Countdown: RU ready? Analyzing the cost of non-compliance

In this fourth edition of the newsletter, we examine the cost a vessel should pay for exceeding targets set by a Goal-Based Fuel Standard (GFS). We first highlight the importance of strong incentives to create a viable business case for adopting sustainable alternatives. Then we use our Integrated Assessment Model, NavigaTE, to estimate the minimum value of the so-called ‘Remedial Unit’ needed to meet the 2023 IMO GHG Strategy.

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GHG intensity targets determine the ambition level while Remedial Units enable the transition

The GHG reduction pathway can be viewed as the level of ambition, determining the speed of the transition. A steeper reduction pathway motivates companies to adopt a greater share of sustainable energy sources sooner. The RU can be viewed as an incentive that drives uptake of sustainable marine fuels and energy, which are significantly more expensive than fossil fuels.

For this incentive to be effective, the cost of RUs must be greater than the cost gap between sustainable and fossil fuels. If the RU cost is set lower than this gap, then regardless of how ambitious the GHG reduction pathway is, companies will continue using fossil fuels and simply pay-to-pollute.

A sufficiently high RU would create the business case for replacing a portion of fossil fuels with sustainable alternatives. Or in the case where trading compliance is allowed – a business case for a portion of the global fleet to fully operate on sustainable energy.

Here, we focus on the need for a sufficiently high RU. We turn to the question of the reduction pathway in our next edition.

The RU determines if the transition is cost-efficient

If the RU is set below the cost gap, companies will pay-to-pollute on a limited portion of their emissions. In this case, a levy on the full scope of emissions would create stronger incentives while also generating funds to support a just and equitable transition, as called for in the IMO Strategy.

In simple terms, a GFS with a low RU would function as a price on a limited portion of emissions which generates less revenue than a levy and lacks needed incentives to adopt sustainable energy in the critical early years.

However, the fact that the GFS coverage applies to a limited portion of emissions also creates an opportunity: the RU can be set high enough to drive the adoption of sustainable energy without imposing prohibitively high costs on the industry. The limited emissions coverage, therefore, could make a higher RU more politically acceptable, and therefore, more likely to last.

Another consideration is the interaction between a GFS and a levy. The combination of a GFS and a levy, paired with rewards for sustainable fuels, will influence the required RU level—an interaction not modeled here.

To estimate the RU value needed, we created a high fuel availability scenario. In this scenario, shipping gets a disproportionate share of the global fuel availability which can be viewed as a consequence of shipping having a higher willingness-to-pay than other industries due to the IMO regulations. This allows us to isolate the impact of the RU cost on the industry’s ability to meet the indicative checkpoints in the IMO Strategy.

NavigaTE is a complex simulation model which considers more than simply closing the cost-gap between fuels. For example, it predicts decisions made by ship owners/operators and fuel producers regarding investment decisions. By doing so, we model not only cost of fuels but also the pace at which alternative fuel production can be ramped up and the long-term lock-in consequences of investments made in the early years of the transition (e.g., continued investment in fuel oil vessels or fuel offtake agreements). The RU value impacts these investment decisions, including when and how fast the global fleet transitions to dual fuel vessels.

The cost gap for all pathways must be closed to avoid delaying the transition

If the RU is set only high enough to close the cost gap for the cheapest sustainable option, such as biodiesel, early adoption will be limited to near-term solutions that are likely to face constraints. Limiting the RU would therefore risk postponing early adoption of less mature but scalable alternatives, such as green methanol or green ammonia.

We see a similar dynamic in the auto sector where subsidies designed to promote the use of crop-based ethanol undermine incentives for more scalable, lower-emission electric vehicles. When only the cheapest sustainable energy can succeed, we risk losing the opportunity to invest in more advanced and scalable sustainable alternatives.

Therefore, the RU should be set high enough so that all sustainable pathways are enabled from the beginning to achieve benefits of early adoption and reduce the risk of delaying the transition.

The ‘Goldilocks’ RU: the “just right” level avoids unnecessary costs

If the fuel market was static, it would be simple to calculate the cost of fuels and set an RU cost which closes the cost gap. But fuel markets are not strictly based on production costs – they are governed by market dynamics of supply and demand. The RU level is part of these dynamics.

As shown in the figure, if the RU is set high enough so that the cost of using fossil fuels plus paying for RUs exceeds the cost of sustainable alternatives, sustainable energy producers may have room to add a premium to their prices and pocket the surplus.

We would expect this scenario if demand for sustainable energy is relatively insensitive to price changes (or ‘inelastic’). This could occur because of high demand for sustainable alternatives driven by ambitious GHG targets and a limited supply.

NavigaTE does not consider market prices and thus we do not provide an upper limit for what the RU price should be. However, to limit the risk of an inflationary effect from inelastic demand, it’s critical that the RU be high enough to drive uptake of sustainable energy, but not set arbitrarily high.

To manage this balance, Member States could consider regular reevaluation of the RU to adjust to changing market conditions.

A sufficiently high RU can create the needed incentive to drive offtake agreements

Investing in sustainable energy production requires significant upfront capital for facilities with long asset lifetimes. Without offtake agreements to guarantee revenue, developers cannot secure needed capital. At the same time, operators cannot commit to high-priced agreements without closing the cost gap with fossil fuels.

An RU that is high enough to close the cost gap can ensure a clear financial incentive that provides the confidence needed for operators and developers to enter into offtake agreements.

While we expect later generations of fuel production to see lower costs due to economies of scale and learning rates, the RU should remain high through 2050. This is because the fuel costs for first mover facilities are expected to be largely locked in from the beginning. Therefore, an RU of at least 450 USD per tonne of GHGs for the full timeline of the transition allows companies and operators to provide offtake guarantees without risking that a lower RU in the future will make fixed prices uncompetitive.

Setting and maintaining a sufficiently high RU is critical to enabling large-scale offtake agreements and incentivizing investment in sustainable energy. By providing the confidence needed for investment, the RU serves as a foundational element to achieve the IMO Strategy.

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