Amidst the fanfare surrounding the launch of Phase 2 of the European Union’s Emission Trading System, little attention is being paid to litigation that has the potential to upset the balance of emissions allowances. In late December, Romania became the ninth European country to challenge the Commission’s annual allocation of emissions allowances for the 2008 through 2012 trading period on grounds the decisions are discriminatory and will unduly harm their growing economies.

The difference between the number of allowances requested by Poland, Hungary, the Czech Republic, Estonia, Latvia, Lithuania, Bulgaria, and Romania and the final allocation adopted by the Commission is 163 million allowances annually — if even a quarter of these allowances flowed back into the market it would represent a substantial number of additional emissions permissible under the cap. (The ninth country, Slovakia, dropped its suit on January 16.)

In the short term, the litigation — which is pending before the European Court of First Instance — poses little threat to Europe’s carbon market. Cases before the European courts typically take between two and three years, and in the meantime, these countries must abide by the quotas set by the Commission. Indeed, the court recently rejected appeals by Poland to postpone implementation of the emissions caps and to expedite the appeals process.

Moreover, the countries’ legal argument relies on a premise that will be difficult to establish: that the Commission discriminated against them when making the National Allocation Plans (NAP). Bulgaria and Romania also are challenging the Commission’s use of a different energy sector model than had been applied to other countries. There is little precedent on which these cases might turn. The Court has reviewed Commission decisions on NAPs in two cases. In November of 2007, the Court found that the Commission inappropriately rejected a proposed provision in Germany’s 2005 through 2007 NAP that would have allowed Germany to withdraw carbon permits from companies if a company had excess allowances on hand. Those permits would then have been taken out of the market and made available to other companies joining the market.

The Court rejected the Commission’s argument that the withdrawal of permits would create uncertainty in the market, finding that even if the adjustments are “liable to deter operators from reducing their production volume and, therefore, their emission rates,” such a rationale is an inadequate basis on which to find the provision illegal in light of other objectives of the Emission Trading System. The decision, which came so late that it had no impact on the 2005-2007 trading period, will have some effect on the NAPs for the current trading period. Thirteen EU member states requested a permit readjustment provision in their current NAPs, which may result in slightly fewer credits on the market — although, in contrast to the eight suits currently pending before the court, it is unlikely that these provisions will create any noticeable market impact.

The U.K. also succeeded in challenging the European Commission’s refusal to accept an upward revision of emissions allowances included in its amended 2005 through 2007 NAP. The court’s conclusion that the Commission could not restrict a country from submitting amendments to its NAP, even if this resulted in an increase in the total quantity of allowances, was more procedural than substantive. The court did, however, explicitly reject the Commission’s argument that a nearly three percent increase in allowances prior to the outset of trading would destabilize the carbon market. If nothing else, the decision indicates that the court will be sensitive to the impact its decisions may have on the carbon market.

Even if the countries’ legal arguments do not win the day, the litigation is part of a broader appeal by these new member states for leniency as the European Union continues to ratchet down its carbon emissions. There is some indication that the Commission is listening. In a draft of the post-2012 trading scheme, which is scheduled to be released on January 23, the Commission is proposing to allow member states with lower per capita GDPs to actually increase their emissions. The Commission, in an effort to share the burden of carbon reductions more equitably, is proposing to cut carbon dioxide emissions of the established member states by up to 20 percent from 2005 levels in order to allow poorer countries to increase emissions as their economies grow.

For further information about this topic, please contact Akin Gump.