The Ten-Year Rule: Allocation of Emission Allowances in the EU Emission Trading System

In its guidance on National Allocation Plans (NAPs), the European Commission has discouraged Member States from adopting allocation methodologies that would provide incentives to firms affecting their compliance behavior. The purpose is to promote economic efficiency and to prevent strategic behavior that deviates from individual and collective cost-minimization. For example, some methodologies would reward one type of compliance investment over another. To discourage such actions, the EU Emission Trading System guidelines prohibit ex post redistribution of emission allowances within an allocation period based on behavior in that period. Similarly, the Commission has indicated that decisions about the initial distribution of allowances in the second phase (2008-2012) must depend on measures prior to 2005 so as not to give companies an incentive to adjust their behavior to receive a larger allowance allocation. However, two other aspects of the NAPs- the treatment of closures and new entrants -may also affect firm behavior. An undercurrent in these guidelines is the question of whether Member States should allow incumbent emitters to hold infinitely lived, once-and-for-all property rights to a share of the emission allowances in the future. This paper develops an approach for balancing efficiency considerations with perceived issues of fairness. We propose a ten-year rule to guide policy regarding closure of existing sources and the status of new sources and to guide the initial distribution of emission allowances in general. A ten-year rule would address issues of fairness and capture an important part of the potential gains that could be achieved through an efficient initial distribution of allowances.