Scarcity and Allocation of Allowances in the EU Emissions Trading Scheme – A Legal Analysis

Working Paper No 2007/32

SEPTEMBER 2007

J. de Sepibus*

ABSTRACT The European Union Emission Trading Scheme (EU ETS) for CO2 emissions was launched in 2005 but, by February 2007, prices had collapsed, destroying any incentive to invest in cleaner technologies. This outcome was compounded by the mode of allocation, based mainly on grandfathering, which favoured CO2-intensive operators and led to windfall profits. This paper discusses the failure of this promising new instrument in a two-step process. The first examines the rules which govern the setting of the cap, as this determines the environmental quality of the scheme. The second looks at the criteria guiding the allocation process. It analyses, in particular, how the Commission assessed the national allocation plans (NAPs) and why its scrutiny regarding the second trading period led to numerous legal claims. The study concludes that a system, whose success essentially depends on the stringency of its overall cap, must either delegate this decision to an independent authority or give it the necessary powers to enforce scarcity and determine equitable allocation criteria. Second, a scheme, which decentralises important decisions regarding its design, can only function if its members are sufficiently homogeneous and committed to ensuring its efficiency. This is probably not true of the EU ETS.

KEY WORDS EUROPEAN UNION EMISSION TRADING SCHEME, ALLOCATION, NATIONAL ALLOCATION PLANS, SCARCITY * Dr. Joëlle de Sépibus, former Professor of International and European Law (University of Fribourg); Consultant, NCCR

rade Regulation—IP6; Stipendiary of the SNFR T

NCCR TRADE WORKING PAPERS are preliminary documents posted on the NCCR Trade Regulation website (<www.nccr-trade.org>) and widely circulated to stimulate discussion and critical comment. These papers have not been formally edited. Citations should refer to a “NCCR Trade Working Paper”, with appropriate reference made to the author(s). 

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Scarcity and Allocation of Allowances in the

EU Emissions Trading Scheme – A Legal Analysis

1. Introduction In January 2005 the European Union (EU) launched an EU-wide trading scheme (the European Union Emission Trading Scheme – EU ETS) for CO2 emissions from companies in the energy industry and other carbon-intensive industry sectors. After a successful start, which saw the price for the European emission allowance (EUA)1 hovering around 26 Euros in the first months of 2006, the price more than halved in a few days in response to the announcement of the verified emissions data for 2005 in April 2006. Later in the year, the price of the EUA collapsed definitively and reached a level of less than 1 Euro in February 2007, thus reducing to zero any incentive to invest in cleaner technologies in the first trading period. This outcome was compounded by the mode of allocation, based mainly on grandfathering, which favoured CO2-intensive operators and led to important windfall profits, mainly in the power sector. These disappointing results raise the question of why the promising new environmental instrument, hailed as the European ‘flagship’ for combating climate change, has failed to live up to its expectations and whether it might warrant a more environmentally effective outcome in the second trading period. To answer this query, our first step is to examine how the total amount of allowances is set, as this determines the environmental quality of the scheme. The focus of the second step will be on the criteria guiding the allocation process that define the final distribution of the allowances. In both steps, the description of the legal framework is introduced by a brief account of the debate preceding its adoption and followed by an analysis of the national allocation plans (NAPs) and their assessments by the Commission. Special attention will be given to the legal actions brought by certain Member States against the Commission’s decisions. A discussion outlining the main lessons learnt from the experience gained in the first years of trading will round off the paper.

2. The total amount of allowances (the ‘cap’) under the EU ETS The legal framework for the European cap-and-trade scheme is set out by the Directive establishing a scheme for greenhouse gas emission allowance trading within the Community (hereafter the ‘Directive’).2 Its aim is to help Member States to meet their targets for greenhouse gas emission under the Kyoto Protocol at minimum cost.3 The allocation process, which determines the actual reduction targets for the covered sectors within each Member State, is governed by Articles 9 to 11 of the Directive in conjunction

1 An EUA is equivalent to one tonne of CO2. 2 Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC.3 See Article 1 of the Directive.

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with Annex III. There are two distinct trading periods: phase I, a three-year period from 1 January 2005 until 31 December 2007, and phase II, a five-year period, coinciding with the Kyoto commitment period, starting 1 January 2008 and ending in 2012.4 For each phase, Member States have to submit a NAP, taking due account of the comments of the public.5 The NAP is submitted to the Commission for approval, which, assisted by a special Committee,6 has to assess the plans.7 The Commission may reject a plan, or any aspect thereof, if it finds it to be incompatible with the criteria set out by the Directive.8 Member States may implement the NAP only if any proposed amendments are accepted by the Commission.9 The Directive itself does not set an upper limit to the number of allowances, but leaves that decision to the Member States, which have to fix the national cap in the NAPs in accordance with the criteria set out in Annex III. This may appear surprising given that the environmental quality of the EU ETS is crucially dependent on the overall amount of allowances. Only if the cap is sufficiently scarce,10 is the price of the EUA high enough to induce industries to invest in greener technologies, such as renewable, carbon-free energy and, eventually, carbon capture and storage.11 As the allocation of mostly gratuitous allowances entails an important distribution of wealth, there exists, moreover, an obvious risk that Member States might hand out an excessive number of allowances, thereby jeopardizing the whole scheme.12 This danger is only partially mitigated by the necessity of having the plan approved by the Commission.

2.1 The legislative history The reasons that have led the EU to leave such considerable discretion to Member States regarding the cap, probably reflect the strong influence exerted by stakeholders during the negotiation process preceding the adoption of the Directive. Whereas the Commission, in its Green Paper,13 stressed the positive aspects of setting the global cap at Community level by pointing out “that possible distortive allocations to individual sectors or companies would be significantly limited”, the first Directive proposal already

4 Article 9 (1) of the Directive. 5 Article 11(1) of the Directive. 6 The Committee is composed of representatives of Member States who express their views on the content of the plan and highlight issues for the Commission to consider in its assessment. See Article 9(2) of the Directive; Zapfel (2007: 23). 7 Article 9 of the Directive. 8 Article 9 (3) of the Directive 9 Article 9 (3) of the Directive. 10An emission trading scheme works only if there are fewer allowances than demand for these allowances. See (Vis 2006a: 47). 11 Betz et al. (2006a: 351). 12 See Morgenstern (2005). 13 See European Commission, Green Paper on greenhouse gas emissions trading within the European Union, COM (2000) 87 final, 8 March 2000.

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reflected in broad terms the final setup of the Directive.14 Instead of mandating the Commission to safeguard the environmental effectiveness of the scheme, it merely enumerated a series of rather vague criteria, according to which the Commission should review the national caps. The lack of a stringent cap in the Directive Proposal was strongly criticized by environmental non-governmental organizations (NGOs) and the European Parliament, who wanted more certainty of a robust environmental outcome for the scheme.15 Their suggestions, however, were not accepted by the Commission. Given the earlier difficulties in reaching an agreement on how to share the ‘climate burden’ during the negotiations preceding the Kyoto Protocol,16 the Commission was afraid that an EU-wide debate on the cap would make the adoption of the Directive impossible.17 In the second reading of the Directive, agreement was reached on a small amendment to criterion 1 of Annex III of the Directive.18 To provide more clarity, the Commission was also mandated to develop guidance on the implementation of the criteria listed in Annex III. In October 2004 the European Parliament and the Council amended the Directive to allow a link between the flexible mechanisms of the Kyoto Protocol and the EU ETS. The so-called ‘Linking Directive’ recognizes that Kyoto ‘units’19 may be used for compliance purposes under the EU ETS.20 It allows firms to use CDM credits for compliance in the first and second trading period, whereas JI credits are only allowed from the beginning of 2008.21 It does not set a cap on the import of these credits but specifies that the total has to be consistent with the ‘supplementarity’22 obligations of Member States under the Kyoto Protocol.

14 European Commission, Proposal for a Directive of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, COM (2001) 581 final. 15 The Parliament sought to ensure that the emission trading was effective and achieved significant reductions in emissions by introducing a mandatory cap on each Member State’s allocation. In its first reading, the Parliament put forward a number of amendments by means of which a ceiling was to be placed on the emission allowances to be allocated by each Member State, representing 50% of the emissions forecast annually for each Member State according to a linear curve converging with the Kyoto commitments. See Meadows (2006: 76); Lefevere (2005: 275). 16 The adoption of a common negotiation position in preparation for the Kyoto Protocol was only possible after an internal debate by the Community on the specific targets each Member State would have to reach. 17 According to Grubb et al. few academics understand the difficulties that policy-makers face when confronted with economically important industries claiming that government policy risks putting them at a disadvantage relative to competitors. See Grubb et al. (2006c: 8); Lefevere (2005: 275). 18 The amendments read: “the total quantity of allowances to be allocated shall not be more than is likely to be needed for the strict application of the criteria of this Annex” and “prior to 2008, the quantity shall be consistent with a path towards achieving or over-achieving each Member State’s target under the Kyoto Protocol”. See Lefevere (2005: 275). 19 The Kyoto ‘units’ are the CDM and JI credits, known as certified emission reductions (CERs) and emission reduction units (ERUs). CDM stands for clean development mechanism and JI for joint implementation. 20 Article 30 (3) of the Directive. 21 These credits are called certified emission reductions (CERs)21 and emission reduction units (ERUs). CERs can be used in both periods and ERUs in the second trading period. 22 In addition to domestic action by Member States to reduce their greenhouse gas emissions, the Kyoto Protocol allows Member States to invest in Joint Implementation (JI) and Clean Development Mechanism (CDM) projects in other countries and to use credits from these for compliance purposes towards their

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2.2 The setting of the national caps (Articles 9-11 and Annex III of the Directive) Art. 9 (1) of the Directive states that the NAP shall be based on objective and transparent criteria, including those listed in Annex III.23 Criteria 1–4 and 12 address, more specifically, the question of which conditions have to be met by Member States when fixing the national caps. Arguably, criterion 1 is the most important with respect to the setting of the national caps. It24 states that caps have to be consistent with the Member States’ obligations to limit their emissions pursuant to the Kyoto Protocol25 and the so-called ‘Burden-Sharing Agreement’,26 taking into account, on the one hand, the proportion of overall emissions that these allowances represent in comparison with emissions from sources not covered by the Directive and, on the other hand, national energy policies. Moreover, caps have to be compatible with the national climate change programme.

emission reduction commitments. Member States are required to ensure that the use of the Kyoto flexible mechanisms is supplemental to domestic action, with a view to narrowing per capita differences in emissions between developed and developing countries. 23 The word ‘including’ makes clear that the criteria contained in Annex III are not exhaustive. Peeters, however, rejects this argument on the basis that Article 9 (3) of the Directive states that the Commission may reject a NAP if it is incompatible with the criteria listed in Annex III or with Article 10. See Peeters (2003: 88). 24 Criterion 1, 3rd sentence of Annex III. 25 According to the Kyoto Protocol the 15 ‘old’ Member States of the EU have to reduce a basket of six greenhouse gases by 8% over the period 2008–2012 with respect to their emissions in 1990. As Article 4 of the Kyoto Protocol allows groups of countries to agree on a common reduction target, the EU has subsequently redistributed this target among the different countries in a ‘Burden-Sharing Agreement’. Each Member State is individually responsible for reaching the specific target set under this agreement. Member States’ targets vary significantly, ranging from a reduction of 21% for Germany and Denmark to an increase of 25 % for Greece. The ten ‘new’ Member States, which joined the EU in 2005, are only liable under the Kyoto Protocol. Malta and Cyprus have no reduction commitments at all. 26 The Background for the ‘Burden Sharing Agreement’ is the so-called ‘bubble’ agreement laid down in Article 4 of the Kyoto Protocol, which allows groups of countries to agree on a common reduction target and subsequently to redistribute this target among the different countries. The origins of the idea of burden sharing can be traced back to the elaboration of the EU negotiating position in preparation for the third Conference of the Parties (COP3) in December 1997 in Kyoto, at which the Kyoto Protocol was adopted. The EU bubble was found necessary to allow the Community to adopt a common negotiating position for a challenging target under the Kyoto Protocol. The environment ministers agreed to propose a 15% cut in emissions of a basket of three greenhouse gases by 2010, while foreseeing specific post-2000 emission targets for each Member State. After the negotiations in Kyoto, the initial burden-sharing agreement of 23 March 1997 had to be adapted to the requirements of the Kyoto Protocol, which laid down a reduction target of 8% for six greenhouse gases for the European Community over the period 2008–2012 with respect to 1990. At the meeting of the Environment Council held on 16 and 17 June 1998, the Member States agreed to divide the 8% emission reduction for the European Community between the Member States. Member States’ targets varied significantly, ranging from a reduction of 21 % for Germany and Denmark to an increase of 25 % for Greece. The EU’s ‘Burden-Sharing Agreement’ was made legally binding through its inclusion in the ratification decision, adopted by the Council on 4 March 2002. See Council Decision 2002/358/EC concerning the conclusion, on behalf of the European Community of the Kyoto Protocol to the United Nations Framework Convention on Climate Change and the joint fulfilment of commitments thereunder. See Lefevere (2005: 109, 114).

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In its guidance27 the Commission states that the proportion of overall emissions of covered installations in relation to total emissions is the first element to be taken into account when fixing the total amount of allowances allocated. Furthermore, the cap must be consistent with the forecast increases or decreases in emissions in non-covered activities. If, for instance, a Member State applies effective policies and measures to sources outside the trading scheme, it is in the position to allocate more allowances to covered installations. Finally, when setting the cap, Member States may take into account the potential recourse to the flexible mechanisms28 of the Kyoto Protocol. Such an intention has to be duly substantiated in the NAPs. Moreover, caps have to be consistent with a path towards achieving or over-achieving each Member State's target under the ‘Burden-Sharing Agreement’ and the Kyoto Protocol in the first trading period.29 The Commission, thus, enjoins Member States to begin to make progress towards their future commitments in the first trading period, following a path to compliance which does not, however, have to be a straight one, but may follow a trend line.30 Finally, criterion 1 states that the total quantity of allowances shall not be more than is likely to be needed for the strict application of the criteria of the Annex.31 Pursuant to the Commission this means that the most constraining criterion of the Annex sets the upper limit of the cap.32

According to criterion 2, the cap has to be consistent with the annual assessments of actual and projected emissions of Member States made by the Commission.33 Consistency with these assessments is deemed to be ensured if the national caps do not exceed the projected emissions contained in those assessments.34

Criterion 3 states that the cap has to be consistent with the potential, including the technological potential, of activities covered by this scheme to reduce emissions. This criterion is deemed to be fulfilled if the allocation reflects the relative differences in the potential, including the economic potential, between the total of the covered and that of

27 Communication from the Commission on guidance to assist Member States in the implementation of the criteria listed in Annex III to Directive 2003/87/EC establishing a scheme of greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, and on the circumstances under which force majeure is demonstrated, COM (2003) 830, 7 January 2004. 28 The flexible mechanisms under the Kyoto Protocol are governed by Articles 6, 12, and 17 and concern the Joint Implementation, the Clean Development Mechanism, and the International Emission Trading, respectively. 29 Criterion 1, 3rd sentence of Annex III. 30 European Commission, COM (2003) 830, par. 12. 31 Criterion 1, 2nd sentence of Annex III. 32 European Commission, COM (2003) 830, par. 18. 33 See European Parliament and Council, Decision 280/2004/EC of 11 February 2004 concerning a mechanism for monitoring greenhouse gas emissions and for implementing the Kyoto Protocol, OJ L 49, 19.2.2004. 34European Commission, COM (2003) 830, par. 25.

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the non-covered activities. Moreover, Member States have to describe the methodology they use to assess this potential in their national allocation plans.35 Criterion 4 stipulates that caps have to be consistent with other legislative and policy instruments of the Community.36 According to the Commission this criterion is satisfied if the allocation process does not contravene the provisions of other legislation.37 Allocation may not undermine the operation of other legislation, for instance by assigning allowances to activities already bound to emission reductions under other rules.38 Whenever such legislation provides for rising emissions, the allocation plan has to make adequate allowance for such an increase.39

Finally, criterion 12 specifies that the plan shall mention the maximum amount of Kyoto units, which may be used by operators in the Community scheme as a percentage of the allocation of the allowances to each installation.40 The percentage must be consistent with the Member State’s ‘supplementarity’ obligations under the Kyoto Protocol and decisions adopted pursuant to the United Nations Framework Convention on Climate Change (UNFCCC) or the Kyoto Protocol.41 No clarification is given in the first guidance of the Commission with respect to this criterion.42

35See above, par. 26-29. 36 According to Meadows this criterion was intended to guarantee that quantities allocated would ensure that collectively, the overall emissions of participating installations would not be higher than if the emission were to be regulated under the IPPC Directive and that emissions trading was not used as a tool to achieve reductions that would result from Member States fulfilling their existing commitments under the renewables Directive. See Meadows (2005: 77). 37 In order to simplify administrative tasks the Commission recommends a Member State to consider a Community legislative or policy instrument only insofar as it is expected to result, per activity or in total, in a substantial increase or decrease (e.g. 10%) of covered emissions. See European Commission, COM (2003) 830, par. 40-45. 38 Mehling (2005: 147). 39 For the sake of simplicity, the Commission, however, recommends applying certain thresholds to this assessment, with consideration being given only to legislation resulting in a substantial rise or fall in emissions. See COM (2003) 830, par. 46. 40 See European Parliament and Council, Directive 2004/101/EC of 27 October 2004 amending Directive 2003/87/EC establishing a scheme of greenhouse gas emission allowance trading within the Community, in respect of the Kyoto Protocol's project mechanisms. The so-called ‘Linking Directive’ recognises that Kyoto units may be used for compliance purposes under the EU ETS. It allows firms to use CDM credits for compliance in the first and second trading period, whereas JI credits are only allowed from the beginning of 2008. See also Convery et al. (2007: 91). 41 In addition to domestic action by Member States to reduce their greenhouse gas emissions, the Kyoto Protocol allows Member States to invest in Joint Implementation (JI) and Clean Development Mechanism (CDM) projects in other countries and use credits from these for compliance purposes towards meeting part of their emission reduction commitments. Member States are required to ensure that the use of the Kyoto flexible mechanisms is supplemental to domestic action, with a view to narrowing per capita differences in emissions between developed and developing countries. The Directive allows operators of EU ETS installations to use JI and CDM credits towards fulfilling a proportion of their commitments under the Directive. See COM (2006) 725, par 2.3. 42 The absence of guidance concerning this criterion is because it was included in the Directive after the Guidance document had been issued.

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When analysing the relevant criteria for the determination of the cap, the most striking aspect is that none of the criteria requests the Commission to safeguard the inherent requirement of any emission trading system, e.g. that the cap is sufficiently scarce to safeguard the environmental effectiveness of the scheme. For instance, the conditions set out in criterion 1 reflect the aim of finding a balance between the contribution of the Directive and other national policies to the international climate targets. They do not impose any strict limit on the cap, which essentially depends on external factors, such as the environmental performance of other policies implemented by the Member States. Overall, the conditions laid down seem to aim more at guaranteeing that Member States meet their international obligations than at realising the goal of the Directive, which is to make sure that the scheme eventually leads to a reduction of greenhouse gases. This impression is reinforced by the guidance provided by the Commission, which stresses that a “Member State applying effective policies and measures to sources outside the trading scheme will necessarily be in a position to allocate more allowances to covered installations”.43 The strictest criterion with respect to the cap seems to be criterion 2, which requests that the total amount of allowances does not exceed projected emissions for the sectors covered by the scheme. Even if this criterion reflects the necessity to provide a certain ceiling, it does not guarantee scarcity. Indeed, this criterion only requests that allowances do not exceed projections, which means that they may be equal to the latter. Given the inherent uncertainty of forecasts, there is no guarantee that projections are not inflated and thus the number of allowances too large.44

Moreover, the guidance remains vague with regard to the criteria the Commission should apply when evaluating the performance of national policies with respect to the international climate targets. As such appraisals depend on a multitude of variables and assumptions, the Commission’s task could hardly exceed a succinct appreciation of the plausibility of the information provided by the Member States. In sum, the guidance contributes little to improving the operability of a series of criteria, which are obviously unsuitable for setting a sufficiently scarce ceiling to the national cap setting process.45 For instance, the guidance does not give any clear indication of how the reduction potential of installations has to be taken into account, how the environmental performance of other policies has to be evaluated or how much domestic abatement has to take place to fulfil the ‘supplementary’ criteria of criterion 12. As a result, the final decision by the Commission could hardly have been anticipated and hinged basically on the manner in which the Commission would interpret the criteria of Annex III when assessing the NAPs.

2.3 The national caps in the first trading period

43 European Commission, COM (2003) 830, par. 11. 44 See in particular on the intrinsic uncertainty of forecasts Grubb et al. (2006a). 45 Zapfel (2007: 21).

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Not surprisingly, when preparing the NAPs for the first trading period, Member States’ views on how the cap should be set, differed greatly.46 In particular, the meaning of the first criterion of Annex III caused confusion.47 Indeed, some Member States, among them most of the new Member States in Eastern Europe, had no compliance problems with their commitments under the Kyoto Protocol.48 For instance, the Czech Republic had an emissions target under the Kyoto Protocol, which was about 17% higher than its recent emissions.49 Accordingly, they expected to make no reduction effort, but rather to be allowed to increase emissions in the covered sectors.50 The Commission, however, made it clear that an allocation ‘according to Kyoto’ would not be acceptable.51 Instead, the discussion became focused on determining the level of ‘needed’ emissions in the future as the key factor in setting a national ceiling for CO2 emissions.52 In all Member States, projections of CO2 emissions played a major role in determining national and sector totals.53 No Member State wished to deviate far from expected emissions when determining the cap.54 Business-as-usual (BAU) emission projections were explicitly the ‘constraint’ for Member States not facing any compliance problem with the Kyoto Protocol. But even Member States, for whom compliance with the ‘Burden-Sharing Agreement’ was problematic, chose only gently constraining totals. In some ways, “the twenty-five cap-setting process in the first allocation round had the effect of a new burden sharing exercise for the emissions covered by the trading scheme”.55 Most Member States decided on the cap based on debate in non-public working groups.56 Accordingly, public debate was limited and little pressure was exerted on governments to resist the lobby of stakeholders opposed to more demanding caps. Apart from certain NGOs, which pressed for a more robust environmental outcome of the scheme,

46 Most Member States decided on the cap based on debate in non-public working groups. See Zapfel (2007: 30). 47 Chmelik (2007: 272). 48 Most new Member States had experienced a large drop in emissions during the 1990s due to the economic collapse after the fall of the Soviet empire. 49The spread of the reduction targets was considerable. Poland and Hungary, for instance had in the first period a target that was about 40% higher than their recent emissions, while Denmark had a target that was about 26% below their recent emissions. See Ellerman et al. (2007: 355). 50 Their opinion was supported by arguments that the drop in emissions in the 1990s represented a burden to industry and that an allocation of this surplus would represent an excellent payback. See Chmelik (2007: 272). 51 Chmelik (2007: 274). 52 According to Chmelik it quickly became clear that a bottom-up approach based only on company-level expectations would result in a consistent allocation level and that some ‘top-down’ constraints were necessary. Thus, the preparation of the allocation was often driven from both ends – with criteria limiting allocation on a macroeconomic level, but with a pressure from the bottom on the basis of company-level data and expected development. See Chmelik (2007: 274). 53 Ellerman et al (2007: 347). 54 Most of the Member States constituting the EU 15 adopted a total allocation for the trading sectors that was less than predicted business-as-usual (BAU) emissions, although often slightly more than recent emissions. Ellerman et al. (2007: 357); Zapfel (2007: 30). 55 See Zapfel (2007: 30). 56 See Zapfel (2007: 30).

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astonishingly little was heard from the interest groups promoting the use of combined heat and power (CHP), renewable energy or energy efficiency, to reduce the caps.57

2.3.1 The Commission’s assessment of the national caps From the standpoint of the Commission, the problem when reviewing the NAPs was the need to avoid overall allocations that exceeded expected needs, as this would cause the collapse of the system. The challenge was compounded by the absence of any reliable information about the actual emissions of the installations covered by the ETS. As projections are seldom accurate because of errors in expectations concerning important determinants of CO2 emissions, such as the rate of economic growth, relative energy prices, the energy efficiency and other structural transformations in the economy that either increase or decrease CO2 emissions, the Commission had to make sure that Member States based their projections on sound assumptions.58 Indeed, when caps are set at or close to the projected total, prediction errors have a much greater effect on the expected tightness or slackness of the cap. The issue was further complicated by the fact that most Member States notified their plans well after the deadline. As staggered submissions resulted in a staggered approval schedule, the Commission had to assess most plans without having an overall view.59 Finally, the relatively short time the Commission had at its disposal and the complexity of the evaluations to be performed made the task a daunting one.60 Clearly, the Commission had neither the mandate, nor the time and the expertise to fundamentally challenge the information provided by the Member States. In the end, the Commission required a lowering of the total cap for more than half of the plans.61 In total, the assessments resulted in some 290 million fewer allowances than intended in the plans initially presented, as well as the commitments for certain Member States to cancel the remains of new entrant reserves. This reduction represented less than 4.5% of total allocations. Unlike other trading programmes, the cap remained “well within the range of projection uncertainty” and thus contained the seeds of the future failure of the scheme.62 In its assessments, the Commission mainly relied on projections of total greenhouse gas emissions that Member States report regularly to the Commission. The Commission justified the necessity for lowering caps mainly by reference to the inconsistency of the proposed path to a Member State’s Kyoto target – in violation of criterion 1 in Annex III of the Directive – and an intended allocation above the projected needs of the covered

57 See Zapfel (2007: 33). 58 See Grubb et al. (2006a); Ellerman et al. (2007: 348). 59 Few Member States, however, submitted their NAP by the official due date. The last was received by the Commission on 3 January 2005, more than 9 months late. See Zapfel (2007: 23). 60 The difficulty of the job of the Commission is stressed by Vis who notes that the Commission ‘was expected to be the “bad guy” who would further reduce allocations, a role which would unlikely win it many friends'. See Vis (2006b: 202). 61 Zapfel (2007: 25); Vis (2006b: 201). 62 Grubb et al. (2006c: 13), Ellerman et al. (2007: 348).

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installations – a violation of criterion 2.63 Some plans were found to be on an inconsistent path to the Kyoto target because they had not sufficiently substantiated the intended purchase of Kyoto ‘units’ with public funds.64 While the cap was lowered for fourteen plans, only with respect to France, Poland and the UK, did the Commission adopt a decision rejecting part of the intended total cap.65 In all other cases Member States formally amended the submitted plan following bilateral contact with the Commission. One German operator and two Member States took the Commission to Court.66 Germany contested the decision on its plan because the Commission had disallowed a number of intended downward ex-post adjustments at the installation level. The case of the UK was special insofar as the Commission refused the amendment of a plan which had been approved at the first stage.67 As the change had the effect of increasing the number of allowances formerly authorised by the Commission, the Commission rejected it.68 It justified its decision on the ground that the UK was not allowed to submit a provisional plan under Article 9 (1) of the Directive and that it was only entitled to amend its NAP in order to address the incompatibilities identified by the Commission.69

2.3.2 The legal challenge of the Commission’s assessment of the British NAP

The UK filed a legal challenge against the Commission’s refusal to allow the increase in total allocations and requested that the action be decided under an expedited procedure.70 It stated, in particular, that the initially notified NAP was provisional and that the Commission had acknowledged this.71 The UK, hence, argued that it was allowed to revise the plan and, if necessary, to increase the number of allowances resulting from this review.72 The Commission objected that an increase of the cap would impair the

63 See the decisions on the first NAPs at http://ec.europa.eu/environment/climat/first_phase_ep.htm. 64 See Zapfel (2007: 25). 65 The decisions concerned the UK, France and Poland. See Zapfel (2007: 28). 66 Case T-374/04, Germany v Commission, action brought on 20 September 2004, OJ C 284, 20.11.2004, p. 25 (case still pending); case T-143/05, UK v Commission, action brought on 11 April 2005, OJ C 115, 14.05.2005, p. 39. The plea of the German operator was dismissed by the CFI as inadmissible. The case was dismissed because the Court decided that Germany and not the companies was entitled to plead before the Court. See case T-387/04, EnBW Energie Baden-Württemberg v Commission, Order of the Court of First Instance of 30 April 2007, OJ C 6, 8.1.2005. 67 The UK government had made it clear in its first submission that it considered the NAP to be a draft subject to revisions – both to the overall cap and to installation-level allocations. The Commission, however, was of the opinion that no changes could be admitted with regard to the cap once the NAP had been notified. See Harrison et al. (2007: 52). 68 Case T-178/05, UK v Commission, 23 November 2005, par. 50. 69 See above, par. 17. 70 To minimise the uncertainty that the legal action might engender, the government decided that only the allocations of the power sector would be affected by the dispute. The eventual outcome of the legal challenge left the total and the allocations of the installations unchanged. See Harrison et al. (2007: 54). 71 Case T-178/05, UK v Commission, 23 November 2005, par. 26. 72 Work on the NAP continued after submission to the Commission. In particular, outside consultants developed more detailed sector-level output projections. The revised projections indicated that the power

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contribution of the Directive to combating climate change and undermine the proper functioning of the scheme, as the market of allowances was reliant on the stability of the caps.73

The Court of First Instance (the ‘CFI’) judged that the plea of the UK was well founded and annulled the decision of the Commission.74 It stated that Member States were obliged to take account of comments received from the public after the initial notification of the NAP.75 If the public consultation was not to be deprived of its effectiveness, Member States would also have to be allowed to amend their NAPs if this meant an increase of the cap, opined the CFI. Moreover, underlining the importance of the comments of the public, it stressed that the consultation “might well identify material errors in the calculations underlying the plan or disclose new information”. The Court considered, further, that the purpose of the Directive was “to establish an efficient European market in greenhouse gas emission allowances, with the least possible diminution of economic development and employment”. This implied, in particular, that Member States had to take “due account of accurate data and information relating to emission forecasts for the installations and sectors covered by the Directive” and, thus, to be able to propose amendments “if a NAP was based in part on incorrect information or erroneous evaluations relating to the level of emissions in certain sectors or certain installations”.76 Finally, with respect to the arguments of the Commission about the repercussions of the increase in allowances on the stability and scarcity of the market, the Court simply held that this preoccupation was exaggerated.77

This decision is interesting in several respects. The main issue is a typical procedural question, where the participatory rights of the public have to be weighed against the interest in providing certainty and stability to the system. In a narrow sense, the Court was probably right when it judged that the marginal increase of the cap would have only marginal repercussions on the market and that precedence should be given to the iterative process of information gathering. From a broader prospect though, the Court seemed to have dismissed somewhat lightly the necessity for markets to rely on a stable cap in order to function properly. If it is true that the small increase of UK allowances would probably not have significantly influenced the market price, the possibility that other Member States would follow suit, was real and probably decisive in the Commission’s decision to reject the UK’s amendment.78 Moreover, unexpected changes may easily destabilise immature markets, which react, often disproportionately, to tiny modifications. Finally, the Court probably underestimated the signal it was sending to the wider public. By supporting the British plea, it reinforced the impression that the Commission’s attention was focused on petty modification, while, in reality, it faced an uphill battle to guarantee stringency, a role which was unlikely to gain it many friends. Surely, the judgment also sector’s analysis would be higher than previously thought. The total allocation was also revised to reflect further verification of emission totals. See Harrison et al. (2007: 52). 73 Case T-178/05, UK v Commission, 23 November 2005, par. 44 and 41. 74 See above, par. 74. 75 See above, par. 57-60. 76 See above, par. 60-61. 77 See above, par. 68. 78 See Harrison et al. (2007: 62).

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encouraged those stakeholders, especially in the ‘new’ Member States, who oppose the system altogether and consider the battle against climate change as secondary.79 A second point of consideration is the comment of the Court on the necessity to guarantee that the scheme leads to the “the least possible diminution of economic development and employment”, contained in recital 5 of the Directive. This implied, in the view of the Court, that the allocation of allowances would have to be based on the most accurate data relating to emission forecasts in the covered sector: a result, which, according to the Court, justifies the public being able to make comments after the notification of the NAP and Member States correcting possible errors. Certainly, the role of the contribution of the public and the correctness of data should not be underestimated.80 The assumption that there is a strict link between the involvement of the public, the accuracy of the calculations and the sound development of the economy, is, however, somewhat problematic. First, as comments mainly stem from affected stakeholders who seek to influence the allocation process in their favour, the flow of information provided to the national governments is heavily biased. Second, the exactitude of the information, especially in the field of emission forecasts, is always relative. As economists point out, emission projections depend on many variables and assumptions and thus have a high margin of uncertainty.81 Finally, the accuracy of the forecasting data is not per se a guarantee that the scheme will lead to the best economic result. Indeed, such a consideration relies on the assumption that, as long as allocations are in accordance with the future emission needs of operators, the efficiency of the scheme is safeguarded. That such a conclusion is wrong, has been abundantly demonstrated by economic theory.82 On the contrary, economists have consistently sustained that an allocation process based on historical emissions and projected emission ‘needs’ favours operators with CO2-intensive emissions over others and leads to an overall less efficient outcome of the scheme and the economy.

2.3.4 The collapse of the price of the allowance Although the Commission had successfully required certain reductions in allowances, many environmental interest groups issued statements censuring the lenient targets adopted by the NAPs.83 They feared that the market would not be sufficiently scarce and called for more detailed information on policies and measures scheduled for other sectors

79 Certain leaders of the new Member States such as the president of the Czech Republic, Vaclav Klaus are well known opponents of any action in the ambit of climate change. According to a report published on the webpage of Euractiv he wrote: “Communism was replaced by the threat of ambitious environmentalism” as “the biggest threat to freedom, democracy, the market economy and prosperity at the beginning of the 21st century”. See http://www.euractiv.com/en/sustainability/eu-emissions-trading-scheme, 15th September. 80 Zapfel (2007: 16). 81 Grubb et al. (2006 a) 82 See, in particular, Neuhoff et al. (2006a,b), Grubb et al. (2006a,b,c), Betz et al. (2006a,b), Sijm et al. (2006). 83 Mehling (2005: 155).

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of the economy. They were proven right. The verified data for 2005, released in April 2006, showed that 2,029 million tons of CO2 were allocated, but only 1, 932 million tonnes emitted. The market was ‘long’ by 93 million tonnes, corresponding to 4.6% of the allocated allowances.84 Only six of 24 countries had allocated less emission allowances than needed.85 As a result of the release of the data the price of the EUA fell from almost 30 Euros in mid-April 2006 to 12 Euros in mid-May before recovering to almost 17 Euros in mid-August 2006. Since then it declined slowly to reach a price level below 1 Euro at the start of 2007, where it has ever remained since.86

2.4 The caps in the second trading period

2.4.1 The second guidance of the Commission In December 2005, the Commission published a second communication, completing the first guidance given on the criteria of Annex III.87 Therein it stressed that Member States should make more use of the emissions trading to meet the Kyoto targets cost-effectively in the second trading period. Regarding the cap, the Commission distinguished between two groups of Member States: those which had a gap to close to reach their Kyoto targets and the others which had no compliance problem. Whereas the former would have to lower their first period caps, the latter were required “to maintain them to align their cap with their potential to reduce emissions” (criterion 3). Overall, the annual average in the second phase would have to be lower than in the first trading period. With respect to the first group, the Commission recommended that Member States aim for a balanced mix of (i) lowering the allocation for the second phase and (ii) implementing additional measures in the non-trading sector, potentially supplemented by (iii) the government purchase of Kyoto unit credits. Regarding the second group, the Commission considered that, as historically (1990–2000) carbon intensity reductions had balanced or even outweighed economic growth, the potential to reduce emissions would have to be calculated according to the combined effect of annual growth of GDP and carbon intensity reduction rates. Furthermore, the Commission stressed that any intended purchase of Kyoto units by the governments had to be duly substantiated, in compliance with the criteria set out in Annex 5 of the guidance. Any failure to fulfil the criteria mentioned therein would be sanctioned by a proportional reduction of the cap. A similar principle was established with respect to additional policies and measures. If Member States substantiated them

84 The market is ‘long’ if at the end of the trading year the number of allowances exceeds the emissions. This does not systematically imply that at the beginning there was over-allocation, as the excess of allowances can also be the expression of a reduction of emissions. See Kettner et al. (2007: 5). 85 Austria, Italy, Ireland, Greece, Spain and the UK. 86 See http:// www.pointcarbon.com; Convery (2007: 104). 87 European Commission, Communication, “Further guidance on allocation plans for the 2008-2012 trading period of the EU Emission trading Scheme”, COM (2005) 703 final.

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insufficiently, the Commission made clear that it would propose a proportional reduction of the cap. Finally, the guidance specified that the ‘supplementarity’ requirement contained in criterion 12 was applicable to aggregate greenhouse gas emissions of a Member State and intended government purchases of Kyoto units would have to be taken into consideration when evaluating the fulfilment of this criterion. What is noteworthy in this second guidance is that the Commission set for the first time an overall ceiling for the cap by requesting it to be lower than in the first phase. The other requirements outlined in the guidance are, however, only indirectly linked to the maintenance of some scarcity in the market. Indeed, neither the rather vague criteria with respect to the ‘reduction potential’ nor the obligation to maintain a balanced mix between the allocation and additional policy measures in the non-trading sector, suffice to secure the environmental effectiveness of the scheme. Moreover, the interpretation of the ‘supplementarity’ principle did not set any significant quantitative limit to the use of Kyoto ‘units’ within the ETS. Finally, the obligations imposed on Member States to substantiate their intention to purchase Kyoto units and provide evidence of abatement policies and measures in the non-trading sectors are certainly important in securing the fulfilment of Member States’ obligations under the Kyoto Protocol, but are not adequate to prevent another price collapse of the EUA. On the contrary, the more Member States can demonstrate that they have taken abatement measures in non-covered sectors, the higher they may set their caps.

2.4.2 The setting of the national caps As a result, the second guidance provided by the Commission was clearly insufficient to ensure that Member States would set constraining caps in the second trading period. It was thus no surprise that, notwithstanding the price collapse that had occurred in the meantime, Member States did not impose significant emission reductions in their NAP proposals for the second phase. A study based on 25 NAPS indicates that the proposed caps were only 1% lower than historical emissions in 2005, 2.1% lower than caps in the first trading period and 2.4% lower than projected emissions in 2010.88 The paper highlights a great dichotomy between old and new Member States. While the EU-15 intended to reduce emissions by 9.6% compared to 2005 data, which corresponds to a reduction of 6.7% with regard to the first trading period, the surplus of allowances in the new Member States was substantial compared to emissions in 2005, and amounted to an increase of 12.7 % compared to the first phase.

2.4.2 The third guidance of the Commission The reductions proposed by the Member States were clearly insufficient to guarantee a well functioning market in the second phase of the ETS. Being the initiator of the scheme and also its final arbiter, the Commission felt compelled to react strongly. Its credibility

88 The NAPs of Bulgaria and Romania were excluded by the study, as they face special circumstances due to their having recently joined the EU (in 2007). Schleich et al. (2007: 22).

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was at stake and what was more, the future of the whole scheme. To avoid a similar price collapse in the second trading period the Commission would have to drastically reduce certain caps. Notwithstanding the lack of a clear mandate, the Commission departed from its formerly cautious attitude. It stated without ambiguity in a communication attached to the appraisals of the first batch of NAPs that it would assess the plans in a manner guaranteeing sufficient scarcity to allow the ETS “to unfold its full environmental and economic potential in terms of environmental and economic benefits”.89 “To ensure a consistent assessment of all plans” its guidance on the criteria of Annex III determining the cap became much more concrete. Where possible, it underpinned the applied criteria with mathematical formulae. What is more, it defined a clear ceiling for the use of Kyoto units within the ETS.

With respect to criterion 1, the Commission clarified that Member States would have “to achieve at least a fair proportion of the outstanding effort”, i.e. the part reflecting the share of covered installations in total greenhouse gases. To calculate this share, it considered the progress Member States had made and the remaining gap to be closed in the period from 2008 to 2012 in relation to 2004. In accordance with its previous guidance, the Commission repeated that intended government purchases of Kyoto units as well as the reliance on other policies and measures would have to be sufficiently substantiated if they were to be taken into account. If this was not the case, the proposed cap would be reduced accordingly. Finally, it added that if Member States used trend developments of CO2 in the transport sector, which were significantly below those of a study mandated by the Commission, their caps would be lowered. 90

Regarding criteria (2) on emissions development and (3) on reduction potential, the Commission indicated that it would use its own methodology and set of assumptions when examining economic growth and carbon intensity trends between 2005 and 2010, taking especially into account the expected improvements in carbon intensity during this period.91 With respect to “banking into the second trading period”,92 the Commission clarified that this practice was only compatible with criterion 3 if banked allowances were deducted from the cap calculated in accordance with this criterion.

Finally, the Commission provided clear guidance with respect to the interpretation of the ‘supplementarity’ principle contained in criterion 12. According to the Commission the maximum overall amount of JI/CDM credits that a Member State can have recourse to, when calculating the part of the reduction effort to be made in the covered sectors to comply with its obligations under the Kyoto Protocol, is 50% of the “expected distance to

89 European Commission, COM (2006) 725, p. 2. 90 European Commission, COM (2006) 725, p. 8. 91 See European Commission, “European Energy and Transport Trends to 2030 – update 2005” published at http://ec.europa.eu/dgs/energy_transport/figures/trends_2030_update_2005/energy_transport_trends_2030_update_2005_en.pdf. 92 “Banking into the second trading period” means that unused allowances from the first trading period can be used for compliance in the second trading period. Only two Member States made use of this possibility, i.e. France and Poland.

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target”.93 If Member States did not intend to purchase any Kyoto units with government funds, operators were allowed to make use of them to the full amount of this limit. If not, the purchases with government funds would have to be subtracted from this limit, but not more than 90%.94

This new guidance is interesting in several respects. Faced with a situation where Member States put the future of the scheme at risk by continuing to confer excessively large quantities of allowances, the Commission finally felt sufficiently confident to assert the necessity to guarantee some scarcity in the second trading period. To warrant such an outcome the Commission had to set a cap below the range of “prediction uncertainties” as well as fix the ceiling for the number of Kyoto units allowed into the ETS.95 In contrast to the first trading period, verified emissions data for the covered sectors were available for 2005. Uncertainty was thus confined to emission projections for the second trading period. The difficult task was to distribute the ‘reduction effort’ among the Member States. As in the first trading period, two categories of Member States could be distinguished: one group with a gap to close with regard to their Kyoto targets, and those facing no significant climate constraints. Whereas the first group would clearly have to shoulder the main reduction effort, the Commission had to make sure that the second group would not free-ride the system through massive hand-outs of allowances. Regarding the group with no gap to close, the Commission’s challenge was to avoid certain Member States being able to calculate their ‘needs’ based on inflated growth perspectives and small improvements in carbon intensity. By substituting the usually more optimistic national forecasts of economic growth with its own prognosis, the Commission found a good compromise to prevent an excessive allocation of emission allowances while taking the perspectives of economic growth of these Member States into account. The problem of striking a balance between the Member States of the first group remained. Some of them had announced that they would largely have recourse to Kyoto units to fill their gap, thus reducing the necessity of achieving emissions reductions through the ETS. Others intended to assign the lion’s share of the reduction effort to the non-covered sectors. To prevent a situation in which a few countries would have to shoulder the whole reduction effort, the Commission had to find criteria allowing an equitable distribution of the obligations. Whether the conditions set out by the guidance give sufficient consideration to the wording of the criteria set out in Annex III is, however, not clear. If the decision to impose a ‘reduction effort’ reflecting at least the proportion of emissions of the covered sectors seems to be in line with the requirements of criterion 1, it is doubtful whether the

93 According to many analysts this limit does not place any practical constraints on the demand of CDM/JI by operators. Those authors consider that the scarcity created in the second trading period can be covered through imported credits. See Openeurope (2007: 20). 94 European Commission, COM (2006) 725, point 2.3. 95 See Grubb et al. (2006a).

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Commission was entitled to interpret criterion 1 in the sense that Member States have to substantiate any measure taken in the ambit of their climate policy to avoid a reduction of their caps. Also somewhat problematic is the decision to substitute the Member States’ emission forecasts with the projections of the Commission on the ground that the former deviate from the latter. Finally, the decision to set a ceiling on the import of JI/CDM credits may not find a sufficient legal basis in criterion 12 of Annex III.

2.4.3 The Commission’s assessment of the caps The Commission cut significantly certain caps of the first batch of Member States in its decision of 29 November 2006.96 Only the cap of the UK was accepted. The caps of the ten Member States, responsible for 42% of the emissions of the scheme, were reduced to a level that is more than 12% lower than the first period totals and about 7% lower than their 2005 verified emissions.97 The largest cut in absolute terms was required of Germany, amounting to 6% of the proposed cap, while the largest cut in relative terms was asked of Latvia – almost 56%.98 By September 2007, the Commission had taken decisions regarding 24 NAPs.99 Overall requested reductions with respect to the caps of 22 NAPs100 amounted to 9.4%.101 Most of the ‘new’ Member States had to substantially curtailed their caps, as most of them considerably exceeded the verified emissions of 2005.102 Applying the criteria developed in its third guidance, the Commission justified its decision to lower the caps in most cases by a contravention of criteria 1–3 of Annex III.103 It considered that non-compliance with these criteria fundamentally jeopardized the environmental objective of the scheme and was likely to amount to state aid pursuant to Article 87(1) EC.104 The Commission held that in these cases it could not exclude that “any state aid would be found incompatible with the common market should it be assessed in the light of Articles 87 and 88 EC.” 105 Finally, those Member States, whose recourse to Kyoto ‘units’ exceeded the ceiling fixed by the guidance were found to 96 The Member States concerned were Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, Slovakia, Sweden and the UK. 97 Convery et al. (2007: 94). 98 See Betz et al. (2006: 383). 99 All decisions on the second NAPs are published on the web page of the Commission under http://www.ec.europa.eu/environment/climat/2nd_phase_ep.htm, 4th September 2007. 100European Commission, Press release, Emissions trading: Commission adopts decisions on amendments to five national allocation plans for 2008-2012, IP/07/1094, 13.7.2007. 101 After negotiations with the Commission, certain decisions were slightly amended. For instance, the total number of allowances for the 2008–2012 trading period for both Ireland and Latvia was increased by 1.18 and 0.14 million tonnes, respectively. Moreover, the limit set on the use of Kyoto ‘units’ was slightly increased for Latvia (from 5 to 10%) and Lithuania (from 8.9 to 20%). See European Commission, Press release of 13.7.2007, Emissions trading: Commission adopts decisions on amendments to five national allocation plans for 2008-2012, IP/07/1094. 102 See, for instance the reductions of the caps for the Czech Republic (14.8 %), Estonia (48.8 %), Hungary (12.4 %) and Poland (26.7 %). 103 See for instance, European Commission, Decision on the second Slovakian NAP, 29.11.2006, par 4. 104 See for instance, European Commission, Decision on the second Slovakian NAP, 29.11.2006, par 15. 105 See for instance, European Commission, Decision on the second Spanish NAP, 26.2.2007, par 7.

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violate criterion 12 and were requested to make reductions in accordance with the Commission’s decision.106

2.4.3 Legal challenges of the Commission’s assessments of the national caps Not surprisingly, Member States, which saw their proposed caps drastically curtailed by the Commission’s decision, protested strongly. Slovakia was the first Member State to file a legal complaint with the Court of First Instance, followed by Poland, the Czech Republic and Hungary.107 Moreover, on 31 July 2007, Latvia published its intention to lodge a complaint with respect to its cap.108 Finally, a number of undertakings took legal action against the Commission’s assessment of the Polish cap. All four Member States that had already lodged their complaint with the Court of First Instance required the annulment of the Commission’s decision regarding the reduction of their caps. They relied essentially on three grounds of review: a violation of essential procedural requirements; an infringement of certain rules of law; and an excess of the Commission’s power of evaluation. Whereas certain complaints were common to almost all Member States, others were specific to one or two Member States. All Member States alleged an infringement of essential procedural requirements.109 The most common complaint in this respect was that the Commission had failed to consult the Member States as to the grounds on which it was prepared to take its decision. Moreover, Member States stated that the Commission had failed to give adequate reasons, in particular for why it had replaced the calculations and data provided by the Member States with its own.110

All Member States alleged a contravention of Articles 9–11 of the Directive and the relevant criteria of Annex III, in particular by “appropriating to itself without authority the task which the directive entrusted to the Member States”.111 Furthermore, many

106 See European Commission, Decision on the second Dutch NAP, 16.1.2007, par. 31; Decision on the second Austrian NAP, 2.4.2007, par.13; Decision on the second Spanish NPA, 26.2.2007, par. 12. After negotiations with the Commission the recourse to Kyoto ‘units’ was slightly increased for Latvia (from 5 to 10%) and Lithuania (from 8.9 to 20%). See European Commission, Press release of 13.7.2007, Emissions trading: Commission adopts decisions on amendments to five national allocation plans for 2008-2012, IP/07/1094. 107 Case T- 32/07, Slovakia v Commission, OJ C 69 of 24.03.2007, p.29, Action brought on 7 February 2007; Case T-183/07, Poland v Commission, OJ C 155 of 07.07.2007, p.41, Action brought on 28 May 2007; Case T- 194/07, Czech Republic v Commission, OJ C 199 of 25.08.2007, p.38, Action brought on 4 June 2007; Case T-221/07, Hungary v Commission, OJ C 199 of 25.08.2007, p.41, Action brought on 26 June 2007. 108 See Web site of the government of Latvia at http://www.vidm.gov.lv/eng/informacija_presei/preses_relizes/?doc=4963. The cap of Latvia had been curtailed by more than 55%. 109 The question of whether a provision is essential is not always easy to answer. Hartley suggests that one should look at the function of the provision and at the likely consequences if it is not observed. He stresses, however, that this is not the only test. See Hartley (2003: 416). 110 See, in particular, the Hungarian plea. 111 Case, in particular, the Slovakian plea.

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Member States stated that the Commission infringed certain legal principles such as the principles of legal certainty and loyal cooperation. Finally, most Member States considered that the Commission had exceeded its powers when evaluating the cap. They stated, in particular, that the Commission had made use of manifestly incorrect data and calculations and applied methods that were neither transparent nor objective and which led to an inaccurate determination of the caps. Slovakia submitted, furthermore, that the Commission infringed the proportionality principle by failing to take into account the need to increase its electricity production from carbon-intensive sources as result of the obligation to close two power stations. Poland raised the criticism that the Commission had limited the use of banked allowances, affected its energy security and failed to take into account that it had no gap to close with respect to its commitments under the Kyoto Protocol. Finally, the Czech Republic alleged that the Commission had infringed the principle of legal certainty and legitimate expectations by failing to publish its decision within the time limit laid down by Article 9 (3) of the Directive. The action brought by Poland was supported by eight other complaints, submitted by Polish companies, all requesting the annulment of the Commission’s decision to reduce the Polish cap by 26.7%.112 The alleged infringements are broadly similar to those asserted by Poland and the other Member States. One operator invoked, moreover, a ‘usurpation’ of competence, an error of assessment of the facts and a disregard of the special situation of Poland with respect to the Kyoto Protocol.113 Six companies criticized the Commission for setting a cap that was lower than that in the first period and adopting a decision after the deadline imposed by the Directive.114 Finally, one operator contended that the Commission had misused its power by underestimating the cap and claimed an infringement of the principles of legitimate expectations, equal treatment and the duty for institutional cooperation.115 It is revealing that all complaints were lodged by so-called ‘new’ Member States, which have no compliance problems with the Kyoto Protocol and did not participate in the debate preceding the adoption of the Directive. While their pleas appear, in part, legitimate, they highlight the complex problems created by the unfortunate compromise struck with respect to the cap. By decentralizing the decision regarding the national caps

112 Case T-193/07, Gόrażdże Cement v Commission, OJ C 170 of 21.07.2007, p.36; case T-195/07, Lafarge Cement v Commission, OJ C 170 of 21.07.2007, p.37; T-196/07, Dyckerhoff Polska v Commission, OJ C 170 of 21.07.2007, p.38; case T-197/07, Grupa Ożarów v Commission, OJ C 170 of 21.07.2007, p.38; case T-198/07, Cementownia "Warta" v Commission, OJ C 170 of 21.07.2007, p.39, case T-199/07, Cementownia "Odra" v Commission, OJ C 170 of 21.07.2007, p.39, case T-203/07, Cemex Polska v Commission, OJ C 170 of 21.07.2007, p.40; case T-208/07, BOT Elektrownia Bełchatów and Others v Commission, OJ C 170 of 21.07.2007, p.41. 113 Case T-193/07, Gόrażdże Cement v Commission. 114 Case T-195/07, Lafarge Cement v Commission; T-196/07, Dyckerhoff Polska v Commission, case T-197/07; Grupa Ożarów v Commission; case T-198/07, Cementownia "Warta" v Commission; case T-199/07, Cementownia "Odra" v Commission; case T-203/07, Cemex Polska v Commission. 115 Case T-208/07, BOT Elektrownia Bełchatów and Others v Commission, OJ C 170 of 21.07.2007, p. 41.

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and mandating the Commission to verify their compatibility in the light of criteria that do not explicitly require it to ensure the scarcity of allowances, future conflicts were inevitable. It is probably only due to the strong commitment and the negotiation skills of the staff of the Commission that more frequent conflicts have been avoided. The multiplication of guidelines laying down criteria that could hardly have been anticipated, are, however, illustrative of the limits of this type of governance. Moreover, the decision to publish its third guidance concomitant to its decision on the first batch of NAPs, seems to be at odds with the principles of legal certainty.

3. The allocation of allowances in the EU ETS

3.1 The legislative history Together with the setting of the cap, the choice of how allowances would be allocated was probably the most contentious issue of the ETS.116 In the Green Paper117 two principal approaches to the initial distribution of allowances were considered: allocation free of charge, often referred to as ‘grandfathering’, and auctioning. Auctioning usually refers to the sale of allowances, where the amount of allowances allocated to a source depends on the price it is willing to pay for them.118 The Commission considered periodic auctioning as the ‘technically preferable option’, judging that it would ensure an equal and transparent allocation for all participants and avoid the politically sensitive issue of determining the share of allowances to be attributed to each operator. The Commission stressed, moreover, that the revenues resulting from auctioning could be used for investments in greenhouse gas abatement efforts. It acknowledged, however, that companies would be reluctant to embrace this method as it implied that they had “to pay ‘up-front’ for what had not been paid for in the past”. While leaving the issue open, it stressed that significant divergences in the method of allocation among Member States could entail significant distortions of competition. In its legislative proposal,119 the Commission departed significantly from its considerations in the Green Paper. Instead of auctioning, it suggested that in the first trading period Member States should allocate all allowances to participating industries for free, based on objective and transparent criteria set out, in particular, in Annex III of the Directive. The Annex contained provisions for new entrants and made consideration of early action mandatory. Moreover, it underlined the need to prevent discrimination between companies or sectors and to limit allocations to what installations were “likely to need”. For the second phase, the choice relating to the method of allocation was left open. It would have to be decided at a later stage “in the light of experience” gained in the first trading period. With this proposal, the Commission hoped to accommodate both the

116 European Commission, COM (2000) 87; Mehling (2005: 135). 117 See European Commission, Green Paper on trading of greenhouse gas emissions within the European Union, COM (2000) 87 final, 8 March 2000. 118 See Lefevere (2005: 119). 119 European Commission, Proposal for a Directive of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC, COM (2001) 581 final.

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resistance to auctioning shown during the consultations among stakeholders and the concern about the effect of differing allocation methods on competitiveness.120 The European Parliament opposed this proposal upon its first reading and recommended, instead, that allowances be auctioned up to 15% during the first two trading periods. With regard to new entrants, it stressed that they should be treated in the same manner as all other participants. For the allowances allocated for free, the European Parliament supported the use of benchmarks, which, contrary to the allocation based on historical emissions, allow a distribution based on performance standards, so-called ‘benchmarks’.121 According to the European Parliament this method of allocation would help to reward past emission reductions and prevent unduly high or low allocation of allowances.122 The Commission rejected most of the amendments made by the European Parliament. Notably, it dismissed the suggestion to use benchmarks and underlined its opposition to any auctioning in the first period. It further clarified that the allocation criteria listed in Annex III were not exhaustive, but left Member States a certain degree of flexibility. Likewise, it stipulated that Member States should be free to choose the way they wanted to accommodate new entrants. Altogether, the Commission confirmed its earlier position that Member States should keep a large amount of discretion with regard to the method of allocation, allowing them to take into account their national specificities.123 The ‘Common Position’ of the Council re-introduced auctioning, but limited its use by stating that Member States would have to allocate at least 90% of the allowances free of charge in the second trading period. Some criteria contained in Annex III of the Directive were slightly amended. For instance, criterion 5, which limited allocation to what installations were “likely to need”, was replaced by a reference to the rules of state aid. Two new criteria relating to information on clean technology and consideration of foreign competition were added.124 Unlike earlier amendments by the Parliament, these changes were largely welcomed by the Commission. The European Parliament, in turn, used its second reading to suggest several more amendments. It pursued a ‘hybrid’ approach with respect to allocation, advocating the possibility for Member States to introduce a limited amount of auctioning in both periods. Benchmarking was made optional.125 Both proposals were acceptable to the Commission because they imposed no additional requirements on Member States. With this, the rules on allocation found their final form.

120 Mehling (2005: 139). 121 Benchmarks are often associated with best available technology, but they can also refer to an average emission rate for the sector. See Ellerman et al. (2007: 352); Vis (2006b: 193). 122 Mehling (2005: 140). European Parliament, Legislative Resolution on the Proposal for a European Parliament and Council Directive establishing a Scheme for Greenhouse Gas Emission Allowance Trading within the Community and amending Council Directive 96/61/EC (COM (2001)581), [2003] OJ C 279/96. 123 Mehling (2005: 140). 124 8th criterion and 11th criterion of Annex III. 125 7th criterion of Annex III.

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3.2 The rules governing the allocation process (Art. 9-11, Annex III of the Directive) Overall, the Directive leaves Member States with a considerable degree of freedom to break down the total number of allowances into amounts to be allocated for each individual installation. The main restriction is the requirement stated in Article 10 to allocate at least 95% of the allowances for free in the first trading period and 90% in the second phase. Moreover, allocation has to be based on objective and transparent criteria, including those listed in Annex III of the Directive. Nothing is said about the method of allocation after the second period, but a signal is given by Article 30(2) c of the Directive, which mentions that the review of the Directive in mid-2006 would have to look specifically at “further harmonisation of the method of allocation (including auctioning for the time after 2012)”.126 Article 22 of the Directive further provides that the Commission may amend the criteria of Annex III through the ‘comitology procedure’,127 with the exception of criteria 1, 5 and 7.128 Contrary to the provisions in the Directive, which concentrate on the mechanisms of emission trading, intended to be timeless and stable, the provisions of Annex III relating to allocation were conceived as more fluid.129 Some of them are obligatory, others optional, some important, others less so. As Member States had realized that constraining criteria would make their allocation process more difficult, they often ‘neutralized’ them by using the word ‘may’ which rendered the criterion optional. They remained in the annex “as a means of appeasing those who advocated the inclusion of these elements”. Criteria 3, 5, 6, 7 and 8 shall be examined in more detail hereafter, drawing notably on the guidance given by the Commission.130 Criterion 3 declares that allocation must be consistent with the emission reduction potential of covered installations. This consideration ensures that allocation reflects the differing abatement costs in covered activities, by placing for instance a larger burden on activities with low abatement costs.131 Criterion 3 (2) specifies that Member States may base their distribution of allowances on average emissions of greenhouse gases, by product, for each activity and achievable progress for each activity. This provision explicitly allows Member States to base their allocation on benchmarks, thus enabling them to penalise installations with a weak environmental performance.

126 See Vis (2006b: 198). 127 The ‘comitology procedure’ in the European Union refers to the committee system, which oversees the acts implemented by the European Commission on behalf of the Council of Ministers. Amendments submitted to this procedure may be decided more quickly than those governed by the normal legislative process. 128 The European Parliament did not want to allow the revision of these three criteria by the Regulatory Committee as, at that time, the European Parliament did not participate directly in the Regulatory Committee. See Vis (2006b: 198). See for more information on the amendments of the comitology procedure Pocklington (2006) and Vos (2005). 129 See Vis (2006b: 199). 130 European Commission, COM (2003) 830. 131 Mehling (2005: 146).

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Arguably, the most decisive criterion related to the allocation method is criterion 5. It rules out discrimination between companies or sectors which unduly favour certain undertakings or activities and violate, in particular, state aid rules. The guidance does not provide any clarification regarding this criterion, merely reiterating that rules on state aid apply.132 In a letter issued to Member States on 17 March 2004, the Commission clarified that “a violation of state aid rules was only likely in the event of excess allocation, allocation of more than 95% of allowances free of charge, and provisions for banking of allowances”.133

State aid is defined in Article 87 EC Treaty as “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States”. It is banned under the Treaty with some noteworthy exceptions. Once allocated to operators, allowances provide an asset to the beneficiaries, which they may sell on the market.134 The allocation of allowances is, hence, likely to favour certain undertakings at the expense of others, distorting competition. The legal doctrine is divided as to the state aid character of the allocation process.135 Another important issue is addressed by criterion 6, which states that Member States have to provide information in their plans on the manner in which new entrants will be able to participate in the scheme. It obliges Member States to define in advance how they want to implement Article 11 (3), which requires them to take into account the need to provide access to allowances for new entrants. Article 3(h) makes it clear that existing installations extending capacity are also ‘new entrants’ in the sense of the Directive. The first guidance136 outlines three possible options for how new entrants may be allocated allowances.137 First, new entrants may buy all allowances on the market. Second, Member States may set aside some allowances for periodic auctioning. Third, Member States may foresee a reserve in the NAP to issue allowances to new entrants for free. The Commission further notes that the operation of a reserve for new entrants increases the complexity and the administrative costs of the emissions trading scheme and recommends, in particular, that no multiple reserves dedicated to separate activities should be created.

Criterion 7 addresses the delicate issue of early action, which concerns installations that have already reduced greenhouse gas emissions in the absence of or beyond legal mandates. It states that Member States may take into account early action, by using, for instance, benchmarks related to best available technology. The accommodation of early action is considered desirable for equity reasons as installations that undertook early 132 Mehling estimates that criterion 5 merely affirms the applicability of state aid rules to allocation decisions. See Mehling (2005: 147). 133 Letter of 17 March 2004, ENV C2/PV/amh/D(2004) 420149, cited in Mehling (2004:148). 134 Mehling (2005: 147). 135 See for a detailed analysis on the state aid character of the allocation process de Sepibus (2007). 136 COM (2003) 830, point 2.1.6. 137 Meadows (2005: 81).

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abatement measures should not be disadvantaged vis-à-vis other installations that have not made such efforts. Member States are, however, free as to how they manage early action, as the criterion is not mandatory.

To illustrate how early action can be taken into account, the Commission provides guidance on three possible options.138 Member States may choose either a relatively early base period, give a bonus in a second round of allocation to operators on the basis of early action, or use benchmarks derived from reference documents concerning the best available techniques. If Member States choose to privilege early action they have to provide information in their NAPs on how they take it into account.

According to criterion 8, which is also optional, Member States may indicate how they take clean technology, including energy efficient technologies, into account. As installations using a clean or energy efficient technology have a lower technological reduction potential than comparable installations not using such a technology, they may make allowance for these features in their NAPs.139 Caution is required however, to avoid the latter being considered twice, once in relation to the reduction potential and once in accommodation of early action.140

3.3 The allocation of allowances in the first trading period

3.3.1 The general allocation methods

3.3.1.1 Little use of auctioning Although economists generally stress the superiority of auctioning over grandfathering and avoid most, if not all, problems associated with windfall profits, early action, excess allocation or treatment of new installations and closures, only four Member States (Denmark, Ireland, Hungary and Lithuania) decided to set aside a very modest amount for auctioning.141 The main reason why auctioning was so seldom chosen is without doubt the strong opposition of the owners of existing facilities who were heavily involved in the process of allocation. Confronted with the argument that unilateral auctioning would inevitably reduce the competitiveness of the affected industry, most Member States were unable to resist the political pressure to allocate all allowances for free.142

138 European Commission, COM (2003) 830, point 2.1.7. 139 European Commission, COM (2003) 830, point 2.1.8. 140 In an annex to the Guidance, the Commission elaborates a common format for NAPs. It lists a set of questions that should be considered in the first allocation plan, notably concerning the determination of the quantity at activity and installation levels. Technical aspects relating to abatement potential, early action and clean technology are mentioned, as are legal constraints under competition and internal market rules. 141 Schleich et al. (2007: 15). 142 Some political scientists, however, also underline the importance of another aspect. They argue that the lobbying argument fails notably to explain the phenomenon of new entrants and closure provisions and stress that distributions of private rights to public resources express social norms that often grant prior use a strong claim. A prior-use norm implies that a charge which imposes a drastic redistribution of those rights must in some way be offset. In the case of the ETS this means that the restrictions imposed by the system to limit CO2 emissions must be offset by the allocation of free allowances. See Ellerman et al. (2007: 365).

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3.3.1.2 Benchmarks are mostly used for new entrants Although the Directive leaves considerable discretion to Member States with regard to the method of allocation, the vast majority of Member States chose to distribute their allowances according to historical emissions. The failure to adopt benchmarking more widely was not because Member States had not tried to propose benchmarks.143 Indeed there is a strong argument in support of benchmarks, which favour carbon-efficient installations over less carbon-efficient ones since operators of the latter need to purchase missing allowances on the market.144 The resulting deviations of allocations from recent emissions at the installation level were, however, too great to gain wide acceptance.145 Even if benchmarks could be differentiated according to fuels or technologies and could thus soften the distributional effects, they were strongly opposed by a large majority of stakeholders.146 Moreover, benchmarking has proved to be very data-intensive, requiring both the establishment of emission standards and disclosure of output data.147 Given the short time Member States had at their disposal and the necessity to rely on voluntary cooperation of the stakeholders, the lack of easy access to data represented an important impediment to the creation of acceptable benchmarks.148 Another problem was source heterogeneity. Installations differed greatly even within the same sector. An example of the extent to which output heterogeneity led to differentiation was provided by the Netherlands, where 120 benchmarks were developed before the concept was abandoned.149 Finally, in contrast to installations in the US SO2 cap-and-trade programme, where benchmarks had been widely applied, there was no well-established standard for CO2 emissions, which could easily be extended to all operators.150

In some cases, however, benchmarking was applied, for example, in Denmark and Italy, where benchmarks were used for the electricity sector.151 In Denmark, the use of a benchmark was made easier by the similarity of the generating fuel profile of the two main electricity utilities. In Poland and Italy, industrial sectors were given the choice between benchmarking and ‘grandfathering’. The most common use of benchmarking, however, was its application to new entrants for whom there is no emissions history. The usual practice was to scale the allocation to capacity or expected output and to apply some benchmark generally reflecting best available technology. In all cases where benchmarks were used, either historical data were not available, sources were homogeneous or the industry was able to agree on a benchmark.

3.3.1.3 Historical emissions as the basic reference

143 See Ellerman et al. (2007: 352). 144 Schleich et al. (2007: 16). 145 Ellerman et al. (2007: 352). 146 Schleich et al. (2007: 16). 147 Vis (2006b: 194). 148 Ellerman et al. (2007: 353). 149 See above (2007: 352). 150 See above (2007: 353). 151 See above (2007: 353).

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In the absence of an obvious benchmark, ‘recent emission levels’ were the basic reference point for the allocations of allowances, both for Member States with a problem in reaching their Kyoto targets and those who were on track to reach them.152 The baseline used to define recent emissions was, however, not uniform. The majority of Member States chose an annual average of a multi-year baseline stretching back three to five years.153 Some countries, like the UK, adopted a drop-minimum rule, to allow firms to eliminate an unrepresentative year from the baseline. Baseline shares thus did not represent the actual shares of any single recent year, but reflected an artificial baseline corresponding to an average level of recent emissions.154

Most EU-15 Member States adopted a total allocation that was less than predicted business-as-usual emissions, but slightly higher than recent emissions. The resulting shortage was generally allocated to the electricity sector as the latter faces hardly any non-EU-competition and is generally supposed to have lower abatement costs than other sectors.155 With the exception of Germany, all Member States did indeed choose to break down first the cap into sectoral budgets as an intermediate step towards the installation level.156 The general method of allocation hence reflected a rationale which attributed as many allowances to industrial sources as they could reasonably be expected to need and imposed a compliance factor on the electricity sector by means of a uniform reduction from installation baselines. The determination of the needs of the industrial sectors was typically defined according to a combination of historical emission levels, emission-saving potentials and sector-specific growth projections.157

To take into account the fundamental uncertainty of emission projections, some Member States foresaw the possibility of making ex-post adjustments to their plans.158 The Dutch plan intended, for instance, to redistribute all allowances of the ‘new entrants reserve’, which had not been used towards the end of the trading period, pro rata to all installations. Other plans, notably the German, projected a curtailment of the allowances allocated if the installations were found to emit less than a certain percentage of their baseline emissions or allocation in a given year. These examples show that both upward and downward ex-post adjustments were foreseen.

152 See above (2007: 355). 153 See above (2007: 357). 154 The extreme version of such a baseline occurred in Hungary where the baseline was negotiated individually with all large emitters. See above (2007: 357). 155 The main exceptions to the allocation of the shortage to electricity generation were Italy and Germany. Italy has little coal-fired generation, which implies hardly any switch from coal to gas, which is considered to be the most common means to reduce CO2 emissions in the electricity sector. In Germany, the distinction took another form, but the rationale was similar. Whereas combustion processes – mainly electricity – were subject to the application of a compliance factor, process emissions were not. The reason given for this is that it is generally acknowledged that they have fewer possibilities for abating CO2 emissions without reducing production than combustion processes. See above (2007: 358). 156 The two-step allocation has both pros and cons. While it allows account to be taken of the specific circumstances of certain sectors, there are many more issues to be discussed and decided than in a one-step process. See Zapfel (2007: 18). 157 Some countries, notably Germany and Denmark, however, chose to give them their historic baseline amounts without involving projections. See Ellerman et al. (2007: 358). 158 Zapfel (2007: 27).

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3.3.2 Special rules

3.3.2.1 Rules concerning new entrants Article 11 (3) of the Directive requires Member States to take into account the need to provide access to allowances for new entrants.159 Specific guidance is given by criterion 6 of Annex III, which outlines three options, from which the Member States may choose. From an economic point of view, the option to make new entrants buy their allowances from the market is the most efficient, as investment decisions will be based on the full social costs.160 It also provides a strong incentive to implement energy-efficient, low-carbon technologies since these technologies require the purchase of fewer allowances. Notwithstanding these clear advantages and the greater administrative simplicity, all Member States chose to set aside a new entrants’ reserve.161 Driven by the fear of being placed at a disadvantage in the competition for new investments, they considered it necessary to allocate allowances to new entrants for free. Also, some felt that it was unfair to award allowances to incumbents and deny them to new entrants, notwithstanding that new entrants face no stranded assets.162 Overall, even though officials in the Member States were well aware that the free allocation of allowances to new entrants contributed to bias towards choices of technology that led to higher CO2 emissions, they were unable to resist the political demands that a reserve be included in the NAPs.163 A decision to build a new entrants’ reserve meant that Member States had to make decisions on many issues, such as the number of allowances to set aside, the allocation formulae applied to eligible new entrants, rules on exhaustion of the reserve and the treatment of allowances left in the reserve at the end of the trading period.164 Making their decisions at a rather late stage left Member States with little time for developing necessary details of the design. While all employed a benchmark based on some definition of best practice or technology multiplied by expected production or new capacity, the characteristics varied significantly from country to country and further contributed to distortions of the common market.165 Some used benchmarks according to which fuel or technology was employed, others applied a uniform benchmark. For instance, the UK, Denmark and Spain used a common benchmark for all fuels, while most other countries, notably Germany differentiated according to the type of fuel, thereby encouraging the installation of CO2-intensive industry. The resulting differences led to considerable dispute, emphasising the need for more harmonisation.166

159 According to Article 3 (h) of the Directive, new entrants are operators who start a business or extend (not increase!) their capacity during a trading period. 160 Schleich et al. (2007: 17). 161 This feature is exceptional insofar it is not found in other cap-and-trade systems. See Ellerman et al. (2007: 360). 162 Vis (2006b:196); Ellerman et al. (2007: 360). 163 Ellerman (2007: 360). 164 Zapfel (2007: 19). 165 Ellerman et al. (2007: 361). 166 Ellerman et al. (2007: 362).

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3.3.2.2 Closure rules The Directive does not fix any rules with respect to the closure of an installation. Member States are free to choose whether they want to give a fixed amount of allowances throughout the trading period or if, once an installation is closed, they want to stop the allocation for the remainder of the period.167 From an economic perspective, if allocation is terminated after a closure, companies do not properly account for the opportunity costs, old plants may continue to be operational too long, and new investment may be postponed.168 Notwithstanding these considerations most Member States chose to set closure rules, mostly for reasons of fairness as the absence of a closure rule was often perceived as equivalent to a ‘shut-down premium’.169 Hence, a type of fairness consideration prevailed over the efficiency argument.170

3.3.2.3 Transfer rules A final variation is the transfer rule that was pioneered by Germany and then adopted by some other Member States.171 A transfer rule allows the owner of a closed facility to transfer the allowances attached to it to a new facility, which is thereby not eligible for allowances from the new entrants’ reserves. The incentive to replace old installations with new is thus greater, especially if the allocation is based on historical emissions of the old installation rather than on benchmarks usually applied to new entrants.172 These rules are, however, detrimental to the efficient functioning of the scheme and distort competition.

3.3.2.4 Special provisions for early action, CHP and process-related emissions

Although the Directive does not require the adoption of special rules for early action, criterion 7 of Annex III expressly allows Member States to take this feature into account. Several Member States took advantage of this opportunity and applied a special bonus or a higher compliance factor to compensate for early action.173 Other Member States accounted for early action more indirectly by using longer or earlier base periods or by applying efficiency factors or benchmarks.

Process-emissions, which are, in particular, the side-products of lime, cement, steel and glass production, are not addressed by the Directive, but received more favourable treatment by many Member States.174 As abatement measures for these production methods are believed to be either very expensive or technically not feasible, several Member States applied a less stringent compliance factor either at the installation or sector level. 167 Meadows (2005: 83). 168 Schleicht et al. (2007: 19). 169 Ellerman et al. (2007: 360). 170 Vis (2006b: 195). 171 Ellerman et al. (2007: 361). 172 Vis (2006b: 195). 173 Schleich et al. (2007: 20). 174 Schleich et al. (2007: 20); Reuter et al. (2004).

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Finally, to support existing CHP, some Member States applied more favourable compliance factors or used ‘double benchmarks’ for heat and electricity.175 Other Member States gave special treatment exclusively to new CHP. Overall, many different types of rules tried to take into account the ecological advantages of this type of technology.

3.3.3 Evaluation of the allocation process The allocation process was a distributional exercise of considerable magnitude, whose success was highly dependent on an effective dialogue between the government and industry.176 An intense negotiation process took place between the responsible officials of the Member States and the industry concerned whereby data were collected, cross-checked and refined at the same time that distribution proposals were made. The time pressure imposed by the Directive worked as an important catalyst.177 Distributional conflicts between companies relating to the calculation of base period emissions, rules for recognition of early action or for new entrants and closures, were frequent.178 Overall, allocation choices, while endless in theory, were, in practice limited by data and political constraints.179 Even though free allocation based on recent emissions was perceived as unfair, as it favours less carbon-efficient installations and punishes early action, it soon became clear that any attempt to deviate from this baseline was to be met with fierce political opposition.180 The clearest example is perhaps the strong resistance to the so-called ‘fuel-blind’ benchmarks in the power sector, which attribute a coal-plant much fewer allowances than needed, while a gas-fired power plant receives considerably more allowances. In Member States with a broad fuel mix such allocation formulae did not receive any serious political attention.181 Although a distinguishing feature of the allocation process was the highly decentralized manner in which it was done, the role of the Commission was critical in arriving at the final result.182 In practice, its functions by far exceeded its formal duty to approve or reject a plan. Its contribution as an educator and facilitator may have been less visible but was probably no less important. During the whole process its expertise and guidance, be it in a formal or informal way, was actively sought both by national authorities and stakeholders.183 Studies funded by the Commission and guidance documents helped officials from Member States to become more familiar with the instrument and to engage in a rapid learning process.184 Working groups were set up to facilitate exchanges of information and allowed those charged with the implementation of the Directive to share experiences. Informal consultations were used to avoid confrontations and to allow the 175 Schleich et al. (2007: 20). 176 Ellerman et al. (2007: 344). 177 Zapfel (2007: 29). 178 Zapfel (2007: 30). 179 Zapfel (2007: 31). 180 Zapfel (2007: 32). 181 Zapfel (2007: 32). 182 Ellerman et al. (2007: 349). 183 Zapfel (2007: 22). 184 Ellerman et al. (2007: 350).

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process to continue. At an advanced stage, attempts were even made to involve the Commission as an arbiter between conflicting interests.185 The Commission, however, refused to take sides prior to the notification of the NAP.

3.3.5 The Commission’s assessment in the first trading period Using its powers to reject a NAP in a minimalist way, the Commission required changes mainly relating to the list of installations included and the intention to adjust allocations ex post.186 In certain circumstances, it asked Member States to make changes in order to avoid outright rejections after notification of the plan, thus sparing them unwelcome news coverage. For three Member States, the Commission adopted the plan only on the condition that more installations than listed in the initially notified plan were included.187 Overall, the Commission’s pro-active but non-interventionist attitude, leaving the Member States considerable discretion in the choice of their allocation methodology, generally avoided the outbreak of open conflicts and subsequent legal proceedings. For instance, only Germany contested the Commission’s decision on its plan because the Commission had disallowed a number of intended downward ex-post adjustments at installation level.188

3.4 The allocation of allowances in the second trading period As in the first trading period, most Member States allocated all allowances for free in the second.189 Likewise, the majority of Member States applied a two-step approach, first creating sector budgets and then allocating them to individual installations. While most EU-15 Member States used sector-specific compliance factors, the new Member States, which could easily reach their Kyoto targets, created no compliance factors at installation level. In all Member States, the basic allocation rules were supplemented by special provisions to account, in particular, for clean technologies, process-related emissions or early action. Again, most Member States allocated the allowances to existing installations according to historical emissions, this time based on periods extending to 2005, as verified emissions data at the level of installations were readily available for that first trading year.190 Only a few Member States avoided such updating and referred to earlier years191 or projected data.192 Several countries193 based their allocation for some existing installations, mostly power plants, on benchmarks. The majority of benchmarks were fuel- and/or technology- 185 Zapfel (2007: 22). 186 See Zapfel (2007: 25). 187 This was the case for France, Spain and Italy. 188 Case T-374/04, Germany v Commission, OJ C 284, 20.11.2004, p. 25, Zapfel (2007: 28). 189 Betz et al. (2006a: 372). 190 Betz et al. (2006a: 372). 191 For example Ireland, Sweden and the UK. 192 For example Greece. 193 For example Belgium, Italy, Latvia, Spain, Sweden and the UK.

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specific average benchmarks rather than uniform benchmarks or BAT194 benchmarks.195 Five Member States more than in the first trading period chose to auction off parts of their allowances.196 As in the first trading period, all Member States foresaw the creation of a reserve for new entrants, usually on a first-come-first-served basis.197 The only noteworthy exceptions were non-CHP plants in the Swedish power sector, which have to buy their allowances on the market. Most Member States allocated new entrants’ allowances based on BAT, only a few198 applied uniform benchmarks to newcomers. The reserves varied substantially in size ranging form about 2% of the total in Germany to approximately 45% in Latvia.199 Closure rules were again applicable in most Member States.200 Transfer rules were extended with respect to the first trading period. The number of special provisions, notably including compensation for CHP, early action increased.201 Most countries continued to treat process-emissions differently, as they are still believed to be either very expensive or technically unfeasible, at least in the short term.202 As a result of the Commission’s guidance, ex-post adjustments have been banned. Transfer rules in the case of closures have been further harmonised.203 In some Member States the complexity of allocation rules has been reduced, especially in Germany, where allocation had been based on almost 60 different rules. Special provisions for early action, process-related emissions or CHP installations have been phased out in several Member States, but introduced in others. Overall, however, the general allocation methodologies and concepts used did not change significantly in the second trading period, reflecting a high path dependency.204 Hence, little progress in terms of improved efficiency has been noted.205 It is particularly unfortunate that most baselines have been updated, as such a measure punishes early action and undermines the incentive of operators to rapidly reduce emissions as they might then receive fewer allowances in the next allocation round.206 Benchmarks were used more extensively, in particular in the power sector of the EU-15, but they are mostly

194 BAT stands for best available technique. 195 Betz et al. (2006a: 373). 196 The share of auctioned allowances amounts to 1.3% of the total budget of the 25 Member States analysed by Betz et al. excluding Bulgaria and Romania. See Betz et al. (2006a: 373). 197 See Betz et al. (2006a: 375). 198 Luxembourg, Sweden, Flanders, Wallonia and the UK. 199 See Betz et al. (2006a: 376). 200 See Betz et al. (2006a: 377). 201 Special provisions include the application of a different compliance factor or a bonus, special early action provisions for CHP or a double benchmark for heat and electricity. Some Member States apply a less stringent compliance factor to new CHP installations. Some Member States establish a special reserve for new CHP plants only. See Betz et al. (2006a: 378). 202 See Betz et al. (2006a: 378). 203 Schleich et al. (2007: 24). 204 See Betz et al. (2006a : 381). 205 Schleich et al. (2007: 23). 206 Grubb et al. (2006c: 16).

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fuel- and technology-specific. Auctioning slightly increased, but still falls considerably short of the maximum level of 10% allowed by the Directive.

3.4.2 The Commission’s third guidance regarding allocation methodologies

In its third guidance on Annex III the Commission addressed two specific issues with respect to the allocation methodologies. The first concerned ex-post adjustments and the second allocations leading to “undue distortions of competition and of the internal market”.207

Regarding ex-post adjustment, the Commission stated that Article 11 and Annex III, criterion (10) of the Directive required Member States to decide before the start of the trading period on the cap and the total quantity allocated to each installation’s operator.208 This implied, pursuant to the Commission, that no decision could be later changed and no allowances could be re-allocated by means of adding to or subtracting from the quantity determined for each operator on the basis of a government decision or a pre-determined rule. No exception was to be made to this rule, except for cases of closures and new entrants.

With respect to potentially discriminatory allocations, the Commission addressed issues specific to certain plans such as the issuance of allocation guarantees and banking.209 The Commission indicated that allocation guarantees, which entail effects beyond the first period and result in preferential allocations for benefiting installations compared to other existing installations, are discriminatory and likely to amount to an infringement of the rules on state aid.210 Moreover, the Commission considered them as detrimental for the environment as they provide a high degree of free allocation for carbon-intensive production modes “stretching far into the future” and, thus, limiting the incentives to invest in clean technologies. With respect to banked allowances, the Commission considered that they were likely to infringe Article 87 EC, if they did not represent the environmental counterpart of real emission reductions during the first trading period.211

3.4.3 The Commission’s assessments of the allocation methodologies

In contrast to the first trading period, during which the Commission had generally limited its examination to the question of whether the NAPs attributed more allowances to installations than they needed,212 the Commission extended its scrutiny in the second

207 European Commission, COM (2006) 725, point. 2. 208 European Commission, COM (2006) 725, point 2.1. 209 Although banking from the first to the second phase is allowed under the Directive, only France and Poland decided to allow banking. See Convery et al. (2007: 96). 210 European Commission, COM (2006) 725, point 2.4. 211 Only Poland and France decided to authorise banked allowances from the first to the second trading period. 212 The reason why the Commission mainly focused in its analysis on cases of over-allocation might be found in the legislative history of the Directive. Indeed, in the Directive proposal of the Commission,

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trading period. It examined, in particular, whether the allocation methodologies led to undue and discriminatory advantages for certain sectors and installations and/or an infringement of the rules on state aid. The assessments of the German, Polish, Spanish and Italian NAPs are illustrative of this new approach and are briefly discussed below.

In its appraisal of the second German NAP, the Commission examined certain provisions, which provided an emission guarantee for installations established during the first trading period, and which led to a more favourable treatment of these installations than of others in a similar situation.213 It rebutted, in particular, the arguments put forward by Germany that this treatment reflected a lower reduction potential of recent installations, stating that, as certain, only slightly older, installations used equivalent technologies, the reference to the starting date could not be used “as the primary justification for discrimination between existing installations”.214 The provision, thus, was held to contravene criterion 5.

Regarding the Polish NAP, the Commission stated that a reference to a baseline reflecting the production and SO2 emission levels of a single year, did not reflect average production conditions, as this rule was likely to discriminate in favour of installations that had particularly low production levels in that year.215 Considering that such discrimination could not be justified by any environmental objective, the Commission considered that “any aid involved would be found incompatible with the common market”. Furthermore, the Commission examined certain provisions providing bonuses for the use of biomass, co-generation and early action. It considered that the bonuses were in accordance with criteria 7 and 8 of Annex III, but, as they were handed out in addition to allowances calculated according to expected needs, they led to allocations for certain installations beyond expected needs.216 Thus, it held that these provisions contravened criterion 5. When examining the Spanish NAP, the Commission scrutinised, in particular, the allocation methodologies in the power generating sector. It found that, within this sector, coal-fired power plants were to receive allocations based on average emission factors, whereas the allocation of combined cycle gas turbines would be based on best available technique.217 Considering that this provision favoured the use of coal, which entails higher emissions than gas, it drew the conclusion that such a rule would not “serve the purpose of the Directive”. Moreover, the Commission examined the methodology within the group of coal-fired power plants. Considering that they were likely to favour installations using domestic coal and installations, which had made investments to reduce their SO2 level, it found that the former could not be justified by any environmental consideration, whereas the latter would not lead to any improvement of the Community standard. Finally, the Commission examined a rule which based allocations on the basis criterion 5 of Annex III, which now refers to the rules on state aid, stipulated: “nor shall any installation be allocated more allowances than it is likely to need”. See for more details de Sépibus (2007). 213 European Commission, Decision on the second German NAP, 29.11.2006, par. 20-24. 214 See above, par. 23. 215 European Commission, Decision on the second Polish NAP, 26.3.2007, par. 23. 216 European Commission, Decision on the second Polish NAP, 26.3.2007, par. 21. 217 European Commission, Decision on the second Spanish NAP, 26.2.2007, par. 8-9.

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of no other criterion than remaining free capacity, not taking into account expected or past capacity utilisation at installation level. As this rule had the effect of favouring installations using the free capacity less than others, the Commission found that the advantage was undue and could not be justified by any environmental purpose either. The Commission, hence, considered that all the rules were likely to be found incompatible with the common market in the light of Article 87 EC. With respect to the Italian NAP, the Commission noted that certain methodologies would lead to an allocation beyond expected needs, especially for the installations with the highest energy efficiency.218 The Commission stated that if Italy was allowed to treat early action or co-generation more favourably, this did not imply the right to allow allocations beyond expected needs. It thus found that these provisions might be found incompatible with the rules on state aid. Overall, the assessments of the NAPs in the second period reflect a refined approach regarding the compatibility of the allocation methodologies with the criteria set out by Annex III. The Commission examined, in particular, whether certain allocation methodologies violate criterion 5, namely the rules on state aid. This practice is to be welcomed, as seemingly objective provisions or distinctions may lead to discrimination between installations in a comparable situation, which cannot be justified in the light of the purpose of the Directive or the criteria of Annex III. Moreover, the Commission sanctions allocation methodologies, which lead to allocations of allowances exceeding ‘expected’ needs. The scrutiny of the Commission is, however, neither entirely consistent nor exhaustive. The limited time and personnel resources of the Commission have not allowed a thorough analysis of the discriminatory effects of the huge number of different allocation methodologies notified by the Member States. For instance, the Commission takes the opinion that the reference to average emissions for generators using coal and to BAT219 for those producing electricity with gas cannot be justified on environmental grounds, as this distinction favours a more CO2 emitting energy source. One would thus expect that the choice to base allocations on historical emissions, which has the same effects, would be submitted to the same scrutiny. This, however, is not the case. The scrutiny remains limited to certain modalities of allocation methodologies, such as the choice of a benchmark, a baseline or other parameters influencing the number of allocated allowances. Moreover, the Commission partly analyses the relevant provisions in the light of the wording of criterion 5,220 partly in accordance with the rules on state aid221 and partly with regard to both.222 The reasons for this difference in treatment are not always clear. The distinction, however, is not trivial, as a violation of criterion 5 results in a conditional approval of the NAP, whereas the potential contradiction with the rules on

218 European Commission, Decision on the second Italian NAP, 15.5.2007, par. 11. 219 BAT stands for best available technique. 220 See for instance, European Commission, Decision on the second Spanish NAP, par. 21. 221 See for instance, European Commission, Decision on the second Spanish NAP, par. 23. 222 See for instance, European Commission, Decision on the second German NAP, par. 23.

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state aid is not immediately sanctioned.223 Thus, only provisions, which contravene criterion 5, have to be amended in a non-discriminatory manner without undue delay and notified to the Commission. The others await an uncertain assessment in the light of Articles 87 and 88 EC. Indeed, it is unclear as to whether the Commission will open a formal state aid investigation once the second trading has started.

4. Conclusions In conventional emission trading systems, the power to fix the cap and to decide on the distribution of allowances is generally entrusted to a central authority.224 The Community chose to do otherwise in the EU ETS, leaving these decisions principally to its Member States. Such a decision was perilous, as the allocation of mostly gratuitous allowances results in a questionable distribution of wealth and confers significant incentives on stakeholders to abuse the system. Not only was it clear that operators would pressure their governments into handing out generous allocations of allowances, but Member States had a clear interest in setting lax caps, as this entailed a transfer of wealth from Member States with strict targets.225 The powers conferred on the Commission to control the allocation process were rather weak. The Commission received neither a clear mandate to safeguard the stringency of the overall cap nor the necessary resources to thoroughly scrutinize the numerous allocation methodologies as to their discriminatory effects on competition. It thus came as no surprise that the allocation process led to significant distortions of competition and a situation of over-allocation, entailing a complete collapse of the EUA price in the first trading period. Moreover, the attempt of the Commission to prevent a similar price drop in the second phase was immediately challenged by five ‘new’ Member States, who contested the right of the Commission to reduce their caps. Hence an outcome similar to that in the first trading period cannot be excluded. This risk is all the more real, as the limits imposed on the use of Kyoto ‘units’ might well be insufficiently strict to guarantee that significant domestic abatement measures will be put in place.226 When drawing the lessons from the experience so far, the first is arguably that a system, whose success essentially depends on the stringency of its overall cap, must either delegate this decision to an independent authority or, at least, confer on the latter the necessary powers to enforce scarcity and set up equitable allocation criteria. Second, a scheme, which decentralizes important decisions regarding its design, can only function if its members are sufficiently homogeneous and committed to ensure its efficient functioning. This is probably not the case in the EU ETS. Not only do certain ‘new’ Member States refuse to impose the slightest ‘reduction effort’ on their industries, but they do not hesitate to challenge the decisions of the Commission notwithstanding the clear risk this action engenders for the scheme. This attitude certainly reflects their more

223 See for more details on this question de Sepibus (2007). 224 See Kruger et al. (2007: 115). 225 Openeurope (2007: 5). 226 See Openeurope (2007: 5).

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