inherently deficient legislation. This simply goes to demonstrate that the CII could unintentionally create a basket of non-exhaustive situations that were previously non-existent. For example, when doing period deals, the ideal situation for tonnage operators is to have charterparties done ‘back-to-back’. However, CII clauses drafted by various interest parties down the charterparty chain would obviously be in conflict. Would this circumstance lead to a slowing down of period fixing activity?
2023 Expectations?
Back in 2022, the consensus among shipping analysts was that dry bulk net fleet growth in 2023 should not exceed 2%. This was partly rooted in the belief that the CII should weed out any poor-performing ships. That belief assumes CII possesses strong potency as a policy tool. Looking at the above analysis, clearly it is not the case. Hence, would we see a slower pace of demolition activity in 2023? With China now aiming to reopening, some shipowners might pause the demolition decision and see if they could catch another bonanza, if it materialized, by late 2023. On a side note, demolition capacity in Bangladesh and Pakistan are being compromised due to the inability to issue letters of credit for scrapped ships. In fact, the Baltic Exchange had approved the suspension of Bangladesh from its shipbreaking index. Then again, with the weakest start over the past 3 years, perhaps demolition in 2023 will be dictated by commercial sense than compliance purposes.
Meantime, others had opined that the CII will motivate slower steaming which will reduce transportation capacity and be a boon for freight prospects. The logic is straightforward. Fuel consumption and carbon emissions had a linear relationship. In contrast, the relationship between ship speed and consumption is exponential. More fuel is needed to increase from 5 to 6 knots than from 4 to 5 knots, and so on. So, slowing down ships reduces emissions exponentially. Entering 2023, in response to a faltering Q4-22 demand, the average dry bulk vessel speed had already plunged to an all-time low (see chart on page 3) according to AXS data.
Hence, we believe any further downside to the fleet’s speed, if any, due to CII should be limited, by extension, influencing dry bulk freight prospects. Some also suggested that reduced port congestion would offset the benefits of any…
…incremental decrease in vessel’s average speed. That said, we believe that CII will be a crucial factor in heightening freight volatility during periods of strong demand. Typically, when demand is significant, ships will increase their laden speed to complete their current voyage and capitalize on expected freight increment. In 2023 and beyond, commercial incentives will now be substituted with compliance inertia. This will in turn raise supply inelasticity in a bullish, perfectly competitive market.
In conclusion, CII will prove to be a steep learning curve for both charterers and owners alike until customary commercial standards are established via a series of legal disputes and settlements. Meantime, each side of the charterparty, as rational economic actors, would obviously seek to interpret any loosely worded CII clause to their best interest. There might be a potential impact on period deals
Lastly, the IMO is to review CII by Jan-2026, so perhaps significant adjustments would need to be incorporated by then, so a different ball game might present itself to the shipping community.