Promoting climate protection while preventing protectionism Susanne Dröge is a Senior Fellow at Stiftung Wissenschaft und Politik (the German Institute for International and Security Affairs, SWP) The implementation of the international climate deal, the Paris Agreement, puts high demands on national policy making across the board. 195 countries have signed up in 2015. They have submitted a first set of climate targets to the secretariat of the United Nations Framework Convention on Climate Change (UNFCCC), and they are now responsible for delivery. The EU, for instance, announced a 40 percent decrease in CO2 emissions until 2030 compared to 1990. Under the Paris Agreement, all efforts will be monitored and shall be renewed every five years. In order to limit global warming to below 2 degrees Celsius, the policy measures will need to go beyond improving energy efficiency and investing in low carbon energy production. More sectors will have to get on board, such as agriculture, buildings, or transport. And also consumption patterns need to change in order to broaden the scope of emission reductions at the national level. Reducing emissions, however, is not a target ending at national borders given that goods and services flow around the globe. Thus, also trade policy tools will play an increasing role in limiting emissions, and trade rules will become more relevant when climate policies are implemented. A well-known issue for effective climate protection is keeping business from circumventing national climate action by replacing domestic production by foreign goods from regions with laxer or no climate policies. Another issue is the alleged protectionism behind local content clauses that governments include in their renewable energy programs. The number of disputes brought forward under the WTO is telling. Trade policy thus needs to deliver on both ends, protecting the climate while keeping protectionism at bay. Border carbon adjustments A potential tool for increasing the effectiveness of climate policy in a world with different climate rules are border adjustments. They made it to the headlines lately, when the US government announced border taxes as part of a planned corporate tax reform that should promote exports and reduce imports. The proposal includes to rebate direct taxes at the border and to charge imports. Also, a group of Republican policymakers and economists has suggested a tax on CO2 that combines taxing with rebates and with a border adjustment (CLC – Climate Leadership Coalition). While the US proposals have triggered a debate on WTO legality and about the new US protectionism taking up speed, an EU initiative has gone widely unnoticed. In mid-February the European Parliament (EP) voted on the reform of the EU’s emissions trading scheme (EU ETS) for the next trading period, starting in 2021. An amended proposal, brought forward by the ENVI (Committee on the Environment, Public Health and Food Safety), included a border carbon adjustment for sectors with low trade intensity (mainly mineral industries, such as lime and cement). Although the proposal was dismissed by the EP, it is worth looking into its details and motivations, because it has the potential to improve policy effectiveness. And it might return. The key idea behind it is that instead of receiving the allowances for free, EU cement, lime and other producers would have had to buy the certificates, while imported inputs and products of those sectors would have faced a charge equivalent to the EU-wide price of CO2 per ton. Thus, competition within the EU market would have been levelled. The proposal was motivated by the concerns about carbon leakage. The effect that occurs if a domestic carbon price leads to relocation of production or to rising importation of products to circumvent the carbon costs at home. Emissions would decrease domestically, while globally they would not, making national climate action ineffective. Levelling the playing field Thus, from a climate policy point of view, in a world without a global approach on CO2 prices, there needs to be some kind of levelling at the border in order to make the policy environmentally effective. Prices on emissions are regarded as an efficient way to stimulate investment in cleaner technologies, to signal to consumers the external costs, and to bring down emissions eventually. A carbon price leaves it to companies how they want to react to carbon costs. They could invest in better technology, reduce output or just pay and carry on. Some firms can pass through those costs, depending on the competitive environment they operate in. The higher the international competition though, the higher the risk that a carbon price will lead to a loss of competitiveness as foreign competitors take over market shares. This risk exists as long as there is no international policy approach on pricing carbon. Thus, after years of ‘behind the border’ measures to prevent carbon leakage from the EU ETS, the inclusion of imports is a consequence of observed strategic behavior to circumvent the carbon costs through trade. It would have helped to achieve consistent pricing on EU territory. A full levelling of carbon costs would include export rebates for firms so that they could keep up with competitors in third markets. The creation of a ‘carbon pricing territory’ by taking into account imports and exports flows would eliminate the undesired carbon leakage effect that undermines environmental effectiveness. The leverage effect, sanctioning, and dual production Yet, and this is where the latest trade policy debates come in, there is also the leverage effect. Climate-related charges at the border will send out two signals to trade partners. First, exporting countries – especially those with a large share of high-emissions products in their portfolio - will interpret a carbon adjustment by the importing country as a punishment for not taking climate action. Developing countries almost instantaneously raise their hands in protest if confronted with the idea of border carbon adjustment, lamenting protectionism. Second, the industries in exporting countries will consider to split their production according to climate policy requirements abroad, selling the ‘dirty’ products at home, and export the ‘clean’ ones. Both reactions are not desirable, neither from a political nor from an environmental policy point of view. The leverage argument dies hard in the context of the climate debate. It was openly promoted in Marrakesh at the UN-climate conference (Conference of the Parties, COP) in November 2016 after the US election outcome. Climate policy makers from Mexico started thinking aloud about imposing a carbon tariff on imports from the US – in case the US would withdraw its international climate commitments. But of course, this statement was also motivated by the harsh announcements during the Trump election campaign on reducing immigration from and trade with Mexico. The aggressive stance of Trump against the Paris Agreement and the UN climate policy at that time led to a range of ideas on how to move forward in international climate policy making without the major player, who, after all, made the big difference in climate diplomacy during the last three years. Leveraging US climate policy cooperation by sanctioning the US for a withdrawal from the Paris deal seemed to offer a straightforward answer. Would it lead anywhere? There should be doubts. Separating the good from the bad and the ugly And how do measures need to look like if they shall implement effective climate policy without being protectionist? To this end, the WTO rules are very helpful. First of all, increasing competitiveness at the expense of foreign producers is forbidden. Accordingly, a country must not discriminate against other countries when implementing a border measure. Or put differently, the measure must not target particular countries of origin and it must not treat national and foreign goods of the same kind in different ways. Moreover, the measure must not subsidize exports in order to promote the competitiveness of own goods in world markets. Second, if a measure is implemented, its design needs thorough attention in order to comply with either the non-discriminatory rules of the WTO or – in case it is not compatible with those rules – to meet the exemption clause which takes care of specific circumstances that overrule the rules of non-discrimination. Protecting the earth’s atmosphere is a motivation that is in line with WTO exemptions. Thus, a border carbon adjustment has to be justified on the grounds of preventing carbon leakage. With the Paris Agreement in force, the parties to both international regimes would need to start a dialogue on the relationship between the trade and the climate rules, the sooner the better. In the long run… A global solution to the pricing of carbon has a short-term and a long-term dimension. In the short term, climate policymakers want to avoid carbon leakage which is likely as long as there is no international agreement on how to deal with the carbon content of traded goods. In the long-term, a consistent pricing system would be desirable. And there is in fact a copy-and-paste example. The idea of adjusting traded goods for their domestic taxes and charges at the border could follow the international value-added tax system. Here, adjustments work in the interest of many countries. The difference to climate policy, however, is that VAT are a well-established source of fiscal revenues, the tax base is measurable, and it comes without a sticker beyond that of its fiscal purpose. The border tax adjustment of VAT is, by the way, fully WTO compatible as VAT are indirect taxes, while adjustment of direct taxes, such as income or corporate taxes, are not allowed under WTO rules. The carbon adjustment at the border in an ideal world would work in a similar way: a critical mass of countries, which apply carbon pricing nationally, decides to cooperate by agreeing on the destination principle. The carbon content of a product, ie. the emissions that come along with its inputs and accumulate from upstream to downstream, and its consumption, is charged in the country where the good is being consumed. Imported goods, thus, would be included, exported goods excluded from the domestic carbon pricing system. However, for this to work, more information will be needed on the carbon intensity of production, and on the energy used during production. The Paris Agreement offers two inroads to such a long-term vision. It includes a clause on carbon pricing coalitions, some call them ‘clubs’, in its Article 6. If countries want to work together in pricing carbon, they are encouraged to do so. Moreover, the current negotiations of detailed rules also focus on more transparency when measuring and monitoring emissions in industrialized and developing countries. This is needed for carbon content calculations. We are far from this ideal setting. Yet, implementing a price signal that works across markets has to start somehow and somewhere. This is where the EU ETS reform proposal for the inclusion of imports comes in. The production of cement is not complicated, it is known that producing clinker emits roughly 0.8 tons of CO2 per ton on average. So charging it when imported will not fail, as often argued, due to lack of data. Rather, filling this loophole that made carbon leakage from EU cement production so easy, would make the difference. It is, of course, a completely different story, to apply such average numbers not to inputs, but to final goods such as cars. There is no way around putting a price on emissions as a key instrument for national policies that bring the Paris deal to live. The World Bank counts some 40 countries with carbon pricing in place. The next big player to install a nation-wide scheme is China. It’s time to talk The G20 summit this year has the issue on its list, too. There are lessons to learn from the EU ETS about handling carbon leakage risks and there is potential for trade policy to assist countries in achieving their goals under the Paris Agreement. It is time to talk openly about the options and the risks and to agree on protecting the climate without protectionism.
Although changes are unlikely to have any impact until 2019, MNEs should be preparing now