International Trade and Climate Change: Is regulation sufficient to solve the problem?

The answer is ‘no’: regulations are insufficient. Ultimately, a successful international trade policy to support climate policy will need to supplement regulation with the price mechanism – imposing taxes or emissions charges on some trade, as the European Union’s Carbon Border Adjustment Mechanism (CBAM) will do. It has to be supplemented with arrangements to charge related domestic activities at the same rate, but the EU and the UK already levy such charges through their Emissions Trading Schemes.

Regulations (actually, the standards that they enforce) are necessary in some circumstances – e.g. where you want to achieve absolute, not net, zero - and an efficient approach in others – e.g. where a simple rule of thumb can replace extraordinarily complex data requirements such as regulating cars by engine size (UK vehicle tax) or car model or London’s Ultra-Low Emissions Zone). However, they cannot tackle climate change alone.

This topic is far too wide for a single blog, but my intention here is to point to a critical piece of evidence that is nearly forty years old, but which has, so far as I know, never been recognised in climate policy debates.

The European Union is launching a Carbon Border Adjustment Mechanism (CBAM), which involves charging certain imports into the EU for the carbon dioxide emissions resulting from their production. It already charges domestic producers for such emissions via the Emissions Trading Scheme and the CBAM is intended to level the playing field – a sensible bit of tax policy. The UK is pondering a similar approach.

However, even for the limited range of products to which the CBAM will apply, actually recording the emissions in every import from every country is an administrative nightmare. This has led a number of commentators to say, ‘Wouldn’t it be easier just to require that all sales be ‘clean’ , whether produced at home or abroad, or perhaps legislate that they are produced by specific, ‘clean’, techniques?’

For a single country, which was prepared to be pretty arbitrary about where the regulated standard was set, it would indeed be easier. For example, the importing authorities would need only to establish whether a product was above or below the threshold and if this was done at a national level (based on national average emissions in the product), it would require less work than assessing each exporting plant individually. Similarly, defining an acceptable technique: they would need to know a bit about the technique(s) and have their use certified, but nothing else.  However, such an approach would be very likely to violate WTO obligations, be economically inefficient and unlikely to achieve the ambition necessary to reach net zero. Moreover, as I show below, when you remember there are many countries involved in trade, the problems multiply.

Consider the single-country case. To curtail emissions by a given amount in the least costly way requires that the cost of reducing emissions by a kilogram be equalised across sectors: if it were not, one could reduce the total cost by abating (cutting back) less where the cost is high and more where it is low. A price-based mechanism does this automatically: firms will undertake any abatement that costs less than the cost of the emissions permits they are required to purchase if they don’t, and if all firms face the same price of the latter the former will be equalised too. For standards, the regulator has to work out the cost of squeezing a bit more abatement out of each product and set the standards to equalise them. This may be feasible initially, but as soon as technology changes or you wish to reduce aggregate emissions, as will be necessary to achieve net zero by 2050, this would have to be done it all over again.

Now add more countries, each designing its own standards. Standards are all-or-nothing - you are inside the limits, in which case you can trade, or outside, in which case you cannot. Only firms producing to the most stringent standard would be able to sell in all markets; otherwise, they have to have multiple production processes (and be able to show what goods come from what process) or the world market becomes segmented. Neither is efficient.

Worse, remember how standards get fixed. Long experience shows that industrial regulations tend to get captured by the regulated sector – typically governments do not have enough information to do it without involving them, and then there are political incentives too. Thus, each country’s regulation will tend to suit its own production structure and aim to minimise disruption to existing practices – i.e. to lack ambition.

A visitor from Mars would say ‘Why not just agree on an international standard?’ But that is formidably difficult. Because standards are all-or-nothing, they are challenging to negotiate: each player wants the others to conform to its preferred or already implemented standard. And if you do it in a club of like-minded countries, you are almost bound to end up being discriminatory and exclusionary - the very contrary of the EU’s and the UK's professed attachment to the multilateral trading system. In some cases, small group discussions enlarged to a broader set of countries may be justifiable, but it is not a general recipe. Furthermore, even if international alignment were achieved, it will tend to gravitate towards the lowest common denominator, and thus be unlikely to achieve the levels of ambition necessary for net zero.

Now the evidence I promised: even before the advent of a new approach that now underpins the European Single Market in 1985, the European Communities (the EU’s predecessor) sought to create an internal market covering all its members. It did so by negotiating the gradual harmonisation of standards among sovereign countries (standards were a member-country competence) – i.e. exactly as a climate-oriented negotiation would need to be handled today. Jacques Pelkmans, who has described the agony, wrote in 19871

In the one and a half decades since the comprehensive Commission proposals for technical harmonization were first published, great difficulties have been encountered and progress has been slow.

… an incredible amount of energy … had been devoted to the production of an extremely limited number of Council Directives. … During these fifteen years the EC has adopted on average only a little over ten technical directives a year.

The policy climate in which the elimination of technical barriers to trade in the EC had to be realized was such that the individual protectionist was thriving whereas the dynamic exporter, attempting to encroach upon other markets, was hampered.

Just like today!

It is true that the standards the EC worked on were more diverse than just emissions-abatement, so cross-standard compromise was probably more difficult than we face now. On the other hand, over the relevant period, the EC comprised ten pretty similar countries settling the terms of competition among themselves. Today, even a ‘like-minded’ climate negotiation will have to add in Japan, Australia, Canada and the USA and it is unlikely to be useful unless it also includes at least some of Brazil, India, Indonesia, South Africa and China.

Climate policy is difficult and adding in trade policy so that we don’t just export our emissions to other countries makes it more so. However, we have a useful tool in the price mechanism, and although adopting it is politically fraught (particularly in the USA), the discussion above shows why the alternative of relying entirely on regulation will fail: it will be inefficient, internationally divisive and almost certainly unable to deliver net zero by itself.