The EU ETS has been up and running since 2005 and it is now the largest emissions trading scheme in the world. It is therefore important to understand how the scheme works in practice and how it operates in relation to general principles of environmental law.

In this chapter we have assessed the compatibility of some of the scheme's features, notably grandfathering and over-allocation, with the polluter-pays principle. Until 2012, the EU ETS primarily uses grandfathering to allocate the allowances free of charge based on historical emissions. Moreover, in 2005 there was an 80 million tonnes gap between emissions and allowances of the ETS sectors, suggesting that polluters received more allowances than they needed. Are grandfathering and over-allocation consistent with the polluter-pays principle?

To set out clear boundaries of our research question, we have built a taxonomy of possible interpretations of the polluter-pays principle where we distinguished an efficiency from an equity version. In relation to the equity interpretation, we speak of an 'extended' form of the polluter-pays principle, because equity is used as a criterion on top of (and not instead of) efficiency. Within the efficiency interpretation, we have identified a 'weak' form (no subsidization) and a 'strong' form (cost internalization).

We have concluded that grandfathering is consistent with the efficiency interpretation of the polluter-pays principle. Because grandfathered allowances entail opportunity costs, pollution costs are internalized, which makes grandfathering consistent with the strong form of the efficiency version of the polluter-pays principle. Moreover, grandfathered allowances constitute lump sum-subsidies that do not distort competition, which makes grandfather-ing consistent with the weak form as well. However, the claim that grandfa-thering does not violate the polluter-pays principle can only be defended from an efficiency perspective. Grandfathering improves the financial position of the shareholders, since polluters receive an asset with a market value for free. Such a capital gift, while not distortive in efficiency terms, has a redistributive impact which is beneficial for the polluter. Accordingly, grandfathering is unfair from an extended polluter-pays perspective. Only auctioning is consistent with this form of the polluter-pays principle, because it internalizes pollution costs and forces polluters to purchase their allowances.

To assess over-allocation, we have constructed a benchmark against which over-allocation can be tested and on this basis we have shown that over-allocation has indeed occurred to a considerable extent in the first phase of the EU ETS. We then explained why over-allocation is inconsistent with all aforementioned interpretations of the polluter-pays principle. Indeed, over-allocation entails a form of cross-subsidization, since environmental costs are shifted from the ETS to the non-ETS sectors. Those sectors outside the scheme will have to pay for the emission reductions of the ETS sectors if the country wants to comply with its emission target. This means that over-allocation violates the weak form of the polluter-pays principle. The cross-subsidy is inefficient because marginal abatement costs are higher for non-ETS sectors than for the ETS sectors. Because over-allocation leads to an allowance price of (almost) zero, there is no cost internalization, leading to a violation of the strong form of the polluter-pays principle as well. Finally, over-allocation violates the extended form of that principle, because of the burden transfer from ETS to non-ETS sectors.

From our analysis, it emerges that the polluter-pays principle is frustrated in a number of ways by the early design of the EU ETS. Some rethinking of the scheme is required if this principle is deemed important for European environmental law. Auctioning the allowances and strengthening the emission caps is necessary to bring the scheme more in line with the polluter-pays principle.

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