Competitive distortions and state aid

Contrary to the general design of the EU directive on CO₂ emissions trading by choosing in favour of permit trading, the specific harmonization of the allocation of emission rights, as foreseen under this directive, is not compat­ible with the neoclassical economic textbook model.

The concept of ‘competitive distortion’ (and thus not something like fair competition or equal treatment) is at the centre of the legal definition of state aid under EC Article 87. Legal research has shown that this concept has been used in European environmental law, sometimes as a distortion of efficiency and sometimes as a distortion of fair competition (Van der Laan and Nentjes, 2001). Many authors are inclined to think that the allocation of emission rights across member states must be harmonized to avoid competitive distor­tions (for example, Lefevere and Yamin, 1999; Cozijnsen, 2002). This depends, however, on what law and economics perspective decision makers and law­yers take (Woerdman, 2004).

Everyone understands that a company has to spend money for its emission allowances at an auction and that it saves these costs when these rights are allocated free of charge. Some lawyers then refer to a gratis versus a ‘finan­cial’ distribution of emission rights and refer to the first option as less market oriented (for example, Peeters, 2002: 191). But many authors do not seem to realize that allowances that have been allocated free of charge also involve costs for firms. According to a neoclassical economic approach, allowances handed out free of charge have an ‘opportunity cost’ when they are used for covering the emissions of the allowance owner (for example, Nentjes et al., 1995; Grafton and Devlin, 1996). This alternative cost, which is equal to the price for which the allowances could have been sold, must be included in the product price if the firm does not want to go bankrupt in the longer term. The opportunity cost is the revenue forgone by not selling the allowances, but employing them in producing output: instead of using the allowances, the firm could have sold them.³

On the basis of this aspect, which has been neglected by various authors (for example, Peeters, 2003: 90), there is no competitive distortion in the aforementioned example in which one firm has to buy its emission rights, while its competitor gets them for free. The latter company does not have a cost advantage vis-a-vis the former (ceteris paribus). Because the firm with gratis emission rights has to pass on the alternative cost, it cannot ask lower product prices (in a well-functioning market) than a firm with auctioned emission rights.⁴ This means that harmonization on the basis of gratis alloca­tion is not necessary according to this efficiency-oriented approach.

The decision to harmonize is therefore not grounded in efficiency, but in equity concerns. A neo-institutional economic approach learns that allocation free of charge distorts fair (not efficient) competition if the emission rights are auctioned in another country, because companies with free permits are financially favoured above their competitors which had to buy their emission rights.

According to EC Article 87(1), we speak of state aid, for example if the aid, granted by a member state or through state resources in any form whatso­ever, distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods, in so far as it affects trade between member states. The European Commission uses additional criteria to determine whether or not a measure is to be regarded as state aid, like the ‘state origin’ criterion which is also satisfied if the government forgoes rev­enue that would otherwise have been collected (COM, 2000b).

Allocating emission rights free of charge is not state aid in the efficiency approach of competitive distortions with a view to their opportunity costs, but it is state aid according to the equity approach because of the financial advantage that gratis allocation implies and because the government would have received income (either to be recycled in the economy or not) in the alternative option of auctioning. Free allocation, like grandfathering, in fact means that the (hypothetical) revenues from an auction are given to the polluters (for example, Welch, 1983: 168). But even then there are legal possibilities to allow an allocation free of charge on the basis of EC Article 87(3). The European Council, for instance, can ‘simply’ decide that the state aid under consideration is compatible with the common market. According to a law and economics approach, such legal ambiguities and complexities add to the perceived set-up costs (by decision makers) of permit trading.

Interestingly, in its decisions of April 2000 and November 2001, the Euro­pean Commission indeed considered grandfathering to be state aid in the experimental permit trading schemes of Denmark and the UK by using the state origin criterion: the state forgoes revenue which could derive from auctioning the valuable permits (COM, 2000c; COM, 2001). Nevertheless, the Commission exempted the aid in both cases by using environmental, economic, legal as well as political arguments. The grandfathering was al­lowed as state aid, among other things, by following EC Article 87(3)(c) on developing certain activities or areas and surprisingly enough not by pointing at aspects of the allocation per se, but by highlighting the more general characteristics of the emissions trading scheme itself, like the positive contri­bution it makes to environmental protection, and by stating a political desire to gain experience with and prepare for emissions trading.