Opportunity costs and the polluter-pays principle
By choosing in favour of harmonization under the directive on emissions trading, the EU has acknowledged, as explained above, that it incorporates not only efficiency, but also equity aspects of the allocation of emission allowances into its legal decision regarding EC Article 87.
It would be inconsistent if this equity aspect suddenly ceases to play a role in other legal matters related to the same allocation of emission allowances. An example is the question whether allocation of emissions free of charge, as foreseen in the European directive, is compatible with the polluter-pays principle established under EC Article 174. The answer to this question is that there is compatibility between gratis allocation and the polluter-pays principle if emphasis is placed on the efficiency aspect of the distribution of emission rights: a consistent application of the equity approach, however, leads to a potential legal conflict between free distribution, like grandfathering, and EC Article 174.The existing legal literature has hardly considered this issue. And those authors who have considered the issue basically believe that a polluter does not pay for his/her pollution if emission rights are obtained for free, contrary to a polluter that has to buy the required emission rights at an auction (for example, Nash, 2000). In his most recent book, however, Woerdman (2004) makes a distinction between two possible approaches. According to the efficiency approach, a polluter also pays when he/she has received his/her allowances free of charge, namely in the form of the opportunity cost of using the allowances (next to his/her, direct, emission reduction costs). Instead of using the allowances, he/she could have sold them. According to the equity approach, in the case of gratis allocation, it is not the polluter who pays, but the public, because allocating emission rights free of charge can be interpreted as a wealth transfer from the public (or government) to the polluters.
In the form of emission rights that have economic value, the polluters, one could argue, receive the revenues that the government would have obtained in the case of an auction.The interesting thing now is that the member states of the EU have opted, as we have seen, for the harmonization of the allocation of emission allowances on a free-of-charge basis so as to avoid competitive distortions. This harmonization, however, is not necessary on efficiency grounds: not only companies with auctioned allowances, but also companies with allowances allocated for free make (opportunity) costs. The fact that a firm got its emission rights free of charge does not mean that it can ask lower product prices than a comparable firm that had to buy such rights. The former has no competitive advantage over the latter: allowances distributed free of charge are a so-called ‘lump-sum subsidy’ that does not distort efficiency. A lumpsum subsidy does not distort efficiency in the product market, since it does not affect marginal emission reduction costs and it does not alter the output and price decisions of firms. Nevertheless, by choosing to harmonize, the EU apparently has interpreted the gratis allocation of emission rights not in terms of opportunity costs, but in terms of a financial advantage or welfare transfer. This advantage plays a role, as we have noted before, in the equity approach.
A consistent application of this interpretation then means, however, that allocating emission rights free of charge is not compatible with the polluterpays principle under EC Article 174. Only in terms of opportunity costs can this allocation method be seen as compatible with this principle. If the EU were to suddenly stress the opportunity cost of gratis emission allowances in the case of the polluter-pays principle, while it disregarded this characteristic when considering the case of harmonization, this would be an inconsistent view on the allocation aspect of emissions trading.
This complex issue could remain a legal-theoretic debate behind the scenes, but it could, in principle, also grow into a political-legal conflict that would slow down (or even block) the implementation of permit trading in the member states of the EU. It seems, however, that the political will of the European institutions to implement emissions trading based on an allocation of emission rights free of charge carries more weight than the consistency of the legal and economic argumentations that are at the root of this system.
In addition, if there is an incompatibility, it still does not mean that the emissions trading system could not function. It is not the first time that legal- economic inconsistencies and imperfections have been observed, for instance in political and judicial decisions regarding European competition law and individual cases of state aid in general (for example, Hildebrand, 1998: 413; Cini and McGowan, 1998: 143). Furthermore, in the emissions trading directive, EU policy makers have chosen an, in principle, economically and legally solid design of trading pollution under an emission ceiling in the form of permit trading.
This does mean, however, that the decision making on this directive has been in two minds about the legal consequences of permit allocation, namely an equity view on the harmonization of the allocation of emission rights regarding EC Article 87 and an efficiency view on the polluter-pays principle applied to the same allocation of emission rights regarding EC Article 174. This is inconsistent from a law and economics point of view, but more pragmatic lawyers are likely to perceive it as a handy and politically acceptable way of getting the emissions trading system up and running.
Moreover, to some extent, one could argue that at least the European Parliament has been consistent, namely in using the equity view (although they could be accused, in principle, of neglecting the efficiency view). Members of the parliament, who initially pleaded for more auctioning, said that allocating first 90 per cent and then 95 per cent of the allowances free of charge would ensure the ‘progressive’ application of the polluter-pays principle and cause ‘less’ distortion of competition, insisting that further harmonization should be considered, including auctioning, for the time after 2012 (Worsley and Freedman, 2003: 15). On the one hand, it seems that a harmonized scheme that prescribes 100 per cent auctioning would ensure the ‘full’ application of the polluter-pays principle for them, which is consistent with the equity view.
On the other hand, it illustrates that in politics an allowance allocation method can be a ‘bit’ (or ‘more’ or ‘less’) consistent with the polluter-pays principle, whereas in a conceptual approach a particular allocation method is either consistent with this principle or not.On such a theoretical level, the analysis in this chapter also shows that the approach of various lawyers is incomplete if not incorrect. According to Nash (2000: 3, 13), for instance, the weak form of the polluter-pays principle is a rule against subsidizing pollution and the strong form is a requirement to internalize the costs of pollution. Nash argues that distributing allowances free of charge as under grandfathering is inconsistent with the weak form of this normative principle, because allowances are allocated at no cost which implies a subsidy. Moreover, because inconsistency is ‘demonstrated’ with the weak form, Nash does not check compatibility with its strong version. These arguments would appear to be inaccurate. First, although grandfathered permits are indeed a subsidy, which plays a role in the equity approach, the point is that they are a lump-sum subsidy which does not affect efficiency. The question of consistency with the weak form of the polluter-pays principle thus depends on the (equity or efficiency) approach taken. Second, grandfathered permits do internalize the cost of pollution, as demonstrated above, because of their opportunity costs. The question of consistency with the strong form thus depends on whether one recognizes and acknowledges the aspect of opportunity costs when allocating emission rights free of charge. This indicates that a law and economics approach is, at least, capable of supplementing the existing legal literature on this issue.