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How Global Trade Can Survive Carbon Border Adjustments

by henrik horn

henrik horn is professor of international economics, senior research fellow at the Research Institute of Industrial Economics in Stockholm and non-resident senior fellow at Bruegel, the Belgian-based think tank. 

Published June 4, 2020


Putting a price on carbon emissions in order to internalize the externality is the economists’ go-to prescription for addressing global climate change. So it’s ironic that another orthodox economics prescription for societal welfare — free trade — appears to stand in the way of implementing the textbook climate solution. But there just might be a way to thread the needle to allow market-based solutions to reach their full climate mitigation potential.

As is widely agreed, a national carbon tax or an emissions trading system forcing domestic emitters to pay for every ton of greenhouse gas they release could both curb emissions and spur investment in climate-friendlier technologies. It obviously would not, however, reduce emissions from the production of imports. On the contrary: foreign output might expand as the added cost of domestic production gives foreigners a competitive edge. Hence the logic of extending national carbon-pricing schemes to cover imports through so-called carbon border adjustments (CBAs); Michael A. Mehling of MIT’s Center for Energy and Environmental Policy Research and co-authors provide a comprehensive positive take on such measures in an article published in the American Journal of International Law.

Foreign output might expand as the added cost of domestic production gives foreigners a competitive edge. Hence the logic of carbon border adjustments.

No country has implemented a CBA yet. But the EU Commission’s proposed Green Deal, which was picking up political steam before COVID-19 virtually shut down all other policy considerations, includes a CBA provision. So does the carbon fee and dividend proposal embodied in the U.S. Energy Innovation and Carbon Dividend Act, which has even garnered some support from congressional Republicans. California’s emissions trading system, it’s worth noting, already applies a CBA to electricity imported from power plants in other states.

There’s just one problem to making CBAs the global standard: Our international trading system is based on mutual consent to trade barriers such as tariffs. But CBAs represent the opposite—unilateral impositions of trade barriers. So critics of carbon border adjustments see them as a direct assault on the principles somewhat precariously holding up the World Trade Organization (WTO). This is a significant issue since enormous values are at stake. I believe, however, that a well-designed CBA could strike a palatable balance.

The WTO’s Fine Print

The WTO, though operating under great stress in the face of the Trump administration’s hostility, is still the only game in town when it comes to multilateral rules governing trade. The agreement requests its 164 member-states to limit their interferences with trade flows, committing to maximum tariff levels and promising not to discriminate against foreign products or to treat imports from one member-state more favorably than another’s.

On their face, CBAs would violate those principles. However, there is some wiggle room here: the WTO accord includes broad exceptions for measures that are necessary to protect human, animal and plant life or health and for measures relating to the conservation of exhaustible resources. And a case could certainly be made that limiting climate change would further all of these ends.

But whether CBAs pass muster has not yet been tested in the WTO’s dispute settlement mechanism. The verdict, I believe, will likely depend on the specific design of the CBA.

For a CBA to be found legal by the WTO it must be non-discriminatory. Indeed, non-discrimination underpins the whole WTO agreement, but its precise meaning is still unclear despite a large case law. Importantly for CBAs, it’s not enough that a carbon-pricing regulation applies equally to domestic and imported goods. It might also require that the burden does not fall disproportionately heavily on imported goods — as it would, for example, if the scheme is applied only in industries where there is little domestic production.

There is an additional, and it appears even more sensitive, legal issue involved — one that goes beyond the WTO agreement. Since carbon pricing only has meaning if internalizing climate externalities actually affects production patterns, CBAs can be viewed as regulations of the activities in foreign countries. The measures can therefore be seen as extra-territorial, encroaching on the sovereignty of other states.

The international jurisdiction is less clear when common global resources are involved, such as the atmosphere. But the issue is nevertheless sensitive. Case in point: the European Union’s extension of its carbon emissions trading system to aviation in 2012. That initiative was denounced by the EU’s major trading partners, including China, India, Japan, South Korea, Russia and the U.S. The opposition focused on the extra-territorial feature of the measure whereby airlines would have to pay fees based on their flights over international waters and the airspace of non-EU countries. The measure was withdrawn and remains, to date, the only attempt to impose a CBA-like measure at the international level.

A Kinder, Gentler CBA

Legality is important, but there are other important aspects. What ultimately matters here is how the CBAs are perceived by WTO members. Here are some features that can contribute to limiting the pushback.

1. Before implementing a CBA, the regulating country should consult with other WTO members.This is not likely to lead to a general acceptance of the CBA. But it might lead to the identification of particularly contentious features of the proposed measures. For instance, how should emission taxes already paid in other countries be taken into account when applying the domestic scheme to imports? It might also lead to the formation of a group of like-minded countries that could work toward a more broadly accepted design for CBAs.

2. The CBA must complement domestic measures that substantially reduce carbon emissions and apply to industries where the regulating country has the largest emissions. This would increase the likelihood that a dispute settlement court will find them legal, since it signals that the CBA is not just backdoor protectionism. Conversely, a CBA that does not complement rigorous domestic measures will most likely be perceived as protectionist. The common current practice of allowing for exceptions for emission-intensive domestic industries would thus likely provoke strong reactions. For example, the EU’s Emissions Trading Scheme allocates free emissions allowances to key energy-intensive industries that are exposed to international competition, such as cement and steel.

3. Before introducing a CBA, the regulating country should credibly demonstrate that it brings significant environmental benefits. This sounds obvious. But CBAs impose costs on trading partners, so the environmental rationale has to be clear or else the CBA will be seen as just another trade barrier.

4. The system should minimize the risk of protectionist abuse. Experiences from other arenas where trade barriers have been unilaterally imposed for purposes other than flat-out protectionism — antidumping regulations, in particular — strongly suggest that there will be enormous pressure on implementing authorities to tweak CBAs toward protectionism. Among other safeguards, then, CBA rules need to be highly transparent both with regard to their design and their implementation.

5. CBA design has to be perceived as fair by trading partners. For example, major carbon emitters like China and India might argue that they should not be targeted by CBAs because (a) they have contributed less in the past to create the climate problem than major industrialized countries, (b) they are poorer, or (c) even because they have already contributed their fair share to abatement. It will be difficult, at best, to design a CBA that is seen as fair by all WTO member states. Indeed, this is the most difficult hurdle.

Global production patterns need to adjust dramatically to save the planet from climate catastrophe.
Getting It Done

If a country wants to impose a CBA while limiting its adverse impact on the WTO system, it would be best to initially limit the adjustments to a few pollution-intensive industries with significant domestic production — and where the measures lead to substantial reductions of domestic emissions. This would have several desirable features, and happily appears to be the path that the EU’s Green Deal is following.

  • It would ensure that the CBA is part of a larger policy package that addresses a severe policy problem.
  • A significant portion of the burden would fall on domestic producers.
  • The CBA would not seem confrontational since the aggregate costs to trading partners would be relatively small.
  • Some of the sectors that are likely candidates employ fairly standardized production technologies, allowing the regulation to be transparent and harder to manipulate by domestic interests.

Whether restricting the CBA in this way would suffice to avoid jeopardizing the already weakened trading tensions is anybody’s guess. And even if accepted by trading partners, it is unclear how effective CBAs actually are for mitigating emissions. What is clear, however, is that global production patterns need to adjust dramatically to save the planet from climate catastrophe.

main topic: Climate Change
related topics: Policy & Regulation, Trade