COMPETITIVE DISTORTIONS IN AN INTERNATIONAL EMISSIONS TRADING MARKET EDWIN WOERDMAN Department of Economics and Public Finance (ECOF), Faculty of Law, University of Groningen, P.O. Box 716, 9700 AS Groningen, The Netherlands (Tel.: +31 50 363 5261; Fax: 7101; E-mail: e.woerdman@rechten.rug.nl) (Received 2 October 1999; accepted in final form 5 September 2000) Abstract. The objective of this paper on international greenhouse gas emissions trading is to find the conditions, if any, under which international differences in domestic permit allocation procedures lead to competitive distortions. The paper finds that grandfathered firms or sectors do not have a cost advantage over identical auctioned firms or sectors abroad, as long as markets are perfectly competitive, because they have to include the opportunity costs of using the permits in the product price. However, grandfathered permits are a capital gift to the firm, inducing a windfall profit, which implies that a similar firm abroad which has to buy its permits has a higher cash outflow and hence less financial resources. This aspect of grandfathering becomes relevant when considering imperfect competition or equity. Firstly, it is concluded that competitive distortions may arise under imperfect competition, mainly because the grandfathered firms can outlast the auctioned firms abroad in a price war. Secondly, it appears that competition (or: the level playing field) is distortedin terms of equity, because the mere process of permit allocation gives the grandfathered firms a stronger financial position and thus an unfair competitive advantage over their auctioned competitors abroad. In legal terms, these findings imply that grandfathering is WTO compatible if one is only willing to con- sider efficiency and assume perfect competition. However, grandfathering constitutes an actionable subsidy under WTO law if one also considers equity or if competition is imperfect, which could necessitate some level of international harmonization of domestic permit allocation rules. Keywords: actionable subsidies, competitive distortions, grandfathering, greenhouse gas emissions trading, permit allocation 1. Introduction The Kyoto Protocol of 1997 to the Framework Convention of Climate Change (FCCC) contains legally-binding greenhouse gas (GHG) emission targets for de- veloped countries. These so-called Annex B Parties shall individually or jointly reduce their overall GHG emission level by at least 5 percent below 1990 levels in the commitment period 2008 to 2012 (Article 3.1). To reach this level Annex B Parties have adopted differentiated allowable emission levels, called assigned amounts, which imply, for instance, a 7% reduction for the United States (US) and an 8% reduction for the European Community (EC). The latter Party redistributed this commitment between its Member States, such as a 21% reduction for Germany, stabilization for France and a 27% allowable emission growth for Portugal. Mitigation and Adaptation Strategies for Global Change 5: 337–360, 2000. © 2000 Kluwer Academic Publishers. Printed in the Netherlands.