Guest posting by Prof. Endre Stavang

Free allocation and the rationale for emission trading: Is there an inconsistency?

Endre Stavang, Oslo University, Faculty of Law

In this post, I argue that free allocation is not inconsistent with the basic social rationale behind alienable emission allowances, and I indicate the legal relevance of this consistency analysis to the issue of designing a robust system. My question is: Is the argument below obvious, obviously wrong, or neither?
Should allowances allocated to each firm owning a polluting plant be given with or without financial compensation? The legislator must choose: 1. Quotas are allocated to firms without financial compensation. 2. The payment of a certain amount of money determined by the state is a condition for the allocation of quotas to the firm (through the use of an auction mechanism or by other means). Existing systems are predominately based on principle 1. Is this inconsistent with the basic purpose of minimizing total costs of regulating the emissions? The answer to this question of consistency is important for two reasons. First, consistency is a basic legal value. If free allocation is not consistent with a statutory rationale that is subject to a broad consensus, it is likely not sustainable. Second, the allocation of emission allowances may be reviewed based on state aid rules. The checking of consistency between the rationale of the regulation and its various details may be a crucial element in the review under the law of state aid. In sum, the following question is of particular interest: Is it inconsistent with the main rationale behind alienable allowances to give out such allowances without compensation?
As a starting point in this evaluation, the concept of opportunity costs is relevant. Generally speaking, there will be an incentive for firms to abate under both principles. If a firm chooses not to abate, it will incur a cost in the form of lost revenues from selling allowances. The opportunity cost is as real as the expense under auctions and other forms of making firms compensate for allocated allowances. However, the existing tax system influences work incentives and savings decisions in an undesirable way. If the allowances were auctioned, the government could lower these disincentives while maintaining their total income. Thus, although the basic rationale behind alienable allowances does not dictate auctions rather than free allocation, it is clear than free allocation causes some extra social costs. By how much is an empirical question. The question, then, is whether these costs are unnecessary or whether there are some corresponding benefits of free allocation.
The benefits of free allocation are related to its distributional consequences which may feed back into the efficiency analysis for both fairness as well as public choice reasons. First, let’s look at the fairness aspect. Obviously, auctioning the allowance will, when compared to the free allocation of allowances, change the distribution of wealth between the firms and the state. If the allowances were sold by the state in a well-functioning market, the firms would have to pay a price that reflected the scarcity of the allowances, and this price would equal the tax rate that the state would have imposed in an optimal emission tax system. Thus, in addition to the costs of abatement, the firms would have to pay a tax that is disproportionate with the harm that, as a matter of theoretical attribution, is the result of the firm’s emission. This so-called excess burden is a well-known feature of an emission tax rate equal to the marginal costs of harm caused by the emission, and auctioning allowances would entail a similar excess burden. This lack of proportionality may run against sentiments of fairness and justice, and if such sentiments are widely shared by individuals in the relevant jurisdiction, it may seem justified to count this lack of fairness or justice as a cost of the auctioning system as compared with free allocation. Second, it may also be relevant under the criterion of cost-effectiveness that the design and operation of the tradable emission allowance system requires industry participation and cooperation. If auctioning rather than free allocation is chosen, and if that choice makes firms ex ante less eager to cooperate in the practical implementation of the allowance system, it may become more difficult and hence costly to gather necessary information and to run the system. Such administrative costs are relevant under the criterion of cost-effectiveness.
It may seem that the costs of fairness and administration discussed above are somewhat fanciful, and that an analysis under the cost-effectiveness criterion should only include costs that may be documented to exist. However, legislative history of the Norwegian greenhouse gas emission trading act indicates that these are real concerns. In the 1990s, some preparatory work indicated that the government was preparing for a shift towards a consistent use of “green taxes” as the preferred environmental regulatory instrument. However, after a hearing in parliament (“Stortinget”) in 1998, it became evident that the politicians and their expert advisors favoured emission allowances (property rights) over taxes to regulate greenhouse gases nationally. Moreover, in 2002, Stortinget explicitly instructed the cabinet to develop the details of the act, based on free allocations of allowances, in close dialogue with industry. In my opinion, it is reasonable to infer that the political system in this way acknowledged that there are relevant considerations to make besides the aggregate costs of harm and abatement.
Another type of argument that might be relevant and could serve as a counter-argument to the free allocation of allowances, is that such allocation contradicts the Polluter Pays Principle (PPP). This principle has been invoked by governments on numerous occasions over the years. However, the PPP comes in a narrow and a wide version. The narrow version says that the polluter should bear his own abatement costs and thus rules out the bribe option. This does not tell us anything about free allocation versus auctions, The wide version of the PPP has relevance as a theoretical idea, but is not supported by actual law or policies in any consistent way. This version states that all harm should correspond to financial expenditures for the firm. However, this version lacks support in actual legal policy-making practices. So far, a consistent set of optimal environmental taxes has not been put into effect. Industrial pollution is mainly regulated through a concession system, and the civil liability for the firms are then regulated not by pure strict liability, but through a system of tolerance limits with entails a doctrine of reasonable use. Thus, the wide version of the PPP is far removed from the preferences of the political community as revealed through actual legislation. In this situation, it is not clear why we should accord it independent weight in the evaluation under the criterion of cost-effectiveness.
It might be argued that the polluters should pay upfront for the allowances in order to keep size of the polluting sectors down. It might seem that free allocation is insufficient in this respect, since the allowances would be withdrawn if the plant shuts down. Thus, the incentive to shut down would be too small, and the polluting sectors too large. However, as long as the total emissions allowed over time are somehow kept within the fixed cap, this should not be a problem in aggregate. Moreover, a real PPP system would also be imperfect in that it is subject to the excess burden problem and thus may lead to too many shut-downs.
In sum, the conclusion must be that it is not a clear inconsistency between cost-effectiveness as the main rationale behind greenhouse gas emission trading and the choice to allocate alienable allowances without compensation. As already mentioned, this conclusion may be relevant for the application of state aid rules, and it may be that Norway and EU members have paid insufficient attention to the implications of this point in the structuring of their emission trading systems. A “property approach” to allocation plans might work, but this would have to be developed elsewhere.