As the U.S. Congress takes on President Obama’s call for a cap and trade system, Kevin M. Dempsey, partner at Dewey & LeBoeuf, argues that it should look towards Europe’s experience. In the second part of his Globalist Paper, he explains the benefits of carbon auctions — and the complications they may create under WTO law.

As the U.S. Congress begins to consider how to follow-through on President Obama’s call to create a cap and trade system to limit greenhouse gas emissions, it ought to begin by looking at the European experience with cap and trade.

The European Emissions Trading Scheme (ETS), which first went into effect in 2005, is the first significant attempt at establishing a wide-scale cap and trade system to limit the emission of carbon dioxide. Like any significant new policy program, it had to work out some kinks in its early days, and the United States would do well to heed the lessons learned from the European experiment.

The ETS was itself modeled on the U.S. cap and trade scheme for reducing emissions of sulfur dioxide — the principal cause of acid rain. The U.S. acid rain scheme had been put into place in the mid-1990s as a first test of academic theories that market-based mechanisms for reducing pollution could reduce emissions of harmful substances more cost-effectively than traditional command-and-control regulatory regimes.

This U.S. system worked remarkably well. This was in part because there were readily available commercial solutions to reducing sulfur dioxide emissions, and in part because it was limited to one sector — coal-fired electric utilities. Substantial historical data on emissions levels from the sector allowed U.S. regulators to efficiently allocate allowances at the introduction of the system.

When the EU created its ETS, it took on a much bigger challenge — seeking to reduce carbon emissions from major installations across a number of sectors for which there were limited historical emissions data.

Like the U.S. acid rain scheme, the EU ETS, in its first phase, allocated emissions allowances for free to various industries and plants, rather than auctioning them off.

Unfortunately, because limited data required reliance on estimates of historical emissions levels and projections, the total amount of allowances initially allocated by the EU authorities placed no significant overall constraint on emissions levels. This led to a collapse in the market price of the allowances when the full measure of the cap became evident.

The EU experience has led policymakers in the EU and many other countries to return to the idea of auctions as an allocation tool for allowances for greenhouse gas emissions. Auctions have long been favored by academics as a more efficient mechanism — one that treats new market entrants on an equal footing with well-established firms.

Auctions also avoid the potential distortions of allocation decisions that can result from lobbying, especially where — as in the case of greenhouse gases — hard data on historical emissions levels may be limited.

But auctioning is much more difficult politically and makes the potential competitiveness issues all the more real. If firms must pay for the right to emit greenhouse gases or use energy whose production created such emissions, then their competitive disadvantage relative to unregulated firms becomes stark.

As the EU debated the introduction of auctioning, the competitiveness/leakage issue came to the forefront, and various proposals — including the adoption of import measures — were actively considered. Ultimately, however, the EU chose a different path to address the competitiveness issue.

In December 2008, the European Parliament adopted a plan to upgrade and expand the existing EU carbon Emissions Trading Scheme by, among other things, introducing the auctioning of emissions allowances beginning in 2013.

As part of the new EU approach, selected industries determined to be of particular risk of carbon leakage (due to their carbon/ energy intensity and trade exposure) would be granted free allowances, rather than being required to buy them at auction.

A program of free allowances should reduce the degree of competitive disadvantage facing such industries as a result of cap and trade regulation, at least to the extent that such industries would otherwise have to buy allowances at auction. Moreover, a free allowance scheme would help on both the import and export side of the equation.

But there is one risk that must be considered with regard to this approach: free allowances may constitute a subsidy under WTO rules.

Under the WTO, an actionable subsidy is deemed to exist if (1) there is a financial contribution by a government, (2) a benefit is thereby conferred, and (3) the subsidy is specific to an enterprise or industry, or group of industries.

To the extent that a free allowance scheme is adopted as a program to assist a few targeted industries within the context of a broader auctioning system, there is a real risk that the free grant of allowances could be found to be an actionable subsidy under WTO rules.

The WTO Subsidies Agreement specifically defines as a "financial contribution" by a government a situation where "government revenue that is otherwise due is foregone or not collected."

If allowances are generally auctioned off by the government, then the grant of free allowances to certain industries certainly looks like the government is foregoing revenue that is otherwise due. Further, if the allowances handed out for free can be sold on the allowance market for cash, then those allowances appear to confer a clear economic benefit to the recipients.

Finally, if the special free allowance program is limited to a few energy-intensive industries, then there is a real possibility that the subsidy would be considered to be specific, and therefore potentially actionable under WTO rules.

Simply because a subsidy is actionable, however, does not mean that countervailing duties or trade retaliation is permitted against the subsidized goods. Under WTO rules, only prohibited subsidies (those conditioned on export performance or import substitution) or those that are found to cause adverse trade effects (e.g., injury to another WTO member's industry) can be acted against.

Nevertheless, the potential for trade action does pose an increased threat to those industries receiving free allowances. This raises the question of whether — given the importance of encouraging countries to take action to address climate change — an understanding should be negotiated in the WTO to permit free allowances granted pursuant to legitimate cap and trade systems.

There certainly are precedents for "green-lighting" of certain subsidies believed to serve other important social goals, and climate change may justify similar treatment.