The Green financing of aviation assets. Market Insight & Outlook.
If the transition to the green economy as measured by Net-Zero emissions, (but more likely to Zero emissions), requires costly decarbonization of aircraft, airlines and airport infrastructure, who will pay the cost (a) private capital, (b) the traveling public, (c) State, regional and city enterprises, (d) airside service providers, and how will competition policy change to enable funding support?
If airlines & lessors are to replace or retire aircraft powered by gas turbine engines (GTE) & replace them with Net-Zero engine (NZE) aircraft technology, then (a) where will the funding come from to pay for the replacemts, and (b) where will the retired aircraft go?
What if the OEMs cannot design aircraft that meet the CORSIA scheme emissions goals, what then is the outlook for financing new and used aircraft?
Where to start in finding answers to these questions.
A good place to start is to understand what the UN expects the air transportation industry to do.
The UN wants everyone to take action to combat "dangerous human interference in the climate system," and to do it in accordance the terms and timetables set out in the Paris Agreement and the ICAO CORSIA scheme, but the UN does not say who will pay for it!
Presume that the global economy for 2050 will be a binary scenario.
Why asset classes are relevant to climate change financing.
Which asset class has the best historical returns?
Agree on how mutch must be invested in aircraft?
Deciding what it will cost to finance the Net Zero transition.
Type of funding - two seperate pools are needed for aircraft financing, depending on which of the two climate change outlooks prevail!
Developing Country funding & aviation finance.
Agree on what airline, airport & infrastructure problem is being solved.
Why solve the problem? It offers Aviation a historic investment opportunity.
What will happen if the aircraft climate change problem is not solved?
What needs to happen to solve Aviation's climate change problem?
What role do aviation investors have solving climate change problems?
What funding tools are availabe to solve the problem?
Build networks that enable you to employ these tools for your airline!
Where to look and what to look for.
Lessors may have issues with some ICAO suggestions!
In all these cases, it is strongly recommended that climate change mitigation projects get expert advice and guidance when financing alternative assets such as airlines, aircraft, airports, MROs, aircraft lessors and after-market parts suppliers.
Retrenchment as a source of funds.
Transformation strategies in response to crisis.
Two financing pools are needed for aircraft, depending on one of two climate change outlooks!
Funding platforms & sources for aircraft & Net-Zero engine emissions technology.
Aircraft transaction parameters.
Interest rates & inflation can be priced into buying Net-Zero aircraft from existing data.
Regulatory oversight of Green financing.
Green Banks could fill some of the expected delivery funding needs.
Private Sector Finance.
Private equity funds industry sources - Green asset managers.
AIMA set up the Alternative Credit Council (ACC) to help firms focused in the private credit and direct lending space. The ACC currently represents over 220 members that manage US$450bn of private credit assets globally.
A AIMA and KPMG surrvey says: 1. 49% of hedge funds are adding to their traditional investment strategies with private markets or other new products or strategies.2. The Investor relations function within hedge funds continues to grow in prominence with one third of all respondents expanding their investor teams.3. 79% of respondents are moving to some form of permanent hybrid working, although many have reservations about their new models Product innovation, encouraged by investor demand, is a top-of-mind concern for many managers and is propelling many of these to offer new forms of tailored investor products and also to enter new investment arenas, specifically around private markets. Just under half (46%) of those surveyed predict hybrid hedge/private equity products to be the most popular in the next 12 months, with another 33% also pointing to private credit. Regulation was cited by 42% of respondents. The new operating model will introduce further considerations for compliance officers around people and data management in a decentralized working environment.Compliance headwinds are expected to increase globally: the pace of regulatory change is accelerating in the EU and UK as each side seeks to forge a new path post-Brexit. Firms increasingly move into new investment classes, be that digital assets or private markets; and supervisors are ever more focused on the operational resilience of the sector – a reaction to the market stresses of COVID-19 – as well as the validity of firms’ sustainability claims in an era of huge growth in environmental, social and governance (ESG) investing.Tom Kehoe, Global Head of Research and Communications, AIMA, said: “When we carried out the research for the annual report last year, the work focused on how hedge fund managers were coping with the economic devastation wrought by the pandemic. We found an industry agile and resilient in the face of massive market disruption. The findings from this year’s research describe an industry poised to accelerate out of the pandemic, with firms adopting new approaches to improve the efficiency of their business model and developing new investor solutions to deepen their alignment with investor clients.”
Almost a third (32%) say they expanded their investor teams and increased its organizational importance as it pertains to capital raising and investor relations. Meanwhile, ESG is also expected to remain as a driving force for change, although hedge funds have currently paused from embracing this important product market trend further by a lack of global standards and actionable data.
Steven Menna, National Hedge Fund Segment Leader, KPMG in the US, added: “In the early stages of the pandemic, the hedge fund industry successfully adapted to meeting the needs of its investors in a decentralized environment. Our new research demonstrates that once again the hedge fund is continuing its agile and resilient journey by addressing the opportunities and challenges presented by product innovation and complexity, the impending compliance headwinds, and the continued search for talented people. At the same time, it’s transforming its operating models for the hybrid working environment and is poised for its next growth phase as it accelerates into 2022.”et Zero Asset Manager Initiative. The initiative was launched in December 2020, by an international group of asset managers committed to the goal of net zero greenhouse gas emissions by 2050 or sooner by supporting investing aligned with that net zero emissions goal. Who can participate in it. According to the Hedge Fund Law Review: "A majority of hedge fund managers are incorporating ESG factors into their investment processes, driven in part by investor demand. The Alternative Investment Management Association (AIMA), in cooperation with Simmons & Simmons and Seward & Kissel, recently published the Global Hedge Fund Benchmark Study – a survey of more than 300 hedge fund managers and investors. It addresses many open issues such as: 1. Fund launch terms. 2. Industry challenges. 3. Responsible investing. 4. Investment in new technologies. 5. Succession planning. 6. Performance and outlook. 7. Fees charged by funds. 8. Liquidity and redemption terms. 9. What asset managers consider when commiting to the Initiative. 10. What ae asset managers required to do. 11. Commitment to new funds versus existing funds.
Central bank collateral as a green monetary policy instrument.
‘Brown’ collateral haircuts increase the financing costs and decrease the volume of carbon intensive investments.
‘Green hairgrowth’ has a similar effect but is in conflict with market neutrality and, therefore, not as broadly implementable.
The synergy of a price instrument and ‘brown’ collateral constraints results in a significantly lower and potentially politically more feasible carbon tax.
Debt & Equity finaning for Net-Zero Aircraft.
Financing against obsolescence uncertainty.
Will airlines buy Net Zero aircraft without access to competitive funding?
The World Resource Center (WRI) wrote in 2019 that "private sector banks are facing political, market, and societal pressure to direct finance towards low carbon, sustainable development." One way they can signal their response is through sustainable finance commitments: 1. publicly-made, 2. time-bound commitments,3. provide or facility capital for climate and sustainability solutions. WRI acknowledged that while the commitments may appear straightforward at first glance, comparing them is anything but. They vary widely in structure and provide only a limited picture of a bank’s approach to sustainability.
To facilitate improved understanding, WRI's data base describe key characteristics of financial commitments and enable comparison of commitments from different institutions. The data base also provies a technical framework for interpreting sustainable finance commitments using information published by committing banks focused on:1. commitment,2. design, 3. accountability, 4. transparency and. 5. the portfolio context of the banks.
Can Investment Institutions persuade oil companies to reallocate some resources to biofuel? or Will investment institutions be forced to choose between fossil fuel and sustainable fuel?
Financing in a long-cycle business.
Current Aircraft Finance Market Outlook (CAFMO)2021.
Financing Sources 2020
Debt & Equity.
Down 40% on 2019.
Commercial Bank Debt
Export Import Banks
Export Credit Agencies
Investment & Hedge Funds
Credit Enhanced Funds
Wealth & Family Funds
Air Transportation Finance Covers:
Work Out Expertise
Technology life cycle
New aircraft transactions
Used aircraft transactions
Engine & parts inventories
Product life cycle
Terms & Conditions
Technology life cycle
Oversupply of aircraft.
Higer labor costs & shortages
Disposabe income spent on bricks & mortar, fewer pax.
Evergrande Taiwan Net-Zero design concepts do not translatee into Type certification
Supply chain disruption Reduced frequency & slower trip times, hub-to-hub concentration, labor force upskilling will have to wait.
OEM/MRO material shortages. Loss of investor interest in the sector, deterioration in the quality of the travel product, heavy government investment in Net-Zero technology R&D to appease civil society groups, ageing fleet leading to higer maintenance costs.
Where is the money to pay for aircraft coming from?
- Airbus and Boeing are convinced that global and diversified funding will continue to flow into the aircraft financing sector as the aviation sector navigates the global pandemic and vaccine deployment continues to accelerate. Boeing's near-term view of market dynamics and assessment of financing sources for new commercial aircraft deliveries is restricted because the company does not publish the customary one- and five-year industry financing projections.
Financing aircraft that emit pollution!
- 1. One of the main factors affecting airline success is bringing aircraft supply and passenger demand as closely together as possible.
- 2. The airline uses a methodological planning approach for selecting the fleet mix.
- 3. Selection of an aircraft for operating a defined route network is a key element of planning. It has a direct impact on the airline's profitability and on cost reduction.
- 3. Most airlines operate short haul and medium haul routes.
- Fleet planning & financing model.
- Fleet planning is a multi-criteria decision making process that decides:
- Fleet composition. Fleet size. Aircraft Type Cost (EA) Deposit (EA)* Financed. Cash Reqd.
- Regional routes: 75 to 100 seats 7 A220/EMBRJ $30M $10M $20M $140M
- Shorthaul routes: 120 to 180 seats 8 A320/B737 $50M $17M $33M $264M
- * Deposit: 20% to 40% ~ 30%
- Challenges. Aircraft financing presents unique challenges that may not exist in the financing of other types of assets. These challenges include:
- Cost of buying aircraft is high.
- Potential buyers of the aircraft if there is a default under the loan agreement, indenture or lease, as applicable.Illiquid nature of the aviation market.
- Liquidity: Airlines and lessors are starved of liquidity and assets are heavily leveraged.
- Price: On average across the potential orderbook of 43,000 to 48,000 Net-Zero aircraft, the average price of a new one will be in the $30M to $50 million each in 2022 dollars.
- Deposits: The amount the borrower will be required to commit to the aircraft financing transaction can be in the 20% to 40% range.
- Down payment: A typical airline might have to find in the range of $400M in cash to replace gas turbine powered aircraft fleets with Net-Zero aircraft, for a typical airline operating a mix of 15 regional and short/medium haul aircraft.
- Used Net-Zero aircraft do not exist cutting off the option of building a Net-Zero fleet around used aircraft.
- Direct operating costs are high for in service fleet and the DOCs for Net-Zero aircraft are unknowable at this state in the life cycle. .
- Aircraft are mobile assets and so the jurisdictions where the aircraft is expected to be located during the financing term may vary.
- Credit exposure management of distressed airlines and lessora is restricting extending credit to customers with low credit ratings.
- Financing structure, term, equity, debt, lease, interest rate, funded amount, residual value, ROI and exit are all under stress.
- Debt service is challenges as airlines delay lease payments or negotiate reductions.
- Security enforcement for events of default have mostly been limited to non-payment on aircraft loans. Other events of default are airline insolvency, breach of warranties or representations which the lender believes will have a material impact on the airline’s ability to meet its obligations under the loan agreement.
- Interests in the aircraft and related assets in the different pools will vary.
- Regulatory interrelationship between Supernational, national, state and local laws and rulations make for complex legal structures..
- International treaties and conventions historically set norms/yardsticks for countries in framing policies and making laws on safety and route rights. With the Kyoto and Paris, treaties and conventions. are driving the timing of the swithch to Net-Zero aircraft.
- Complexity of the interelationship between treaties, laws and regulations when negotiating aircraft transactions.
- Documenting for the aircraft financing transactions is complex and expensive.
- Insurance coverage and cost, loss events, accidents and incidents.
- Cost of transferring ownership to buyer.
- Transfer of ownership, registration, deregistration, certificate of airworthiness are time consuming processes.
- Care and maintenance is regulated and the costs are high.
- This limits the number of participants that have the requisite expertise to participate in these projects and may put significant pressure on aircraft operators’ cash flows.
Outlook secular, economy, aircraft, orders & deliveries.
- Market outlook Understanding the numbers.
- Boeing began publishing its Boeing Market Outlook (BMO) in 1961. The BMOs offer perspective on key trends and variables that affect Boeing's view of the markets it serves. Other aircraft, powerplant and equipment manufacturers adopted the practice of publishing annual market outlooks. These reports provide an annual analysis for the commercial and cargo aircraft markets. They cover long-term market analysis of the commercial, services, defense and space, aerospace personnel, air cargo, and finance. The subject matter of these reports covers economic, airline, travel and fleet data.
- In time Boeing, and later, Airtbus became trusted sources for market commentary. They have evolved into guides showing how manufacturers make design and production decisions for their customer base. The aircraft industry continues to depend on the Boeing mantra that in the longer term:
- Key industry drivers are expected to remain stable.
- Key industry drivers will return to the longer term trend apparent since the 1960s.
- Passenger traffic growth is expected to recover to the 4.5% per year around 2025.
- The commercial (aircraft) fleet forecast will return to its 60 year growth trend to date.
- The 10 year commercial aircraft market-share forecast was for a need for 18,350 commercial aircraft, valued at $2.9 trillion – 11% lower than the comparable 2019 forecast.
- Extending the 2030 projection by a decade, Boeing sees a demand for more than 43,000 new aircraft in the the 20-year forecast time period to 2040.
- On the upper end of expectations, the global commercial fleet is expected to reach 48,400 by 2039, up from 25,900 aircraft today.
- A full recovery will take years.
- Airlines globally had begun to recover from a greater than 90% decline in passenger traffic and revenue early in 2020.
- The aircraft financing environment ended 2020 with enough liquidity to finance deliveries.
- The damage to the total aerospace industry as a whole, due to the impact of the COVID-19 pandemic, is minimal.
- The company predicts the value of the aerospace market will be $8.5 trillion from 2020 to 2030, a $200BN drop from its 2019 forecast.
- The real damage would occur in the commercial market.
- Boeing identified stresses particularly in the bank debt and tax equity marketsIn 2021, at the industry level, commercial aircraft delivery funding volume totaled $59 Billion, a 40% decrease from 2019 levels.
- Commercial banks withdrew liquidity and long term dept financing from the market.
- Institutional investors and funds have cut aviation exposure and increased spreads.
- Capital markets for aviation volumes were 70% higher than 2019!
- The percentaged of the global commercial fleet leased is 46%.
The Outlook Shannon Aero produces evaluates Net-Zero aircraft market demand against supply of the gas turbine fleet, fossil fuel powered, & replacement aircraft propulsion from biofuel, battery/electric, hydrogen, synthetic & hybrid energy.
- Expect the global economy trend of uncertainty, volatility and inflation to continue to late in the decade.
- Political leadersips may undergo considerable change as they navigate the divergent interests in their economies vs CSGs.
- Key economy sectors will struggle to return to pre-pandemic levels, transportation & energy being susceptible to black swan events.
- Societal pressure may grow for the global economy to transition to renewable, sustainable energy, transportation, travel and tourism.
- The rate of change in technology will accelerate as new manufacturing processes, equipment and tooling are introduced.
- Returns across asset classes may be more volatile as resource diversion and disruption continues the downward pressure on earnings.
- Disruptive investors with resources to create change will build new industries, products and services.
- Long term interest rates will continue to be low, and additive to positive rates of return that would otherwise be lower for securities.
- Equities markets may experience substantial differentiation across regions and sectors.
- It is likely time for the aircraft leasing industry to to return to the pre-Pandemic, attractive returns required by private credit providers.
Risks from Rogues Gallery of 2022 risks. (Bloomberg)
Net-Zero Aircraft launch outlook.
- The concensus market trading view has weakened, but remains that, commercial aviation has always been a long-cycle business, the inference being that it will always return to the long term growth trend line.
- OEMs tend to define the parameters for measuring the future market for commercial aircraft, sensetizing market beaviour for economic cycles, market shocks, tecnological advancements, social and political change.
- The tendency for the aerospace sector to accept the OEM market outlooks for over 60 years, will likely change.
- Airlines, service providers, banks, lessors, regulators, politicians, opinion formers and civil society at large, will look to independent industry analysyts to provide their perspective on the investment dynamics of the aerospace sector.
- As of 2020 the OEM view of the market has focused on near term uncertainty more than any forecast before.
- Not surprisingly the OEMs are hesitant to return to bullish aircraft market outlooks common prior to the Pandemic.
- The present concern is that air travel is detached from the global econonomy as other sectors show signs of economic recovery.
- This has engendered a loss of confidence and a sense of going it alone, especially for the lessors, who carry the burden of financing, placing and, for the first time, managing the orderbook faced with disruption in the new and aftermarket aircraft supply chains.
- The financial institutions confidence in commercial aircraft as an asset class has been considerably weakened to the point where their is a scarcity of liquidity and banks rely on lessors to liquidate portfolios in a controlled manner.
- Their is widespread acknowledgement that the tripartite shock of pandemic, black swan events and climate change have disrupted the shape of the aerospace sector, the air transport industry and the aircraft supply chain.
- The value of the current fleet of commercial aircraft and the valuation of the replacement fleet of Net-Zero aircraft from an equity, debt, collateral and residual value point of view will, in future, have to price in assumptions that were not relied on prior to the Pandemic.
- The changes in asset valuation will eventually feed into balance sheet valuations for all stakeolders.
- It will take several decades to identify the operating economics of Net-Zero aircraft versus the gas turbine powered aircraft in todays fleet.
- Overall the burden of working through the aircraft market crisis has fallen on the lessors and asset managers for the transition from today's fleets to tomorrows replacements, believing renewable, SAF fuels will be mass produced, have regulatory approval, be price-competitive with attractive DOCs.
Order & Delivery timing risk
What if the OEMs are wrong, what then is the outlook for financing Net-Zero aircraft deliveries?
- Decisions are being made today to order gas turbine powered aircraft entering the decline phase and for Net-Zero aircraft in the R&D design phase of their life cycles.
- As the order books stands today both technology groupings will be in service within the next few years and over the next 20 years.
- CO2e emissions standard for current fleet is based on studies from the mid-1990s that were more or less incorporated into the ICAO CORSIA scheme in 2016.
- Aircraft that came off the production line in the last 20 years would comply with the CORSIA scheme as currently defined.
- Concerns are emerging that the emissions compliance standard in the ICAO CORSIA scheme for new aircraft is voluntary, not seen as effective, not all stakeholders have signed-off on it, and may not comply with standards enforceable by legislation and regulations on the agenda for 2027.
- If any aircraft similar to those illustrated above do go into commerial production, the manufacturer will have to commit to building a family-line similar in scope to the range Airbus built over 50 years.
- This carries enormous financial, engineering, regulatory and political risk.
- To phase out the current aircraft fleet will require government supported R&D investment in unproven designs over 20-40 years with no guarantee the investment will be paid back.
- It needs a global concensus for energy sources/storage/supply and use because Chicago Convention countries must agree on common design standards.
- Before buying, airlines, lessors, lenders, investors and insurance underwriters will want assurances that any new design will deliver similar payload/ranges, similar operating economics, reasonable capital costs & type certification. MROs will need to know their re-equipment investment will be recouped. These new designs will need the acceptance & confidence of the public.