Paying the polluter? Lessons learnt from a review of the UK’s capacity remuneration mechanism under EU state aid law and WTO subsidies law

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Paying the polluter? Lessons learnt from a review of the UK’s capacity remuneration mechanism under EU state aid law and WTO

subsidies law

University of Eastern Finland Law School Master thesis 07.03.2020 Moritz Petersmann (304125) Supervisors: Kaisa Huhta, Harro van Asselt

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II

ABSTRACT

UNIVERSITY OF EASTERN FINLAND Faculty

Faculty of Social Sciences and Business Studies

Unit

Law School Author

Moritz Petersmann Name of the Thesis

Paying the polluter? Lessons learnt from a review of the UK’s capacity remuneration mechanism under EU state aid law and WTO subsidies law

Major

Sustainability Science at Leuphana University Lüneburg

Description Master’s thesis

Date

7 March 2020

Pages 81

Abstract

Fossil fuel subsidies are environmentally harmful and potentially distort trade. Despite several pledges to phase out fossil fuel subsidies, Member States of the EU provide hidden support for fossil fuel-fired power plants through capacity remuneration mechanisms. Security of electricity supply is the main rationale to justify capacity remuneration mechanisms which remunerate capacity providers for being available in case of need. WTO law and EU law contain provisions for subsidy control. Are these provisions effectively disciplining fossil fuel subsidies through capacity remuneration mechanisms? This thesis approached the stated question by reviewing the UK’s capacity remuneration mechanism under EU State aid law and WTO subsidies law. Moreover, the ability of both regimes to effectively regulate fossil fuel subsidies was compared.

The findings suggest that fossil fuel subsidies through capacity remuneration mechanisms are most probable not prohibited under WTO law but might be actionable. The compatibility of fossil fuel subsidies with WTO law ultimately depends on the evidence of adverse effects to the interests of other WTO Members. EU law restricts fossil fuel subsidies through capacity remuneration mechanisms to a far greater extent: Recently, secondary legislation on the internal electricity market introduced a CO2 emission threshold which bans subsidies to coal-, lignite- and oil-fired power plants by 2025. Subsidies to gas-fired power plants remain possible.

Recommendations for enhanced regulation of fossil fuels subsidies include, for the WTO, expanding the list of prohibited subsidies by the category of fossil fuel subsidies and, for the EU, to increasingly utilize the EEAG as a vehicle for fossil fuel subsidies discipline.

Key words

Fossil fuel subsidy, Capacity Remuneration Mechanism, State Aid, Subsidy Control, UK Capacity Market

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[https://www.telegraph.co.uk/finance/newsbysector/energy/12046050/Dozens-of- new-dirty-diesel-generators-to-be-built-with-175m-subsidies.html] (07.03.2020).

Greenpeace, Media briefing: EXPOSED: €58 billion in hidden subsidies for coal, gas and nuclear. New EU rules would allow big energy companies to continue cashing in on dirty energy. September 13, 2018 [https://www.greenpeace.org/eu- unit/issues/climate-energy/1508/media-briefing-e58-billion-in-hidden-subsidies- for-coal-gas-and-nuclear/] (07.03.2020).

Group of Seven (G7), G7 Ise-Shima Leaders’ Declaration. May 26-27, 2016 [https://www.mofa.go.jp/files/000160266.pdf] (07.03.2020).

Group of Twenty (G20), G20 Energy Ministers Communiqué. Bariloche, Argentina. June 15, 2018 [http://www.g20.utoronto.ca/2018/2018-06-15-energy_communique.html]

(07.03.2020).

G20, G20 Leaders Statement: The Pittsburgh Summit. September 24-25, 2009 [http://www.g20.utoronto.ca/2009/2009communique0925.html] (07.03.2020).

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XVI House of Commons, Science and Technology Committee. Oral evidence: Technologies for meeting clean growth emissions reduction targets, April 23, 2019 [http://data.parliament.uk/writtenevidence/committeeevidence.svc/evidencedocume nt/science-and-technology-committee/technologies-for-meeting-clean-growth- emissions-reduction-targets/oral/101230.html] (07.03.2020).

Mazengarb, Michael, Capacity market will act as a fossil fuel subsidy, Australian regulators warned. October 24, 2019 [https://reneweconomy.com.au/capacity-market-will-act- as-a-fossil-fuel-subsidy-australian-regulators-warned-20802/] (07.03.2020).

OECD, OECD analysis of budgetary support and tax expenditures. Fossil fuels data. 2018 [https://www.oecd.org/fossil-fuels/data/] (07.03.2020).

Office of Gas and Electricity Markets (Ofgem), Electricity, Electricity interconnectors.

March 7, 2020 [https://www.ofgem.gov.uk/electricity/transmission- networks/electricity-interconnectors] (07.03.2020).

Ofgem, Informal Consolidated Version of the Capacity Market Rules. July 26, 2019 [https://www.ofgem.gov.uk/system/files/docs/2019/09/informal_consolidated_capa city_market_rules_26_july_2019.pdf] (07.03.2020).

United Kingdom (UK) Government, Electricity Settlements Company LTD. Incorporation.

March 26, 2014 [https://beta.companieshouse.gov.uk/company/08961281/filing- history?page=2] (07.03.2020).

United Nations Framework Convention on Climate Change (UNFCCC), Submission by Switzerland, Costa Rica, Finland, New Zealand and Sweden, supported by Monaco.

Talanoa Dialogue – How do we get there? Fossil Fuel Subsidy Reform. April 2, 2018 [https://unfccc.int/sites/default/files/resource/167_Submission_Fossil%20Fuel%20 Subsidy%20Reform_Talanoa%20Dialogue_Switzerland_Costa%20Rica_Finland_

New%20Zealand_Sweden_%20supp_by_Monaco.pdf] (07.03.2020).

Vaughan, Adam, UK's backup power subsidies are illegal, European court rules. Surprise judgment means government must halt capacity market scheme. The Guardian, November 15, 2018 [https://www.theguardian.com/environment/2018/nov/15/uk- backup-power-subsidies-illegal-european-court-capacity-market] (07.03.2020).

World Health Organisation (WHO), Air pollution. Key facts. May 2, 2018 [https://www.who.int/en/news-room/fact-sheets/detail/ambient-(outdoor)-air-

quality-and-health] (07.03.2020).

WTO, Legal texts: the WTO agreements. March 7, 2020

[https://www.wto.org/english/docs_e/legal_e/final_e.htm] (07.03.2020). (WTO 2020a)

WTO, Member Information. The European Union and the WTO. March 7, 2020 [https://www.wto.org/english/thewto_e/countries_e/european_communities_e.htm]

(07.03.2020). (WTO 2020b)

WTO, UK notifies WTO on implications of withdrawal from the EU for itself and other

members. February 3, 2020

[https://www.wto.org/english/news_e/news20_e/mark_03feb20_e.htm]

(07.03.2020). (WTO 2020c)

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XVII WTO, WTO News: Speeches – DG Pascal Lamy. April 29, 2013

[https://www.wto.org/english/news_e/sppl_e/sppl279_e.htm] (07.03.2020).

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XVIII

ABBREVIATIONS

ASCM Agreement on Subsidies and Countervailing Measures

CRM Capacity remuneration mechanism

CJEU Court of Justice of the European Union

CO2 Carbon dioxide

DSR Demand side response

EEAG Guidelines on State aid for environmental protection and energy 2014-2020

EU European Union

EGC General Court of the European Union

ENTSO-E European Network of Transmission Operators for electricity GATT General Agreement on Tariffs and Trade

G20 Group of Twenty

G7 Group of Seven

GHG Greenhouse gas

IEA International Energy Agency

IMF International Monetary Fund

MW Megawatt

MWh Megawatt hours

NECP National Energy and Climate Plans

OECD Organisation for Economic Co‑operation and Development

PSO Public service obligation

RES Renewable energy sources

SGEI Services of general economic interest

TEU Treaty on European Union

TFEU Treaty on the Functioning of the European Union TRIMS Agreement on Trade-Related Investment Measures

UK United Kingdom

WTO World Trade Organisation

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XIX

FIGURES AND TABLES

Figure 1: Evolution of average demand and generation capacity for the EU as a whole Figure 2: Evolution of wholesale market price and dispatched capacity

Figure 3: The UK’s electricity generation 2018 Figure 4: The UK’s electricity generation 2014

Figure 5: Capacity agreements (MW) awarded in the 2014 and 2015 T-4 auctions Figure 6: Energy subsidies and their capture under WTO law

Table 1: T-4 auction results from 2014-2018 .

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1

1 INTRODUCTION

1.1 Research scope

Worldwide, public money directed towards fossil fuels amounts to massive numbers.¹ Fossil fuel subsidies are socially and environmentally harmful.² Their existence poses a major obstacle to the sustainable energy transition by enhancing the competitiveness of fossil fuels, diverting investment from renewable energy sources (RES) and energy efficiency, and locking in carbon-intensive energy systems for the coming decades.³ The European Union (EU), together with several other international actors, acknowledges the problematic effects of fossil fuel subsidies which has led to a longstanding history of pledges to phase out fossil fuel subsidies.⁴ Ten years after the Group of Twenty (G20) declared to “rationalize and phase out over the medium term inefficient fossil fuel subsidies that encourage wasteful consumption”⁵ the issue remains largely unsolved on the decarbonization agenda of States.⁶ That is alarming because there is currently no sufficient action to mitigate climate change.

Further it is missing out an opportunity for action as the elimination of fossil fuel subsidies opens the chance for considerable greenhouse gas (GHG) emission reductions.⁷

A major challenge for reforming fossil fuel subsidies is the vague definition of what constitutes a fossil fuel subsidy.⁸ There is a huge variety of measures that can constitute a fossil fuel subsidy. Obvious forms of support for fossil fuels include direct spending of State resources towards fossil fuels through grants and loans or special tax levies and exemptions for activities related to or based on fossil fuels.⁹ However, there are also more indirect forms of support for fossil fuels. In Europe, for example, it can be observed that capacity remuneration mechanisms (CRM) have subsidised fossil fuel-fired power plants with billions of Euros.¹⁰ Recently, CRMs have been increasingly introduced by governments to

1 See Coady et al. 2019, p. 5; IEA 2018, p. 55; OECD 2019, p. 5; OECD – IEA 2019, p. 16.

2 See Section 2.2.

3 Asmelash 2016, p. 4.

4 See also G20 2009, section Energy Security and Climate Change; G20 2018, section Inefficient Fossil Fuel Subsidies that encourage wasteful consumption; G7 2016, section Climate Change; APEC 2009, section Promoting Sustainable Growth; Free Trade Agreement between the European Union and the Republic of Singapore, Brussels, 12 October 2018, into force 21 November 2019, 7972/1/18 REV 1, Art. 12.11; COM (2010) 2020 final, p. 16; COM (2019) SWD 1 final Part 4/11, p. 211–212.

5 G20 2009, section Energy Security and Climate Change.

6 Koplow 2018, p. 23.

7 G20 2009, section Energy Security and Climate Change; Coady et al. 2015, p. 25–26.

8 Rive 2019, p. 244–245; Koplow 2018, p. 23.

9 Koplow 2018, p. 28.

10 See Greenpeace 2018, p. 1; van der Burg – Whitley 2016, p. 30; Whitley et al. 2017, p. 7–8.

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2 address concerns about security of electricity supply, which arise hand in hand with the energy transition. CRMs are State interventions in the electricity system that “remunerate electricity generators and other capacity providers, such as demand response operators, for being available in case of need”¹¹. Consequently, States create new revenue options for power plant operators solely for the provision of capacity, which is beyond the normal market remuneration for electricity. With the need for decarbonization in mind, it is problematic that the design of CRMs tends to favour conventional generation capacities, which results in subsidies for fossil fuel-fired power plants.¹²

Fossil fuel subsidies are environmentally harmful and are therefore in the scope of environmental policy and law.¹³ Nonetheless, their potential trade-distortive character also means that fossil fuel subsidies can fall within the scope of World Trade Organisation (WTO) law on subsidies and EU law governing State aid.¹⁴ Both legal regimes provide guidance on the legality and possible discipline of subsidies (in EU law termed State aid¹⁵).

Moreover, EU law contains specific provisions for the implementation of CRMs which inter alia addresses their distortive character on competition and trade as well as, to some extent, their tendency to result in support for fossil fuel consumption. It has already been recognized that WTO law currently does not provide a comprehensive framework to effectively discipline fossil fuel subsidies.¹⁶ This has also been argued for EU State aid law.¹⁷ Considering the evidence for above mentioned subsidies directed towards fossil fuel-fired power plants in Europe affirms the perception that EU State aid law is inadequate to effectively discipline fossil fuel subsidies. Assuming that WTO and EU law are lacking in providing effective legal instruments to tackle fossil fuel subsidies, it follows that a great opportunity to encounter the global environmental crisis is missed out on. The former Director-General of the WTO, Pascal Lamy, stated when leaving his post that the “discussion on the reform of fossil-fuel subsidies has largely bypassed the WTO. This is a missed opportunity”¹⁸.

11 See COM (2016) 752 final, p. 2.

12 Huhta 2019a, p. 131; Gençsü et al. 2019, p. 31.

13 See also van Asselt – Kulovesi 2017; UNFCCC 2018.

14 Verkuijl et al. 2019, p. 314; Rubini 2009, p. 38–40.

15 For the purpose of this thesis the terms ‘subsidy’ and ‘State aid’ will be used indifferently.

16 Verkuijl et al. 2019, p. 366–367; Horlick – Clarke 2016, p. 9; Trachtman 2017, p. 7, Rive 2019, p. 106.

17 Pirlot 2017, p. 28.

18 WTO 2013.

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3 This link between fossil fuel subsidies to environmental and trade/competition legal regimes is interesting from an environmentally motivated perspective: International environmental law rather seems to govern the externalities of transactions, rarely interfering with the core of the economic actions.¹⁹ This becomes apparent inter alia with the increased introduction of market instruments, e.g. in the climate change regime. Efficiency aims from an economical perspective can easily outdo environmental ambition.²⁰ Assuming that international trade law and EU competition law is setting the scene for transactions and from an environmental perspective, which pursues the goal to phase out environmentally and socially harmful fossil fuel subsidies, it is intriguing to review both regimes regarding their capacity to discipline fossil fuel subsidies. This research motivation is supported by the circumstance that WTO law²¹ and EU law²² are committed to pursue the goal of sustainable development. Fossil fuel subsidies form an obstacle to sustainable development in different ways, e.g. by hindering sustainable production and consumption patterns²³ or by slowing down the energy transition. For these reasons the WTO and the EU should aim at phasing out fossil fuel subsidies.

In short, this thesis focuses on the problem that CRMs tend to subsidize fossil fuel-fired power plants and neither WTO subsidies law nor EU State aid law effectively seems to discipline them. To approach this problem the objective of this thesis is to analyse the legality of the United Kingdom’s (UK) CRM under EU State aid law and WTO subsidies law and compare the ability of both regimes to effectively regulate fossil fuel subsidies. Research questions guiding this analysis are the following:

I. To what extent are fossil fuel subsidies through CRMs compatible with EU State aid law and WTO subsidies law?

II. What can be learnt from the legal review of the UK’s CRM for the effective regulation of fossil fuel subsidies under EU and WTO law?

19 Viñuales 2018, p. 9.

20 Mehling 2018, p. 42–46.

21 See preamble of the Marrakesh Agreement Establishing the World Trade Organisation, Apr. 15, 1994, 1867 U.N.T.S. 154.

22 See Consolidated Version of the Treaty on the Functioning of the European Union, OJ 26.10.2012 C 326 (TFEU); Consolidated Version of the Treaty on European Union, OJ 26.10.2012 C 326 (TEU).

23 See also GA. Res. 70/1, p. 23.

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4 In order to lay the foundations for analysing the stated research questions, two supportive questions aim at clarifying the characteristics of CRMs and at identifying relevant legal sources for their review:

i. What are CRMs and to what extent are they problematic from an environmental and trade perspective?

ii. Which are relevant WTO law and EU law provisions for subsidies through CRMs?

This thesis contributes to rare but existing knowledge on the compatibility of fossil fuel subsidies with WTO law.²⁴ That knowledge reveals the difficulty of litigating fossil fuel consumption subsidies under the Agreement on Subsidies and Countervailing Measures (ASCM)²⁵, but also shows that under certain circumstances disciplinable production subsidies can be found. Further, scholars suggest assessing the legality of fossil fuel subsidies on a case-by-case basis, because, due to their various manifestations, treating them undifferentiated can lead to hasty generalizations.²⁶ Rubini points out that comparing WTO law and EU law in light of subsidies turned out to be a fruitful exercise as it enables “a process of cross-fertilization between the two”²⁷ systems. Additionally, inconsistencies between the systems can be highlighted.²⁸ By including a comparative element, this thesis aims to benefit from these merits of a comparison. The suggestion to assess fossil fuel subsidies on a case-by-case basis is followed as well by the selection of an exemplary case:

the UK’s CRM.

In particular, this thesis contributes to the outlined knowledge as it adds a legal review of the UK’s CRM, under both EU and WTO law, to the literature. In doing so, it sheds light on the under-captured, “new and hidden”²⁹ category of fossil fuel subsidies through CRMs and explores its characteristics. Finally, this thesis outlines recommendations for the enhancement of fossil fuel subsidies’ discipline under WTO and EU law based on the findings of the analysis.

24 See Slattery 2019; Verkuijl et al. 2019.

25 Agreement on Subsidies and Countervailing Measures, Apr. 15, 1994, Marrakesh Agreement Establishing the World Trade Organisation, Annex 1A, 1867 U.N.T.S. 14.

26 Verkuijl et al. 2019, p. 335–336.

27 Rubini 2009, p. 423.

28 See Rubini 2009; Marhold 2017.

29 Gençsü et al. 2019, p. 30.

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5 1.2 Methodology

This thesis is driven by an interdisciplinary approach, which is inherent to legal analyses on energy issues:³⁰ Focusing on fossil fuel subsidies granted through CRMs involves engagement with the physical and economic preconditions of electricity markets.

Subquestion (i) guides this first part of the inquiry on fossil fuel subsidies through CRMs in Chapter 2. Finding answers to the two main research questions (I,II) is characterized by combining a doctrinal with a policy approach: The first research question (I) requires an approach that is based on legal positivism which describes and explains law as it is.³¹ Answers to the first research question will be gathered through a legal review of the UK’s CRM based on afore identified relevant legal sources in EU law as well as in WTO law.

Noteworthy, there is no comprehensive governance of fossil fuel subsidies either in the EU or in the WTO. However, EU law targets the phenomenon of subsidies through CRMs in specific while applicable WTO law on this type of state intervention in the electricity sector can be found in its provisions on subsidies.

For an EU law perspective, the assessment of CRMs requires an understanding of the interplay of EU primary law, secondary law and soft-law provisions because the governance of CRMs in EU law has evolved through different instruments. The main sources of information relevant for the analysis are the Treaty on the Functioning of the European Union (TFEU), the Recast Electricity Regulation³², and the non-legally binding Guidelines on State aid for environmental protection and energy 2014-2020 (EEAG)³³. A guiding principle for analysing the interplay of these legal sources is the maxim lex specialis derogate legi generali, which means that more specific rules should be given priority over more general ones. The recent entry into force of the Recast Electricity Regulation changed the application of Treaty law in some ways: Whereas State aid control under the TFEU continues to have a high relevance for the adoption of CRMs, some possibilities to escape the status of State aid are due to the Recast Electricity Regulation blocked.³⁴ The relationship

30 Heffron – Talus 2016.

31 Cryer et al. 2011, p. 38.

32 Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019 on the internal market for electricity (recast), OJ 14.6.2019 L 158 (Recast Electricity Regulation).

33 COM (2014) C 200/01.

34 See also Huhta 2019b, p. 224.

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6 between primary and secondary legislation on CRMs in EU law is further discussed in Section 3.1.6.

For a WTO perspective the Marrakesh Agreement is central, especially Annex IA with the General Agreement on Tariffs and Trade (GATT)³⁵, the Agreement on Trade-Related Investment Measures (TRIMS)³⁶ and the ASCM. Concerning lex specialis, it can be stated that the provisions set out in the ASCM consolidate the GATT’s provisions on subsidies and countervailing measures expanding above the rules provided by the GATT. The whole picture of relevant law on fossil fuel subsidies through CRMs can only be presented with further digging into EU and WTO case law. Besides these legal sources, case study materials make detailed information about the measure under scrutiny available.

As stated, CRMs tend to favour conventional generation capacities which results in support for fossil fuel-fired power plants. The perceived role of CRMs for security of supply in the energy transition and, from a practical perspective, the existing legal framework for CRMs in EU law, make them an interesting case of fossil fuel subsidy to be under scrutiny. The UK’s CRM was chosen as a case example because it has been reported to grant subsidies to fossil fuels which highlights the general controversy about CRMs.³⁷ The UK is a member of the WTO and despite the fact that the UK left the EU on 31 January 2020, EU law applies for a transition period which will last until the end of 2020.³⁸ The State aid case on the UK’s CRM was the first to be assessed under the EEAG in 2014, which was the guiding instrument for the implementation of CRMs at that time. Therefore, the analysis of the UK’s CRM in light of EU State aid law can be based on the European Commission’s³⁹ decision in this particular State aid case SA.35980⁴⁰. The analysis concerning the compatibility with WTO law on the other hand has not been undertaken by anyone before and must rely on relevant case law and the support of literature on the application of ASCM provisions. A comprehensive analysis of fossil fuel subsidies granted through CRMs and their legality

35 General Agreement on Tariffs and Trade, April 15, 1994, Marrakesh Agreement Establishing the World Trade Organisation, Annex IA, 1867 U.N.T.S. 187.

36 Agreement on Trade-Related Investment Measures, Apr. 15, 1994, Marrakesh Agreement Establishing the World Trade Organisation, Annex 1A, 1868 U.N.T.S. 186.

37 Greenpeace 2018, p. 1; van der Burg – Whitley 2016, p. 30; Vaughan 2018.

38 Agreement on the withdrawal of the United Kingdom of Great Britain and Northern Ireland from the European Union and the European Atomic Energy Community, 31 January 2020. L 29/7 (Brexit Withdrawal Agreement).

39 Hereafter referred to as the Commission.

40 COM (2019) C 7610 final.

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7 under EU State aid law and WTO subsidies law requires the examination of different types of CRMs because States design them in many ways. This thesis is limited to a review of one case example under EU State aid law and WTO subsidies law and provides a starting point for possible further analyses of CRMs. Due to this, generalizations can only be articulated carefully as they are based on a single analysis.

The method of analysing case studies allows to focus the legal analysis and provides a solid base to approach the second research question (II). In this sense, applying a doctrinal approach “is a prequel to the making of statements about what the law ought to be”⁴¹. Indications about how the law ought to be are given by answering the second research question. Chapter 5 which is guided by the second research question follows a policy approach.

Policy approaches evaluate law as it is and give recommendations for further enhancement.

The process of evaluation requires referencing to a certain standard.⁴² When evaluating existing law, this thesis references to the implicit standard of both legal systems which is the goal to pursue sustainable development and the external standard set by Sustainable Development Goal 12.c, which suggests a fossil fuel subsidy phase-out.⁴³ The method used for the second part of the analysis is a comparison. While Chapter 4 carries out two separate legal analyses of the case example, Chapter 5 aims at a comparison of both legal reviews with the goal to indicate recommendations for the enhancement of fossil fuel subsidy discipline under WTO and EU law. This comparison of the results from the legal reviews is not considered to be an exhaustive analysis. Instead, it offers the space to explore in a comparative way if and how the two legal systems (could) effectively discipline fossil fuel subsidies granted through CRMs. This seems promising because “experience has taught us that comparisons enhance knowledge”⁴⁴.

41 Cryer et al. 2011, p. 38.

42 Ibid., p. 9–10.

43 GA. Res. 70/1, p. 23.

44 Rubini 2009, p. 6.

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8 1.3 Outline

This thesis proceeds as follows. Chapter 2 introduces the context of the analysis by firstly giving an overview on different approaches to define fossil fuel subsidies and describing rationales for their phase-out. Secondly, an insight to the controversy on CRMs is offered.

This insight outlines how CRMs are justified in the setting of physical preconditions of the electricity system and economic realities of the electricity-only market. Further it shows to what extent CRMs are problematic from an environmental and trade perspective.

Chapter 3 identifies relevant legal sources within the bodies of EU and WTO law concerning the legality of fossil fuel subsidies through CRMs. For an EU law perspective, this includes introducing the framework on State aid in primary legislation, soft-law provisions for State aid specified for CRMs, and the address of CRMs through secondary legislation. The interplay of these provisions is discussed. WTO law also provides a subsidy control system.

The functioning of this system is subject of analysis in the second part of Chapter 3.

Chapter 4 deals with the UK’s CRM. After introducing the background for the UK’s CRM and its functioning, afore identified relevant legal sources are applied to the case example and legal reviews of the UK’s CRM under EU law and WTO law are carried out. Chapter 5 highlights key legal questions that determine the legality of fossil fuel subsidies through CRMs under both legal regimes, compares the results of the legal reviews carried out in previous chapter and concludes lessons learnt for an effective regulation of fossil fuel subsidies under EU and WTO law. Finally, Chapter 6 summarizes the findings.

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9

2 FOSSIL FUEL SUBSIDIES THROUGH CAPACITY REMUNERATION MECHNISMS

2.1 Defining and Measuring Fossil Fuel Subsidies

Capturing the essence of a subsidy and developing a definition out of it that has operational value is not a straightforward exercise. Snape noted that the term ‘subsidy’ can be all- embracing which follows that “virtually every government action can be regarded as a subsidy for someone. And virtually all such actions can impact on export”⁴⁵. An internationally agreed definition of a subsidy is provided by the WTO. Accordingly, a subsidy is a financial contribution by a government that confers a benefit on its recipients.⁴⁶ In the case of energy subsidies this governmental support is directed towards the producers or consumers of energy.⁴⁷ Production subsidies, for example, are governmental interventions that typically result in lower costs for the production of energy, or raise the proceeds for energy received by their producers.⁴⁸ Fossil fuel subsidies “can be described as government interventions that support either consumers or producers of fossil fuels”⁴⁹ such as coal, lignite, peat, petroleum, natural gas.⁵⁰

Among other reasons, this vague definitional background leads to different measurement methods of fossil fuel subsidies and different types of policies captured as fossil fuel subsidies. Accordingly, there are various estimations concerning the magnitude of global fossil fuel subsidies which also differ due to geographical scope: For 2017, the International Monetary Fund (IMF) projected fossil fuel subsidies at US$ 5.2 trillion⁵¹, the International Energy Agency (IEA) at US$ 300 billion⁵², the Organisation for Economic Co‑operation and Development (OECD) at US$ 140 billion⁵³. A combined estimate of the IEA and OECD amounts to US$ 340 billion for 2017⁵⁴. The EU estimates its fossil fuel subsidies on a stable level barely under € 60 billion since 2009.⁵⁵

45 Snape 1988, p. 3.

46 ASCM, Art. 1.1.

47 van de Graaf – van Asselt 2017, p. 317.

48 Espa – Rolland 2015, p. 3.

49 Verkuijl et al. 2019, p. 316.

50 Steenblik 2014, p. 18.

51 Coady et al. 2019, p. 5.

52 IEA 2018, p. 55.

53 OECD 2019, p. 5.

54 OECD – IEA 2019, p. 16.

55 COM (2019) SWD 1 final Part 4/11, p. 215.

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10 Basically, there are two strategies about how to capture fossil fuel subsidies: the inventory and the price-gap approach. The inventory approach, as taken by the OECD, constructs an inventory⁵⁶ by identifying individual subsidies that constitute support for fossil fuels.⁵⁷ The aggregate amount of fossil fuel subsidies is determined by the total value transferred to market participants from particular government activities such as direct transfer of funds.⁵⁸ The price-gap approach, as taken by the IEA, on the other hand assesses “the variance between the observed and the ‘free market’ price for an energy commodity”⁵⁹. Due to this macroeconomic perspective, many subsidies are missed out on, but its simplicity is prima facie appealing.⁶⁰ Furthermore, it plays an important role if negative externalities of fossil fuels are included in the calculations.⁶¹ For example, environmental and health costs, which are not reflected in their market price. The IMF post-tax subsidy estimates do so and include transport and pollution externalities.

Defining and measuring fossil fuel subsidies in different ways is not merely a technical issue, but a highly political one which makes fossil fuel subsidies an essentially contested concept.⁶² This also requires consideration of the effects of and rationales behind fossil fuel subsidies. Economic activities in modern societies highly rely on energy, which makes secure and reliable access to energy a strategic government interest.⁶³ Derived from this general reason to subsidize national energy production, rationales behind fossil fuel subsidies include for example the affordability of energy for industries and households or the protection of employment in a certain region or industry.⁶⁴ Surely, the effects of fossil fuel subsidies should be assessed on different levels and case by case. But in general, fossil fuel subsidies are environmentally and socially harmful and can lead to economic distortions and inefficiencies, as the following section explains.

56 OECD 2018, section fossil fuels data.

57 Kojima – Koplow 2015, p. 23–24.

58 Koplow 2018, p. 24.

59 Ibid.

60 Koplow 2009, p. 3.

61 Koplow 2018, p. 36.

62 Skovgaard 2017, p. 343.

63 Oosterhuis – Umpfenbach 2014, p. 108.

64 Ibid., p. 108–109.

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11 2.2 Adverse Effects of Fossil Fuel Subsidies

The evidence that humans are causing climate change is overwhelming.⁶⁵ Fossil fuels play a central role in the challenge of mitigating climate change. Staying well below a global temperature increase of 2°C compared to pre-industrial levels, as aimed for by the international community under Article 2 of the Paris Agreement⁶⁶, suggests that most of the world’s fossil fuel reserves should not be burnt. This can be concluded from the Intergovernmental Panel on Climate Change report 2014, which calculates remaining Carbon dioxide (CO2) emissions that would be consistent with that goal and finds that

“estimated total fossil carbon reserves exceed this remaining amount by a factor of 4 to 7, with resources much larger still”⁶⁷. Fossil fuel combustion, which is on the one hand single largest contributor to GHG emissions, also causes local air pollution.⁶⁸ Air pollution is one of the greatest risk factors for human health. Worldwide 4.2 million people died prematurely in 2016 due to ambient air pollution.⁶⁹ The combustion of fossil fuels is the predominant source of air pollution.⁷⁰ Further adverse environmental effects include loss of biodiversity, water pollution, and soil contamination due to the extraction, transport, production and combustion of fossil fuels.

Besides the outlined environmentally harmful effects, fossil fuel subsidies are also problematic from a social and economic perspective. Firstly, they place a burden on government budgets.⁷¹ This hinders the government from spending on “more efficient welfare generating initiatives, such as education and health care”⁷². In some countries public spending to fossil fuel subsidies even exceeds the amount spent to healthcare and education.⁷³ Scholars have also shown that fossil fuel subsidies reinforce inequality: Fossil fuel subsidies over proportionally benefit high-income households which also make them an inefficient instrument to protect the welfare of poor households.⁷⁴ However, in case of price reducing impacts of subsidy schemes, their phase-out should mitigate energy price increases

65 IPCC 2014, p. 4–5.

66 Paris Agreement on Climate Change, Paris, December 12, 2015, entered into force November 4, 2016, T.I.A.S. No.16-1104 (Paris Agreement).

67 IPCC 2014, p. 63.

68 Ibid., p. 46.

69 WHO 2018, section air pollution.

70 IEA 2016, p. 19.

71 Whitley – van der Burg 2018, p. 48.

72 Smith – Urpelainen 2017, p. 330.

73 Clements et al. 2013, p. 16.

74 Coady – Flamini – Sears 2015, p. 3.

Paying the polluter? Lessons learnt from a review of the UK’s capacity remuneration mechanism under EU state aid law and WTO subsidies law