Debate is raging at the moment as to the economic and political wisdom of imposing a so-called windfall tax on the profits of the UK's energy companies. Politicians, business people and consumer groups have all offered their views on what has been described as a "legalised raid" on the energy companies. But are the proposals "legal" at all?

In that context it is important to consider where the profits in question are likely to have arisen. The high retail prices being paid by energy consumers are, in many ways, simply a reflection of the high wholesale prices (particularly for imported gas) being paid by energy suppliers.

On the other hand, it is certainly the case that energy suppliers have profited from the sale of allowances allocated to them free of charge under the EU emissions trading scheme. The EU scheme, which operates on a 'cap and trade' basis, enables those who do not use up their capped entitlement to emit greenhouse gases to sell their unused allowances for cash to those who need more to stay within their own caps. The scheme has been running since 2005. During the first phase of the scheme (2005 – 2007) a minimum of 95% of allowances were allocated free of charge. This has been reduced to 90% for the next phase of the scheme, which runs from 2008 to 2012. The balance of allowances are made available through the market, e.g., via auctions. In future phases of the scheme, the percentage of allowances allocated free of charge will be reduced drastically.

The profits made by selling these free allowances have become a major focus for the windfall tax campaigners. The suggestion is that either these profits should be clawed back directly by the Treasury by taxing them (presumably over and above the normal corporate taxes to which they would be subject) or that the free allocation of allowances should be cancelled, at least in part, and suppliers should be forced to pay full market price for them.

However, what these arguments do not appear to take into account is that the free allocation of allowances is an explicit part of the EU scheme. Indeed, the EU Directive, which established the scheme specifically mandates each of the Member States to allocate the minimum percentages mentioned above, "free of charge". It is on that basis that the UK Government created something known as the 'National Allocation Plan' (which envisages allocating 93% of allowances free of charge during the 2008-12 phase of the scheme) and then notified individual firms last year as to the precise number of free allowances that they had been allocated for the 2008-12 period.

The requirement to allocate a (gradually diminishing) proportion of allowances free of charge is, of course, designed to permit industry time to adapt to the caps imposed under the scheme. The profits generated from the sale of these free allowances means that industry can invest in new, cleaner plant or in other ways of reducing emissions. The imposition of a harmonised, minimum level for free allowances across all Member States is also designed to ensure that competition across the EU is not distorted, as might well be the case if the bulk of allowances were allocated on the basis of auctioning in one Member State but allocated free in another.

So, given that the Directive clearly requires allowances to be allocated on a "free of charge" basis, is it legally open to the UK Government to impose a windfall tax or other claw-back mechanism aimed at the profits generated from selling these free allowances? In my opinion, the answer to that question is likely to be 'no'. However it is done, it seems clear that the effect of any such measure would be to impose a price for the allocation of these allowances. They would, in other words, cease to be "free of charge". In addition to this fundamental legal objection, the option of cancelling some of the free allowances would also appear to contravene the requirement under the Directive that Member States cannot make adjustments to the numbers of allowances allocated after they have made and notified their final allocation decisions (which the UK did last year).

Unless the UK Government can persuade the other Member States to amend the Directive (which would seem unlikely), it would therefore seem to face something of an legal roadblock.

Gordon Downie is head of the Competition, Regulation and Public Law Group at Shepherd and Wedderburn LLP.

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