Whilst the debate surrounding a possible 'windfall tax' on the profits of energy companies has concentrated on political and economic issues, would such a tax be lawful?

It may now be less likely, given the package of energy efficiency measures recently agreed by Government and industry, that we will see an attempt to introduce a so-called 'windfall tax' on Britain's energy companies. 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. But would a windfall tax in this context be lawful?

In looking at the legality of a windfall tax of this sort, there is a range of arguments one can 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 and on any explicit assurances given about the 'one off' nature of the last utility windfall tax in 1997. In addition, there are perhaps obstacles to the introduction of a windfall tax in terms of EC Treaty law, such as those 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.

However, in the context of the current discussion, it is also important to consider arguments based in EU environmental law. This article focuses on that area and, in particular, on the legal difficulties that could arise under the EU Emissions Trading Directive (ETD) (Directive 2003/87/EC of the Parliament and Council). The ETD is of course the foundation of the EU Emissions Trading Scheme (the EU-ETS) in which many energy utilities currently participate.

The EU-ETS operates on a 'cap and trade' basis and 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 (to the extent they are not required) 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(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% of the allowances free of charge. For the five-year period beginning 1 January 2008, Member States shall allocate at least 90% of the allowances free of charge". On the basis of these minimum requirements, the UK submitted its National Allocation Plan for Phase II of EU-ETS to the Commission in August 2006 and had the plan (which envisages allocating 93% of allowances free of charge during Phase II) accepted by the Commission in November 2006. The approved plan and DEFRA's Final Allocation Decision, 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 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 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? It is suggested that the answer to that question is likely to be 'no'. As is noted above, the ETD clearly confines any Member State discretion on this point to the 10% of Phase II allowances (which, in terms of Article 10, can either be allocated free of charge or auctioned) that are not required to be allocated free of charge. However, it seems clear that the effect of a windfall tax directed at profits generated from the sale of freely allocated EU-ETS allowances would be to impose a price for the allocation of these allowances. They would, in other words, cease to be "free of charge".