Who is [not] paying the carbon price? The subsidisation of heavy polluters under emissions trading schemes

Abstract

In the absence of a comprehensive and legally binding international agreement on global emissions reduction, the free of cost allocation of permits has been a political condition of the acceptance of Emissions Trading Schemes (ETSs) in most jurisdictions. As a consequence, up to now, many heavy polluters participating in the ETSs are not paying the full price of carbon. The extent to which pricing carbon affects specific sectors in practice remains unclear in most jurisdictions. In this thesis, I bring together and analyse the economics and legal literature in relation to free allocations. A detailed comparison of the free allocation mechanisms utilised in three ETS systems is then undertaken in order to make recommendations for scheme design rules that will be legally robust and will support the effectiveness of the ETSs, whilst limiting any negative impacts on international trade. Based on a systematic analysis of the available economic data, I observe that carbon leakage rates have been historically overestimated. As a result, governments have been providing free permits to a number of sectors which are not significantly exposed to carbon leakage. Furthermore, the inconsistent eligibility criteria for the free allocation of permits can distort trade between competitors liable under independent schemes. However, such trade distortions may be mitigated by harmonising the free allocation methodologies.The harmonisation process may take place under a linking agreement and should follow a best practice approach, avoiding the eligibility of an excessive number of sectors as carbon leakage exposed. I suggest in this thesis that cumulative criteria of high emission-intensity and high trade-exposure thresholds are recommended, along with the removal of any sole trade-exposure thresholds and sole emissions-intensity thresholds.Differences in the free allocation methodologies can raise legitimate concerns that such allocations can interfere with free trade, thereby invoking the various mechanisms of the World Trade Organization (WTO). I argue that the free allocation of permits is a subsidy according to the definition provided by Article 1.1(a)(1) of the Agreement on Subsidies and Countervailing Measures (SCM Agreement). Subsidies generally represent an unnecessary cost to society and may compromise the fairness of the ETS. I conclude that the European Union Emissions Trading System’s sole emissions-intensity threshold is a de facto specific subsidy, and that it may be actionable if it has adverse effects on the interests of other WTO Members. Furthermore, I argue that the free allocation of permits, based on a trade-exposure threshold, is subject to the notification rule provided by Article XVI, A(1) of the General Agreement on Tariffs and Trade. The European Union has been notably failing to comply with this requirement.