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Trade and Climate Change – Five Points to Consider

With COP-26 starting today and one month to go until the 12th  WTO ministerial conference, the trade-climate nexus is under the spotlight yet again. We will host a panel to discuss these questions. You can register here. In the meantime, here is a quick overview of some of the questions by way of background.

We used to be friends…

In the early 1990s, the then Director-General of the GATT, Arthur Dunkel, predicted that the next trade negotiations round would be a “Green Round”. At the time, he was presiding over the Uruguay Round of negotiations that led to the creation of the WTO. His views reflected the important contribution trade, and trade policies, could play in meeting environmental goals. Some thirty years on, his prediction has still to be realised, but the substance of his views hold. It’s worth reiterating that, since, if you believe the rhetoric over the last two decades, the relationship between trade policy and climate seems more antagonistic. Some fear countries won’t take strong commitments on climate because they worry that investment, production and jobs will “leak” to those countries that are less ambitious. Others fear that trade liberalisation will worsen environmental degradation and threaten climate outcomes.

It shouldn’t be that way. Getting to a low carbon economy requires technology. Technology doesn’t float around in a disembodied form – it is embodied in goods and services. Trade liberalisation helps the diffusion of technology. It also helps more subtly by boosting productivity. Using fewer inputs (including energy) for the same, or more, outputs is good for living standards. It is also good for the environment. Trade rules that limit the ability of countries to suddenly shut their markets give investors a measure of certainty about their investment in new technologies that boost productivity. Finally, one of the central, but not yet operational aspects of the Paris Agreement is international carbon trading. The idea is that by trading abatement opportunities, countries can collectively deliver a global public good (stable atmospheric concentrations of Greenhouse Gases) at least cost, since abatement occurs where it can be undertaken efficiently.  That is straight out of the trade policy textbook.

That being said, in order for trade’s potential to be properly harnessed, the institutional context and rule-book needs to be looked at closely and refreshed, as Dunkel himself anticipated.

Buried incentives

The Nobel laureate, Oliver Williamson, famously said that economists need to be good archaeologists. You understand a problem by digging under the surface. In this case, we need to look at the treaty architectures for trade and climate. Both share a common objective of resolving collective action problems. The intellectual underpinnings of both are found in the same body of economic thought: correct a distortion (remove a tariff, price carbon) and enhance welfare. And as we saw, you need trade to get the technology to meet carbon reduction targets.

The main divergence lies in what economists call the “participation constraint”:  persuading countries to sign on because they are better off inside the treaty than outside. In trade, the problem is there but mitigated by the fact that a country is better of liberalising even others do not. Negotiations help to address the political challenges of domestic liberalisation.

That’s not the case in climate – the payoffs to your own efforts at decarbonisation depend on whether others are doing the same. That also means there is a temptation to free ride off the efforts of others. Much of the angst in climate discussions comes from trying to crack the participation constraint. It is made worse by the fact that a large swathe of countries – correctly – feel that they have done little to create the problem, and have fewer means to tackle it.  It is also made worse by the fact there isn’t a way of punishing those who are recalcitrant or who renege on commitments, in contrast to trade.

Cracking the participation-commitment problem still lies at the heart of the challenge nearly three decades after the UNFCCC’s inception at the Rio Earth Summit. One possibility is to pay countries to help with the costs of signing on and committing to mitigation. But countries that have pledged money are falling short. Another is to provide better market access for countries that sign on to climate commitments. A few countries, including the UK, are looking to do this but this hasn’t found favour with precisely those countries that are hesitant about making commitments on climate in the first place.

The problem is specific

Making sure emissions are priced in a way that reflects their social costs is an essential precondition for decarbonisation. But the pathway to developing and bringing new technologies to market is complex. This is mainly because the pervasiveness of market failures. Investors may refuse to commit funds to projects if they believe that the financial returns are insufficient to compensate them for risks, even if the projects are socially beneficial. Measures like subsidies can correct this by shifting risks and therefore reducing hurdle rates of return. Hence the plethora of subsidies for innovation and commercialisation that are in place or are under consideration.

Setting aside public finance concerns about whether such prodigality leads to profligacy, the recourse to financial support raises trade policy concerns. This is because the subsidies in view are specific to industries, even to particular groups of firms, and therefore come squarely within the scope of subsidies that are actionable under trade law. That is, the activities in question could be the object of trade remedies, or the policies supporting them could be challenged before the WTO if they are shown to create adverse effects to partners. It isn’t too difficult to see how high-profile areas, such as battery technology and electrical vehicles could become the next decade’s trade war equivalent of the Boeing-Airbus disputes.

There are no specific exceptions for subsidies on environmental grounds under WTO trade rules, nor is it clear that general exemptions (under GATT Article XX) are applicable to such subsidies. One option would be negotiate such an exemption, or create a process for granting waivers from trade rules, to create a safe harbour for subsidies used for the purpose of supporting innovation and a low carbon transition.

Setting the scope of such a safe harbour would be arduous at the best of times. It is even more complicated at a time when developed countries are arguing that subsidy rules are too broad and need be tightened. Specifically in a bid  to clamp down on state financed industrial policy in emerging countries, notably China.  A tacit understanding not to challenge each other’s measures might be a possibility, but given the investment and employment prizes on offer, it isn’t clear that would hold for long.

Looking more broadly, there clearly is a systemic issue with WTO rules and their treatment of market failures. Rules are they stand can capture what would be perfectly justifiable practices from an economic point of view (e.g. subsidies for decarbonising specific industries) or as part of commercial practice (e.g. price discrimination practices targeted by anti-dumping measures). At the same time, they ignore egregious distortions, such as the absence of carbon pricing.

Adaptation – the neglected question

A considerable amount of climate change is already locked-in. That is because of historical emissions, and because even a 1.5 Celsius target implies significant climatic effects. So countries will need to adapt, both to long term trends (such as changes in agricultural productivity) and short term shocks from disruptive weather phenomena. Those shocks can have significant trade effects, from fires that disrupt production to storms that knock out power systems, roads and ports. In world of cross-border value chains, these effects will tend to cascade- Effects on infrastructure are a bit like introducing a hidden tax on trade (without the revenue collection). Building the resilience of international trade will thus rely on resilient infrastructure.

Part of the solution to the trade- adaptation nexus comes from trade itself. Specifically through access to technologies embodied in goods and services. These include engineering and construction to financial services for risk management. In areas such as engineering and construction, the services side of the equation will be important, and is increasingly difficult to separate from the goods side given how far the two are integrated. That integration does not sit easily with trade rules and negotiations that have historically treated goods and services differently. It does also highlight how tackling some of the more pervasive barriers to services, such as restrictions on commercial presence and the movement of people can have important spillover benefits.

New wine, new wineskins

Given the scale of challenges flagged above – and even this is a quick summary – it is small wonder that talk about WTO reform is on the agenda.  There clearly is a need for clarifying rules, particularly around subsidies and trade remedies, and measures (such as border tax adjustments) that jurisdictions might take to mitigate concerns about carbon leakage. Under current settings, there are substantial risks that rules penalise economically sensible policies,  while at the same time ignoring egregious distortions, such as the absence of carbon pricing. Relying on recent jurisprudence could provide a short term option, but is far from ideal. Arthur Dunkel’s prediction of a “Green Round” of trade negotiations, might seems fanciful in current circumstances. But WTO members need to recognise the need to refresh the rules toolkit that they are working with.

Keen observers of the WTO will also point out that talk of  “WTO reform” has been on everyone’s minds since its inception in 1995. That this has proven difficult is a reminder that reform begins at home. None of the necessary changes to the “rules” will come about if each country feels that reform is best when it happens to others. The Uruguay Round negotiations worked because there was an appetite on the part of the then GATT contacting parties to tackle tough reform questions. Indeed the impetus for the negotiations came in part from a recognition, especially in the US and the EU, that multilateral negotiations were needed to tackle domestic protectionist pressures. That philosophy no longer holds in most parts of the WTO membership. But that needs to be recovered.  And it is an essential condition for ensuring that trade and  trade policy can pull their weight in meeting the climate challenge.


About the Author

Amar Breckenridge

Amar
Breckenridge

Amar Breckenridge is a manager in Frontier Economics' public policy practice, and leads its work on international trade policy.

Amar’s work on trade spans trade policy analysis and modelling, support to dispute settlement and litigation, and trade negotiations. Amar spent five years as a staff economist at the World Trade Organisation prior to joining Frontier.

He is also a member of the Experts Network at ICTSD.


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