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International arbitration report
In this edition, we focused on the Shanghai International Economic and Trade Arbitration Commission’s (SHIAC) new arbitration rules, which take effect January 1, 2024.
Financing onboard carbon capture: What are the options?
Global | Publication | March 2024
A version of this article was first published in Riviera Maritime Media.
Emissions, or more precisely, the reduction of emissions, is a key topic for the shipping industry. Whilst many ship owners have voluntarily taken steps to decarbonise, there is regulatory pressure, both at supra-national level with action taken by the International Maritime Organisation (IMO) and also at national and regional level, most notably by the European Union (the EU) which has introduced a raft of measures. The EU measures, such as expanding its emissions trading scheme to include shipping (see Shipping and EU ETS: The changing landscape) and introducing new FuelEU Maritime legislation which requires an incremental decrease in shipping emissions (see: New regulation on the FuelEU Initiative adopted by the European Council following scrutiny) have set ambitious decarbonisation standards which will impact all vessels trading to, from or within Europe.
There are a number of ways that shipping companies can look to decarbonise. The most obvious is through the use of a ‘cleaner’ fuel which produces fewer emissions, an issue which the maritime industry has been focussing on for the last few years. There is however, not yet a clear answer about which maritime fuel will be widely adopted: there are a number that have been mooted and which are being trialled but they all have different hurdles to overcome before they can be used in a significant way for the industry as a whole. There are no quick or easy fixes here. Other methods to decarbonise include energy-efficiency modifications to vessels such as the use of sails or other vessel design improvements. Another option is to capture some or all of the carbon emitted from, or present in, traditional maritime fuels on board (On-board Carbon Capture). There are two main methods of On-board Carbon Capture technology: pre-combustion carbon capture and post-combustion carbon capture. Pre-combustion carbon capture involves the gasification of the marine fuel, and then the separation of the carbon, which is then captured, and the hydrogen, which can be used as fuel. Post-combustion carbon capture involves capturing the carbon from the vessel’s exhaust fumes. In either process, the captured carbon will need to be stored on board – different equipment manufacturers are exploring different methods to do this, but it usually involves the carbon being liquified or stored as a solid. This will require deck/hull space, which for some existing vessels, will be a challenge, and the additional weight of the carbon will also need to be taken into account.
This captured carbon will need to be removed from the vessel periodically, probably after the end of a voyage and sent for permanent storage, often in naturally-occurring geographical formations in the sea-bed.
Installing equipment for On-board Carbon Capture will involve substantial capital investment and so shipowners will want to consider financing options. There are a number of issues to consider in the financing of the On-Board Carbon Capture equipment (OCC Equipment) which are explored in this article.
One key issue to consider before looking at the different financing options is whether the OCC Equipment will form part of the vessel for the purposes of any security to secure a financing. Looking first at the mortgage, where the owner of the vessel is also the owner of the OCC Equipment, the question from an English law perspective is whether the OCC Equipment would be categorised as an ‘appurtenance’ of the ship as the statutory form of British ship mortgage creates security not only over the ship but also over its ‘appurtenances’. Case law1 suggests that appurtenances should extend to equipment on board the ship which would be necessary to the navigation of the ship or the ‘prosecution of the adventure’ and without which a prudent person would not set sail. In view of this, it would be likely that the OCC Equipment, necessary for compliance with emissions reduction legislation, would be seen as an appurtenance of the ship: this article will assume this is the case.
Content
Unmortgaged vessels
The position with unmortgaged vessels should be relatively straightforward as there will be no other financiers who already have security over the vessel. Either the financier of the OCC Equipment can finance part of the value of the vessel as well as the OCC Equipment or it can just finance the OCC Equipment. Either way, the financier can take security in whatever form it agrees with the vessel owner/borrower, including by taking a first ranking mortgage over the vessel to secure the loan.
Mortgaged vessels
The position is more complicated for vessels which already have mortgages granted over them. From an English law perspective, there are a number of cases which consider whether appurtenances which are added to the vessel after the date of the mortgage are subject to the mortgage. A key element in deciding this is whether the equipment is ‘appropriated’ to the ship2. In the context of the OCC Equipment, which is likely to be purchased, manufactured for and fitted on a specific ship, it would seem likely that this would be seen as being ‘appropriated’ to the ship and so should become subject to any pre-existing mortgage. This in turn would mean that in an enforcement scenario it would be sold by the court or mortgagee along with the ship. In any event, equipment fitted to the vessel after the date of the mortgage will usually be caught by the charge over the vessel usually contained within the deed of covenant which will usually be entered into ancillary to a statutory ship mortgage On this basis, if the existing mortgagee of the vessel is not the financier of the OCC Equipment, then it will benefit from the installation of the OCC Equipment in terms of the increased value of the vessel over which it has security. In this situation, absent any agreement with the existing mortgagee, the OCC Equipment financier will be unsecured (at least as regards the vessel itself and the OCC Equipment installed on it).
The vessel financier/mortgagee would usually have the right to approve any new financing relating to the vessel and/or material modifications to the vessel, so it will need to be included in discussions around the OCC Equipment financing arrangements in any event. The OCC Equipment financier could of course, if the existing mortgagee consents, take a second priority mortgage over the vessel to secure the loan for the OCC Equipment and will then need to enter into a security co-ordination agreement with the existing mortgagee. Inevitably, this would mean that if there is a default under the OCC Equipment loan, the OCC Equipment financier would be prevented from enforcing its second ranking mortgage to recover sums due without the consent of the first ranking mortgagee. There is also the risk that the funds raised from an enforcement of the first ranking mortgage are insufficient to repay what is owed to the OCC Equipment financier after repayment in full of the original vessel financing.
Other finance options for mortgaged vessels
Financiers of OCC Equipment may therefore need to look to different ways to secure their loan where the equipment is being fitted to an already mortgaged vessel. Some of these options include:
Finance lease
- The OCC Equipment financier could seek to retain title to the OCC Equipment and lease it to the vessel owner, either under a finance lease or a sale and leaseback with a put option. In these circumstances, assuming that the OCC Equipment is sufficiently identifiable and the lease is correctly drafted (it would need to contain a clear acknowledgment from the vessel owner that title to the OCC Equipment is retained by the OCC Equipment financier notwithstanding its installation on the vessel), the OCC Equipment financier should be able to retain title to the OCC Equipment. However, difficulties may arise if the vessel owner defaults on payments to the financier as it would be both difficult and costly to remove and recover the OCC Equipment from the vessel. Even if the OCC Equipment could be removed, it is not clear what the resale value would be and whether it would be feasible to fit the removed OCC Equipment onto another vessel. Even if there was a resale market, the OCC Equipment financier needs to consider whether the costs involved with the removal of the OCC Equipment and the subsequent sale would prohibit the OCC Equipment financier from recovering all sums owed.
- Another issue that needs to be considered in the context of a finance lease arrangement is the potential impact of a bankruptcy proceeding relating to the vessel owner: in particular there are questions over whether the Chapter 11 regime in the US would recognise the title of the OCC Equipment financier. If the vessel owner files for Chapter 11 protection in the US, there is a risk that the US courts will recategorize the finance lease as a loan and determine that title to the OCC Equipment vests with the vessel owner (as lessee) and not the OCC Equipment Financier as lessor. The OCC Equipment financier would, in this scenario, be treated as a creditor in the bankruptcy. It would therefore be prudent for the OCC Equipment financier to be granted a security interest over the OCC Equipment in the finance lease by the vessel owner (which it would hold in addition to the legal title to the OCC Equipment). This would ensure that the OCC Equipment financier it is treated as a secured creditor in a Chapter 11 scenario to the extent that the US bankruptcy court does not recognise its ownership interest.
- Where a finance-lease structure is used and the vessel itself is subject to a pre-existing mortgage in favour of a third party financier, the financier of the OCC Equipment will also (minimally) need an acknowledgment from the third party financier that the OCC Equipment does not form part of the vessel for the purposes of the mortgage, This would then mean that if the mortgagee arrested the vessel with the intention to sell the vessel either through an court sale process or through a private sale, the OCC Equipment financier should have the ability to apply for injunctive relief to postpone the sale and either arrange for the sale to be delayed or else come to some arrangement with the mortgagee to have its loss covered. It is not a very protective position, but it could give the OCC Equipment financier a seat at the table.
- Alternatively, the OCC Equipment financier may be able to agree a put option arrangement with the vessel’s existing financiers. In this scenario, if the vessel owner defaults on its loan obligations, the vessel’s existing financiers would repay amounts owed to the OCC Equipment financier and in return, the OCC Equipment financier would transfer title to the OCC Equipment to the vessel owner. This transfer of title to the owner would, at least in theory, benefit the vessel’s financiers as the OCC Equipment would then form part of the vessel and, when sold (whether on enforcement of the mortgage or otherwise), hopefully, increase the purchase price.
Increasing the loan commitment under the existing facility
- The existing vessel facility could be increased and existing financiers (if they do not themselves wish to participate in the increased loan amount) could sub-participate the increased portion to the OCC Equipment financier. In this scenario, the OCC Equipment financer would receive a first priority security position (pari passu with the other lenders). However, the existing financiers may not agree to an arrangement such as this without some sort of contractual subordination of the OCC Equipment financier.
For the existing financiers, one potentially attractive aspect of this option might be that the facility increase could be documented as an additional sustainability-linked tranche to the existing loan, which could then benefit from the existing security package. It could be argued that the OCC Equipment may qualify for a green financing, as the proceeds of the additional tranche would be used solely for the purpose of financing the cost of construction and installation of the OCC Equipment, but whether this will fit within the EU Taxonomy would depend on the nature of the underlying vessel and its uses.
Contractual arrangements in lieu of vessel security
- The OCC Equipment financer’s position could be dealt with purely through contractual arrangements. For example, the OCC Equipment financier could agree with the existing mortgagee that the existing mortgagee will, upon receipt of security proceeds and, after payment of the existing mortgage debt, pay out the excess to the OCC Equipment financier (up to the amount outstanding loan amount owed to the OCC Equipment financier). This contractual arrangement would need to be coupled with an assignment from the vessel owner in favour of the OCC Equipment financier of the vessel owner’s right to receive the balance of the proceeds at the bottom of the waterfall in order for this to withstand a challenge in an insolvency scenario. The OCC Equipment financier will not have any independent enforcement rights under this option, but it is a way of taking an effective second priority position in relation to the proceeds of the security without having a second ranking mortgage.
Where the OCC Equipment financier is the charterer of the vessel
- If the OCC Equipment financier is the charterer of the vessel, then the OCC Equipment loan could be repaid via a set off from the charterhire or a discount to the charter rate. These arrangements would be likely to need consent from any existing mortgagee/vessel financiers.
Conclusion
On-board Carbon Capture is a novel, innovative area but it has the potential to offer meaningful reductions in vessel emissions which will help shipowners and operators achieve decarbonisation targets and comply with environmental regulation in this area. Banks and financial institutions have set increasingly ambitious sustainability objectives in their lending policies and so the OCC Equipment financing offers an opportunity to meet these objectives whilst continuing to support and invest in the maritime sector.
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