The introduction of the International Maritime Organisation’s (“IMO”) new sulphur emissions regulations (IMO2020) is one of the most significant environmental shifts by any global industry undertaken in recent years.
The new rules are a part of a regulatory journey two decades in the making, with an objective of dramatically reducing the environmental impact of one of the world’s most polluting industries.
The potential impact of IMO2020 spreads far beyond shipping operators, from oil producers and global manufacturers to retailers, policymakers and consumers. We will briefly consider some of these impacts and how KPMG Restructuring can support business impacted by the changes.
The exponential growth in global shipping has been a major contributor to climate change. The impact has been exacerbated by the principal fuel types used in shipping. Thick, sulphur-rich, ‘bunker fuel’ used by most vessels contains 3,500x more sulphur than automotive diesel. It’s estimated that 200 of the world’s largest ships produce as much sulphur dioxide as all cars in the world.
Research by the IMO has identified the risk that if new rules were not introduced and met then the sulphur produced by the shipping industry could lead to approximately 570,000 premature deaths over the next five years. Sulphur pollution is also linked to broader environmental damage including ocean acidification, crop damage and even changes in localised weather patterns.
IMO2020 is the latest in a series of steps aiming to reduce the industry’s environmental impact, which includes cutting emissions of carbon dioxide by 50% by 2050 compared to 2008 levels. The most significant component is a new upper limit on the percentage of sulphur content in the fuel that can be used in the sector, down from 3.5% to just 0.5%. Higher sulphur fuels can only be used where costly ‘scrubbers’ are fitted to clean the exhaust gases.
There are a number of ways the shipping sector can adjust to the new rules, including the fitting of exhaust gas scrubbers or LNG conversion, though none are without cost or operational/technical challenges.
The shipping sector as a whole have been relatively slow to react, perhaps in the expectation that the changes would be delayed or diluted. With little sign of that on the horizon, a number of shipping companies are making a belated dash to ensure compliance. This has itself caused a number of technical and operational headaches, not least that global capacity for exhaust scrubber installations is a fraction of the 53,000 merchant ships currently pounding the oceans.
As shown by a recent IEA report, the net result is that 60% of ships will need to switch from High Sulphur Fuel Oil (HSFO) to Marine Gas Oil (MGO) or (Very) Low Sulphur Fuel Oil (VLSFO) virtually overnight.
S&P Global Platts recently released a report stating that the total costs of IMO2020 in various sectors could cost upwards of $1 trillion over five years.
The impact on shippers is far-reaching, with a number of ramifications which aren’t immediately apparent.
Installation of scrubbers is estimated to be $2-4m per ship, a significant initial outlay which will require sector lenders to support. S&P Global Platts have reported that around $4bn a month of extra credit will also be required by ship operators just to cover the expected rise in fuel costs for those ships who have not been able to install new scrubbing technology. Whilst the larger players should be able to use their balance sheets to extend existing credit lines, for smaller operators with less leverage finding additional credit is likely to be challenging. For lenders and institutions with exposure in the sector, understanding and supporting both the immediate and longer-term working capital implications on their customers will be critical during this transition phase.
Some of the broader impacts on associated sectors are also worth mentioning.
Petrochemicals sector will also be significantly impacted by the change.
The shipping industry currently uses 3.5 million barrels of HSFO every day and is one of the few remaining users of the heavier fractions from crude oil distillation. The impact on oil producers will be highly uneven, with the largest impact affecting operators where oil output is naturally higher in sulphur and where there has been historic underinvestment in refinery modernisation, such as Iraq and Venezuela.
Whilst it is possible to convert fuel from HSFO to LSFO, the multi-billion dollar investments in increased refining capacity is unlikely to come online for a number of years. Desulphurisation is itself expensive and CO2 intensive requiring large volumes of natural gas. In the short-term, for those regions and refineries extracting and refining lighter oil, such as the North Sea and shale crudes, margins are likely to increase and globally keeping up with demand may be a challenge.
Even after all that, initial evidence suggests that a number of low-sulphur fuels will be incompatible with each other, potentially causing significant engine damage and further unexpected costs and disruption.
Manufacturers, retailers and consumers
Clearly, preparations for compliance with IMO2020 requires a significant capital investment; to update ships to the latest technology, and a significant uplift in operational expense in the form of higher fuel prices and appropriate disposal of sulphur wastewater collected from scrubbers.
Both the capex and opex costs are likely to be borne, sooner or later, by the users of shipping firms – from manufacturers to retailers and ultimately consumers. Given 60% of a ship’s operating cost is fuel, any uplift will inevitably be reflected in material increases in shipping fees, potentially by a fifth. There is likely to be a one-off inflationary impact on consumer goods of all types – from bananas and bikes to televisions and tablets.
Total shipping capacity is also likely to reduce, at least in the short-term. Material volumes of cargo space are lost when scrubbers and LNG tank and installed, whilst polluting ships may be docked awaiting scrubber installation or fuel conversion. In addition, some operators are advocating increased and mandated use of ‘slow steaming’ - lowering ship speeds to reduce emissions and costs. The impact can be significant – a 12% reduction in average speed resulting in a 27% reduction in fuel usage. Yet ships travelling more slowly reduces aggregate shipping capacity, increasing costs to shippers.
The rise in shipping costs attributable to IMO2020 is unlikely to, in itself, make a significant change to global trade flows. When combined with unpredictable and unprecedented shifts in the modern global political landscape, any further impediments to intercontinental trade have the potential to accelerate the trend towards localised supply chains.
There’s still a lot of questions to be answered – enforcement will be challenging and relies on a certain degree of self-policing by ship owners. There may yet be an eleventh-hour change to regulations, although operators shouldn’t bet on such an outcome.
This is arguably the biggest change to shipping since the advent of containerisation, with ramifications that spread far beyond operational and investment decisions by ship owners. Whilst the ultimate aim should be supported by all operating in the sector, in the short-term there is likely to be significant industry disruption.
Whether you are manufacturer or retailer facing increased costs, or a shipping company directly impacted by the new regulations, our expert team are here to help. We can undertake scenario modelling, help you to understand the cash and working capital impact and evaluate the various options available. We can also help you evaluate the impact of any proposed changes on your supply chains.
If you would like to talk to us about any of the issues raised, please get in touch.
© 2020 KPMG LLP, a UK limited liability partnership, and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.
KPMG International Cooperative (“KPMG International”) is a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.