A windfall tax on the energy sector's emissions permits would probably be illegal as well as unfair, says Gordon Downie

Although attention has shifted towards energy efficiency measures, the political debate surrounding a windfall tax on Britain's energy companies looks set to continue into the autumn. The TUC conference this month is expected to endorse a call by the union Unite for "a windfall tax on the huge profits of energy companies", which have been accused of exploiting the rise in oil prices. Given that the Compass pressure group has won the backing of 93 Labour MPs for a petition calling for a windfall tax, it also seems likely that the point will be debated at the Labour Party Conference in October.

In most discussions about such a tax, the debate tends to centre on the economic and political wisdom of imposing a measure of this sort. Politicians, business people and consumer groups have all offered their views on what has been described by the Association of Electricity Producers as a "legalised raid" on their members. But are the proposals "legal" at all?

In looking at the legality of a windfall tax, there are a range of arguments to consider. There are, for instance, points that could be raised under domestic constitutional law, such as the Human Rights Act and the common law doctrine of legitimate expectation. Much could potentially be made of the absence of any manifesto commitment to introduce such a measure. Likewise, much could be made of explicit assurances given about the one-off nature of the last utility windfall tax in 1997.

There are, perhaps, obstacles to the introduction of a windfall tax in terms of EC Treaty law, such as the provisions aimed at avoiding the distortion of competition between firms. These rules are of particular relevance when it comes to considering the detailed implementation of any such measure and, for example, the exemption or exclusion of particular classes of person from coverage.

Environmental law
It is also important to consider arguments based in European Union environmental law, particularly the legal difficulties that have already been raised under the Emissions Trading Directive (the ETD). The ETD is the foundation of the EU Emissions Trading Scheme (ETS) in which many energy utilities currently participate.

The ETS operates on a cap and trade basis and enables those who do not use all their entitlement to emit greenhouse gases to sell their unused allowances to others. The scheme has been running since 2005. During the first phase of the scheme (2005-07) a minimum of 95 per cent of allowances were allocated free. This has been reduced to 90 per cent for the next phase of the scheme, which runs from 2008-12. The balance of allowances are made available through the market, such as via auctions. In future phases of the scheme, the percentage of allowances allocated free will be reduced drastically.

The profits made by selling these free allowances became a major focus for the windfall tax campaigners. One suggestion was that the money 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). Another proposal was that the allocation of free allowances should be cancelled, at least in part, and suppliers should be forced to pay full market price for them.

What these arguments did not appear to take into account is that the free allocation of allowances (otherwise referred to as "grandfathering") is an explicit part of the EU scheme. Indeed, Article 10 of the ETD states: "For the three-year period beginning 1 January 2005 Member States shall allocate at least 95 per cent of the allowances free of charge. For the five-year period beginning 1 January 2008, Member States shall allocate at least 90 per cent of the allowances free of charge."

Allocation plan
On the basis of these requirements, the UK submitted its National Allocation Plan (NAP) for Phase II of ETS to the European Commission in August 2006. The plan, which envisages allocating 93 per cent of allowances free of charge during Phase II, was accepted by the Commission in November 2006. The approved plan and the Final Allocation Decision issued by the Department for Environment, Food and Rural Affairs (which includes the list of individual allocations of Phase II allowances) were published on 16 March 2007.

The requirement to allocate a gradually diminishing proportion of free allowances is 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 and free in another.

So, given that the ETD 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?
The answer to that question is likely to be "no". The ETD clearly confines the discretion of any member state on this point to the 10 per cent of Phase II allowances that are not required to be allocated free of charge. It seems clear that the effect of a windfall tax directed at profits generated from the sale of freely allocated allowances would be to impose a price for the allocation of these allowances. They would, in other words, cease to be free.

Free allowances
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 ETD that member states cannot make adjustments to the numbers of allowances allocated after they have made and notified their Final Allocation Decisions. The guidance, issued by the Commission in relation to the approval of NAPs, points out that before taking a Final Allocation Decision, a member state can make changes to the number of allowances for individual plants as a result of improved data. An example of this would be if historic emissions data are used for a plant-level allocation formula. However, once the Final Allocation Decision has been taken and the final NAP published, no more changes to the number of allowances in total or per plant can be made. This is because the Final Allocation Decision concludes the allocation process and opens formally the market for allowances in the member state. The UK NAP and Final Allocation Decision were published in March last year.

On this basis, unless the UK government were to persuade the other member states to amend the ETD (which would seem unlikely), it would seem to face something of a legal roadblock in terms of introducing any form of windfall tax directed at ETS profits.

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

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