Competitiveness and carbon – is it time to engage with trade policy?

It is clear that UK climate policy is in somewhat of a crisis at the moment. In the near future I shall be blogging on the sustainability of and threats to the Climate Change Act. But this post takes a different direction. However, there is a link, in the sense that the position of Osborne and others bearing down on strong unilateral UK climate policy is based on the idea that this will be bad for the competitiveness of UK industries.

It is not at all clear that the new round of global climate negotiations coming out of COP 17 in Durban will yield an agreement by 2015. However, away from the UN process itself, thinking has turned increasingly towards a different approach – that of achieving action on reducing emissions through trade policies. Two recent proposals are interesting, both based on the idea of using trade restrictions in a strategic way.

One comes from Scott Barrett, who has previously produced the definitive analysis of multilateral environmental agreements and why a climate change treaty is so hard to reach. His proposal is to build on the trade restrictions built into the Montreal Protocol (MP). The MP bans imports of goods containing ozone-destroying chemicals (i.e. CFCs, HCFCs) into countries that signed up to the agreement, Since these countries included large markets including the USA and the EU, this created an incentive even for countries that didn’t sign up to stop producing fridges etc with CFCs in, since they would not be able to sell them in the key markets. In fact, this mechanism was so effective that such bans have never actually been enforced. Thus what makes it strategic is the threat, not the implementation. The Montreal Protocol has been very successful, and as the gases it covers are also greenhouse gases, it has ironically reduced greenhouse gas emissions far more than the Kyoto Protocol.

Barrett proposes taking a similar approach to carbon emissions, through a series of agreements on minimum emissions or technology standards in particular sectors, including aviation, iron and steel production, and cars. This approach might not be economically optimal, but Barrett argues that it would have a better chance than a Kyoto-type agreement of actually working because it would create incentives for participation. Standards need to be realistically achievable, and can be tightened over time, which is exactly what has happened with the MP. In addition, and crucially for equity, this approach can allows for differential treatment of developing countries (which have a longer term frame for compliance under the MP) and side payments to help upgrade technology.

To make Barrett’s proposals work in the real world, they would have to be squared with World Trade Organisation agreements, presumably through new international agreements such as the MP, and they would require an initial group of countries with a sufficiently large aggregate market for the goods or services in question to produce a large enough incentive for other countries to participate.

A second approach has been floated by Dieter Helm, Cameron Hepburn and Giovanni Ruta. Their proposal is based on the use of border carbon adjustments (BCAs). BCAs have been proposed as a way of stopping “carbon leakage”. For example, since steel makers in the EU have to pay a carbon price because they are included in the EU emissions trading scheme, their steel is made relatively less competitive than steel made by Asian competitors who don’t face a carbon price. There is a danger that steel making may be relocated to Asia as a result and produced less efficiently, with the perverse outcome that carbon emissions end up higher, not lower. A way to prevent this is to put a tax (i.e. BCA) on steel imports from Asia that reflect the carbon intensity of their production, and thus level the playing field once more.

The argument of Helm and colleagues is that, as long as BCAs are WTO-compliant, their imposition can be expected to have a strategic effect. For example, if the EU were to slap a BCA on say, steel imported from China made inefficiently and with a higher embedded carbon content than EU made steel, China couldn’t then take the EU to a WTO dispute panel. It might consider starting a trade war by imposing trade restrictions on European imports into China, or subsidising its own steel exports. But incentives under the WTO are purposely designed so that countries will not really want to start trade wars, which is why they are relatively rare and temporary. If China does nothing, its steel industry will lose valuable market share in the EU. So the best option for China, on Helm et al’s argument, will be to seek to reduce the carbon intensity of its own steel exports. Thus somewhat analogously to Barrett’s bans, BCAs are strategic here because it is expected that other countries’ industries will end up not actually paying them because they will prefer to reduce their emissions instead.

If BCAs are WTO compliant, then unlike sectoral agreements, they could proceed without any equity considerations, such as side payments, although in practice it is likely that developed countries might want to help low and even l0wer middle income countries achieve lower emissions in particular industries in order to avoid paying BCAs.

A key test of this approach is the inclusion of aviation in the EU ETS, which is equivalent to a BCA. Helm and colleagues argue that this has so far survived legal challenge, and that in April last year China was considering imposing a passenger tax and using the revenues to lower emissions in its airline industry. However in June last year China also said that it was considering a trade war and the US Congress is still developing legislation to counter the EU move. This week, the EU has frozen action on flights in and out of the EU until next year to try reach an agreement. If BCAs turn out not to be WTO compliant (and it seems there is no simple answer to this question), then a lot of the force of the Helm et al argument is lost, at least unless a way can be found of changing WTO law.

Personally I tend to lean towards the Barrett approach, since it builds on an existing successful mechanism which can easily incorporate equity considerations. The Helm et al approach is untested and won’t work if it is not WTO compliant and just leads to trade wars. It also has the challenge of setting the level of the BCA correctly, which has high information costs, whereas Barrett’s approach can just have a ban or arbitrarily high tariffs.

But both approaches make the same basic point that, sooner or later, the search for effective international action on climate will have to integrate with the strategic use of trade policy. The alternative to a strategically designed integration between climate and trade policy is a messy car crash, as the aviation example shows. As Barrett concludes, “Ironically, to protect the trade system, trade restrictions need to be incorporated in future climate agreements”.

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