Free Trade and Climate Change

Last Friday saw two interesting developments on trade and climate change, on both sides of the Atlantic, that for a change sought to formulate trade rules based on the problems faced in the real world. They involve imposition of trade barriers on certain industries for a specific (in this case, environmental) reason. However, the economic rationale behind such trade measures sets the stage for its logical extension to other more discomforting areas.

First, the US House of Representatives passed the landmark Waxman-Markey Bill on climate change. Its highlight is a cap-and-trade system that sets a limit on overall emissions of heat-trapping gases while allowing utilities, manufacturers and other emitters to trade pollution permits, or allowances, among themselves. The cap would grow tighter over the years, pushing up the price of emissions and presumably driving industry to find cleaner ways of making energy.

Of particular interest is a controversial provision that would impose trade penalties on countries that do not accept limits on global warming pollution. The provision, added to secure the votes of wavering Rust Belt lawmakers fearful of job losses in heavy industry, seeks to to impose a "border adjustment" — or tariff — on certain goods from countries that do not act to limit their global warming emissions by atleast 2020.

Second, drawing on a report prepared with UNEP, the WTO announced permission for a broad set of border-tax arrangements (border adjustment measures) that would impose some limits on free trade so as to stop runaway climate change, provided the restrictions do not become a cover for protectionism. This would permit countries implementing cap-and-trade systems for greenhouse gases to use border taxes to protect their domestic industries from unfair competition with firms in countries without restrictions on carbon emissions. In the absence of such protection, companies would be incentivized to move their energy-intensive production to countries that refuse to join carbon trading programs, and thereby nullify the effectiveness of cap-and-trade systems.

In this context, Paul Krugman points to the theory of "non-economic objectives in trade policy", formulated by Jagdish Bhagwati, and claims that "there’s perfectly sound economics behind border adjustments related to cap-and-trade". The theory states that when there are non-economic objectives, it is necessary to choose policy instruments to align incentives with that objective. For example, achievement of self-sufficiency in food production demands consumer or producer intervention or even tariffs.

Therefore, as Krugman writes, "But in this case the non-economic objective is to reduce greenhouse gas emissions, never mind their source. If you only impose restrictions on greenhouse gas emissions from domestic sources, you give consumers no incentive to avoid purchasing products that cause emissions in other countries; as a result, you have an inefficient outcome even from a world point of view. So border adjustments here are entirely legitimate in terms of basic economics."

Paul Krugman has also argued that cap-and-trade restrictions and carbon tariffs should be treated in the same way as border adjustments associated with value-added taxes (VAT). He writes, "It has long been accepted that a VAT is essentially a sales tax — a tax on consumers — which for administrative reasons is collected from producers. Because it’s essentially a tax on consumers, it’s legal, and also economically efficient, to collect it on imported goods as well as domestic production; it’s a matter of leveling the playing field, not protectionism."

While border taxes to control the emission of greenhouse gases is indeed laudable, much the same logic can be applied for protecting specific categories of industries. It is a small step to invoke the same rules to justify the imposition of phyto-sanitary conditions (food safety and animal and plant health), labor standards, protection of fledgling industrial sectors, and indeed a whole host of semi-protectionist and fully protectionist policies.

The basic reasoning here is that when there is a non-economic objective - like protection of bio-diversity, culture, industries affecting national security and food security, etc - it is imperative that there be appropriate policies to create a level playing field between competing domestic and international firms and thereby align market incentives accordingly. The critical point for consideration here - one that would determine the subversion or otherwise of this logic - is the extent of acceptability/consensus of the specific non-economic objective. Once the objective is agreed upon, it is important as to what set of policy instruments are deployed to achieve the objective.

Developing countries argue that their developed world partners have steered the world trade negotiations in a direction ignoring many of their genuine "non-economic objectives" like food security, cultural sensitivities, health care concerns, protection of the rights of indigenous people, pollution and environment, poverty related challenges etc. In this context, it is more appropriate if both the blocs engaged each other in a dialogue to arrive at an agreement on the right set of policy instruments to address such issues.

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In this context, the aforementioned report by WTO and UNEP (full report here) claims that "opening up trade and combating climate change can be mutually supportive towards realizing a low carbon economy". The report feels that while freer trade could lead to a rise in carbon dioxide emissions as a result of greater economic activity, it can also help control climate change by accelerating the transfer of climate-friendly technologies and products. Further, rising incomes, linked with trade opening can also change social dynamics and aspirations with wealthier societies having the opportunity to demand higher environmental standards including ones on greenhouse gas emissions. In addition there is evidence that more open trade together with actions to combat climate change can catalyze global innovation including new products and processes that can stimulate new clean tech businesses.

Update 1
Martin Feldstein has an excellent article summing up the problems inherent in the imposition of tariffs or trade barriers on countries not adopting cap-and-trade.

Update 2
Robert Stavins has three excellent articles explaining why the Waxman-Markey Act may be a good beginning, here, here and here.

Update 3
Greg Mankiw explains why the US Climate CHange Bill pending for approval, by providing too many permits free of cost, actually ends up doing more bad than good.