What has climate to fear from trade?

1 December 2015

This article provides a rough guide to the collective reflections of the climate community when considering the relationship between mitigation and the multilateral trade regime.

Climate is, in economic terms, an externality. The pursuit of conventional economic growth, particularly through production and energy processes, can cause incremental changes to the biosphere that are not directly willed. Moreover, even if these biosphere changes and impacts generate a cost, these are usually not felt or are perceived extremely weakly by the relevant economic actors in comparison to the benefits of economic action. While new non-polluting production processes may well eventually be discovered, a change in global economic values reducing demand for energy and greenhouse gas (GHG)-intensive production of goods might occur, and consumer demand might become sensitive to GHG footprints of goods and services, it is nonetheless unrealistic to expect revolutionary changes for these factors in the short term.

Reducing GHG pollution and climate impacts is economically inefficient from the perspective of most individual economic actors. However, if legal obligations are created and enforced to bind on all relevant actors, then this problem should not exist. The “tragedy of the commons” will be avoided by the action of a superior power capable of constraining all those who consume the commons. No economic actors will welcome the cost imposition but at least the legal obligation will seem fair. 

However, where some potential commercial rivals are outside the reach of those legal obligations, there will inevitably be “free riders” unless governments or other creators of the relevant legal obligations act in coordination. The great majority of legal obligations are imposed and enforced at the level of national or regional governments. Economic activities between, rather than within, these national or regional units constitute international trade itself governed at the multilateral level by the WTO. Thus economic actors fearful of free riders undercutting their competitive position by avoiding costs imposed on the “home team” will look carefully at relevant WTO rules. If free riding on climate costs is not prevented by those rules, expect trouble.

And this is not only a question of competitiveness. The world’s atmosphere is a single unit even if its governments are not, so measures that simply have the effect of moving emissions from one government’s jurisdiction to another – a process often described as carbon leakage – are ultimately pointless, whatever they do to the terms of trade.

The carbon leakage problem

The UN Framework Convention on Climate Change (UNFCCC) represents the major multilateral forum for international coordination of climate policies giving rise to legal obligations. However, it is in principle weaker than the WTO, its members are arguably less united about its objectives, it is often perceived as unfair in its approach to cost comparability, has little enforcement capability, and has failed to have much practical impact. Many economic and climate observers also saw the withdrawal of the EU from its climate-driven attempts to impose common levels of cost in international aviation at the 2013 International Civil Aviation Organization (ICAO) Council as a significant indication that trade objectives will beat climate ones in the push and pull of international policymaking. 

So from the perspective of many climate – and business – stakeholders, the edifice of global control over GHG emissions can only stand if there is a system preventing international imports escaping from national cost impositions to reduce emissions, and allowing exporters to remove those costs where they compete against those who do not have to bear them. Logically, in the absence of a strong UNFCCC, the guardian of that system could only be the WTO.

Is competitiveness really so important?

Plenty of stakeholders strongly object to the idea that serious government action to reduce GHG emissions will just not happen without firm safeguards against changes in business competitiveness. The first objection often raised is that changes to a company’s international competitiveness from domestic climate actions and their costs are a myth.  There is a background of constant changes to absolute and relative costs of many different key factors of production and the naturally varying factors of geography, history, skill levels, and intellectual property. Few if any accredited and peer-reviewed examples can be found of changes in cost created by climate action clearly affecting the location or quantum of production of relevant goods and services.  But this point tends to be met by responses that have raw political force. First, representatives of companies and industries can say they understand the true reasons for their locational and production decisions better than anyone else. Second, even if few examples of company closures due to relocations can be found at current levels of cost associated with regulation, the increases in prices which the climate community says are needed could change the position entirely. Third, it stands to reason that increasing costs to any extent at all when competitiveness is balanced on a knife-edge risks tipping the situation into a loss, with consequences that cannot be recovered.

The second objection looks at the position from the perspective of national competitiveness. Even if it is true that certain companies will be adversely affected, the impact on national prosperity as a whole will be lost in the constant noise of changes, growth, and decline in comparative advantage. Moreover, if the impact is that high carbon industries will be removed, surely that should be accepted as a desirable outcome, and one which may make the national economy more fit for an inevitable low carbon global future. The problem here is the iron law of politics that makes the complaints of the incumbents who would lose out ring louder than support from less powerful or not fully-formed potential beneficiaries.

The third objection is that the history of social progress is one of government imposition of costs on business. Petty considerations of commercial or national advantage forgone have not been enough to prevent action in other fields, so there is no reason why they should be decisive in the face of the global emergency of climate change. Unfortunately, the reason that the economic consequences of these changes were eventually set aside was the political demand from voters and the changing moral environment, which grew strong enough to overcome the economic interests in the status quo; something that has not yet sufficiently manifested itself in the climate context yet for whatever reason. 

Common but differentiated responsibilities

One major challenge to the carbon leakage and competitiveness approach is that the UNFCCC was founded on the principle of common but differentiated responsibilities (CBDR). By signing the UNFCCC the developed world accepted it would bear costs over developing countries, tipping international competitiveness in their favour. Even under forthcoming changes to the CBDR system to graduate the difference between developed and developing countries, the principle of a tilted playing field remains, and is highly sensitive. Other features of the UNFCCC founding documents and political landscape suggest that developed countries have no business trying to manipulate or avoid normal world trade rules to protect themselves from this economic consequence, and must take into consideration the impacts on international trade of their climate mitigation “response measures,” even if these are alterations in underlying demand rather than specific alterations to the terms of trade.  Whatever the logic of these arguments, developed country businesses tend, particularly since the global financial downturn of 2008, to reject them or limit them severely, and most developed country politicians have not been willing to defend them in the face of national economic concerns. And so while the climate community may treat the initial competitiveness arguments from business and their responses to the counter-arguments with disdain or disbelief, many also recognise these as a fact of national political life, and understand that some way has to be found to deal with them.

Levelling up

It is generally accepted that there are three broad paths available to achieve a “levelling up,” in other words, ensuring that no third party accrues economic benefits by not taking substantive climate action.  These are reducing the national costs of climate change action; globalising the costs of climate change action; and adding or reducing costs of particular flows of goods and services at the border to accord with the treatment of those goods and services in the target market. Reducing the national costs has been the most popular approach so far. Industries regarded as “trade exposed” in an environment where key international competitors have no obvious climate costs are granted some form of exception from the application of costs under national climate policies, typically by exempting them from the cost of purchase of national or regional emissions permits. But immediately potential WTO warning signs begin to flash. Derogations from national regimes purely to increase the competitiveness of national industries in international trade are prima facie illegal. The calculation of the “appropriate” level of climate cost coverage in other countries and the compensatory costs, exemptions, or subsidies for different industries and products is likely to be extremely complex and contentious. However there are some examples of rough-justice calculations of thresholds, costs, and benefits used in the EU Emissions Trading Scheme (ETS) and in other spheres, such as tax determinations, that could offer precedents. 

The second path is international coordination of the application of climate costs. In essence, this is the approach of the UNFCCC, with the important proviso that the CBDR principle ensures that coordination does not have to mean harmonisation. Costs introduced in pursuit of UNFCCC obligations are a long way from harmonisation, in particular, the progress towards an international carbon market with global pricing for emissions reductions has stalled and perhaps for a very long time. Smaller groups of countries, coming together outside the UNFCCC framework to harmonise prices and treat imports from and exports to non-club members on a common basis, are obviously a second best option but again this lights up WTO warning signs. In the absence of clearly justified exemptions in international trade legislation, it is an obvious instance of departure from the most-favoured nation principle, and without the protection of conformity to a UN-administered, multilaterally agreed regime it could look anomalous in trade law terms. In principle, the coordination could happen voluntarily within international trade associations or business groups rather than between governments; but the patchy and constrained public interest motivation that usually characterises businesses, and the difficulty of within-industry sanctions to ensure comprehensive coverage and enforcement systems even at the national level, are problems in principle for confidence in business action.

Adding or reducing costs at the border through border adjustment measures (BAMs) is the third path and now discussed increasingly frequently. Nevertheless, there are obvious difficulties in choosing and justifying the precise cost level, particularly for products with complex supply chains. Moreover, any form of special taxes or their equivalent on imports and exemptions for exports, once again lights up warning indicators. There appears to be ambiguity about the WTO status of taxes imposed on energy content. From the perspective of the climate community, therefore, all three ways of levelling the playing field look difficult and potentially dangerous in WTO terms.

Environmental goods and services

Another trade-related approach is the favouring of environmentally friendly goods and services against high carbon alternatives. Suspicions that definitions of “environmentally friendly” are being rigged to favour domestic industries can, however, quickly arise. The recent plurilateral initiative towards an Environmental Goods Agreement (EGA) involves 17 WTO members, counting the 28-nation EU as one, and may lead to effective action on tariff reduction. But for serious inroads to be made into the conventional economic superiority of high carbon, the notion of “environmentally friendly” has to be extended to include goods and service whose production processes and supply chain are low carbon compared to some alternatives. This pitches climate objectives against the conventional WTO concept of “like products,” since high carbon and low carbon production processes generally leave no impact on the final product itself, and at present have only niche effect on consumer preferences. 

Sanctions

The third, most contentious, approach involves trade sanctions against countries failing to take adequate or appropriate domestic measures against GHG emissions. Merely skimming the surface of a complex and highly charged subject, it is safe to say that the justification of trade sanctions proposed for whatever reason, tends to be problematic. But provisions for trade sanctions do exist under multilateral environmental agreements. The most frequently cited example being the Montreal Protocol on ozone-depleting substances, whose mixture of financial aid and trade sanctions is believed to be responsible for its success, and frequently leads the climate community to question why similar approaches cannot be made to work for GHG emissions. 

The most important reason for the difference is that the parties to the Montreal Protocol agreed specifically on a regime with a trade component and the parties to the UNFCCC did not. Indeed the careful protection, within the latter, of the existing trade regime and its norms has already been noted. However, from the climate community perspective, it is arguable that a climate regime without effective sanctions has proved not to work. While the world hopes that a bottom-up system can emerge from the pivotal Conference of the Parties (COP) in Paris, France, and create a good peer-reviewed system for the delivery of independent national emissions reduction targets, very few believe that acceptable global targets will be met as a consequence in the immediate future. Perhaps the world may have to come back to sanctions at some stage in the future.

What needs to change, at least ideally?

On the basis of a wholly non-professional understanding of WTO instruments and jurisprudence, the following issues certainly seem to need to be seriously debated. First, the

ambiguities in the WTO General Agreement on Tariffs and Trade (GATT) Article XX need to be removed – specifically the words “unjustifiable” and “arbitrary” in the chapeau – and the place of global climate protection assured in clause (b)’s “necessary to protect human, animal and plant life and health” and clause (g)’s “relating to the conservation of exhaustible natural resources.” Second, the inclusion of the atmosphere in the definition of the conservation of exhaustible natural resources needs to be seriously debated. Next, subsidies and procurement practices commensurate with the promotion of domestic low carbon energy sources and production processes should be specifically authorised as a policy option. The principle of most-favoured nation treatment should also allow a derogation for distinctions based on evidence and defensible differences in national control of GHG emissions, taking into account historic responsibilities and capabilities. Finally, specific provision should be made to ensure that smartly-designed BAMs are treated as legitimate national tax measures, applicable to imports as well as domestic production.

However, even if the arguments in favour of these changes are accepted, there is at present no politically realistic prospectus for comprehensive amendment of global trade legislation or a revised approach to trade in international climate policy. More indirect approaches, via declarations, guidelines, or the development of jurisprudence, are more likely to work, even at the expense of long processes and uncertain outcomes when the urgency of climate action is mounting.

Henry Derwent, Senior Advisor, Climate Strategies. Derwent is also the Co-convener of the E15Initiative Expert Group on Measures to Address Climate Change and the Trade System

More details on the ideas outlined in this article can be found in a longer research piece published by the E15Initiative: What has climate to fear from trade?  Implemented jointly by ICTSD and the World Economic Forum, the E15Initiative convenes world-class experts and institutions to generate strategic analysis and recommendations for government, business, and civil society geared towards strengthening the global trade and investment system for sustainable development. 

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