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This article provides a legal analysis of some of the key issues that arise in examining the system for allocating emissions allowances under the EU's emissions trading scheme directive (EU ETS). There is a strong series of arguments in support of the view that the free allocation of allowances under the various national allocation plans (NAPs) involves an element of State aid, which has neither been formally notified to, nor cleared by, the Commission under the EC Treaty. Even if it is found properly to have been notified, there are serious doubts as to whether the extent of aid granted satisfies the proportionality principle. As a result, the operation of the EU ETS may be subject to some legal uncertainty with regard to possible legal challenges to the current allocation of allowances. Going forward, proposals to amend the operation of the EU ETS must take into account similar State aid considerations (particularly proportionality) and the experience gained from the working of the EU ETS in phase I. The structural outline of a possible legislative package has been suggested, which could achieve the safeguarding of commercial and legal certainty under the current allocation regime, while at the same time providing a basis for amendment of the allocation mechanism under the EU ETS for phase II and beyond. [ABSTRACT FROM AUTHOR]