Let WTO referee carbon border taxes

Efforts to reduce global greenhouse gas emissions must overcome the free-rider problem, and carbon border adjustment measures are the most effective way to level the playing field. But only a revived World Trade Organization could ensure that such a mechanism is applied fairly

Jeffrey Frankel 2 Dec 2022

Perhaps the most important task confronting the international order is enforcement of national limits on greenhouse gas emissions, such as those that were negotiated in the 2015 Paris agreement. Carbon border adjustments could give these limits teeth, but fair application requires a revived World Trade Organization (WTO).

Past attempts at curtailing carbon dioxide (CO2) emissions have yielded limited results. China and other emerging and developing economies resist curbing their rapidly rising emissions, understandably arguing that the industrialized countries should go first because they created the problem. To be sure, the European Union has had some success, raising the price of CO2 on that continent to around €75 (US$78) per tonne through its emissions trading system. And the United States recently passed the Inflation Reduction Act, which heavily subsidizes electric vehicles and other green technologies, though the country still balks at a carbon tax.

Despite good intentions, these global efforts have not put much of a dent in climate change. Negotiators continue to waste time haggling over whether to set a global target of 1.5 or 2 degrees Celsius for the magnitude of global warming. But existing national emission policies are too lax to achieve either outcome. Most countries have failed to meet even their own standards.

Enforcement is non-existent. When countries miss their targets, they are not called out, let alone penalized by the international community. Carbon leakage and global competition greatly exacerbate the problem. If a country imposes regulatory costs on its own carbon-intensive domestic firms, production tends to move to lower-cost countries.

Carbon border adjustment measures offer a potential way around this collective action problem, because they raise the cost of cheaper, carbon-intensive imports that threaten to undercut rule-abiding domestic firms. Tariffs level the playing field by making it harder for industries to offshore their emissions to countries with lower regulatory standards and compliance costs. They also encourage governments to join the club of countries making serious commitments and then to abide by them.

The EU is expected to finalize plans for a carbon border adjustment mechanism (CBAM) in December. Beginning in 2026, the EU will impose tariffs on imports to equalize CO2 prices between domestic producers and their foreign competitors. The mechanism is designed to protect the most carbon-intensive EU industries, beginning with five: aluminium, iron and steel, cement, fertilizer and electric power generation. The European Parliament wants to expand the list to encompass other industries, including those with indirect emissions.

The EU’s border mechanism could be a major step toward a more effective global market. But it comes with dangers. American firms will likely feel threatened and cry foul.

EU officials say the mechanism will comply with WTO rules, and they may turn out to be right. WTO members are already permitted to enact trade barriers for environmental ends, so long as the measures do not unfairly discriminate against foreign firms.

There are precedents for the WTO’s environmental exceptions. Article XX (b) and (g), which dates back to the WTO’s predecessor, the General Agreement on Tariffs and Trade, allows exceptions to protect health and natural resources. The preamble to the 1994 Marrakesh agreement, which established the WTO, makes clear that this includes environmental objectives, as do subsequent rulings, beginning with a 1996 decision on US gasoline imports. Most notably, the WTO dispute settlement mechanism upheld non-discriminatory environmental exceptions in the famous 1998 shrimp-turtle case. A 2007 WTO Appellate Body decision on some Brazilian import restrictions also confirmed the applicability of Article XX, finding that the rules accord considerable flexibility to WTO member governments when they take trade restrictive measures to protect life or health, and that problems like global warming are included.

Adjudicating CO2 border taxation would be a natural job for a revived WTO, if its members were to give it the mandate. Even the US, which has stifled the Appellate Body by leaving it inquorate since 2019, might rediscover the usefulness of the WTO dispute settlement mechanism. It could take a case to the WTO if the EU CBAM were to become protectionist, whether by including too many industries with indirect and hard-to-quantify CO2 use, or by over-estimating the gap in the effective prices of carbon in the US and EU.

An environmentally-driven reinvigoration of the WTO would benefit developing countries, too. Vietnam and other Asian countries could bring cases targeting US and EU trade barriers against imports of solar panels and other renewable energy equipment. Similarly, the “buy American” aspects of the Inflation Reduction Act might give US trading partners reason to litigate, rather than simply retaliate. Producers in plaintiff countries would benefit, but so would US buyers, who would gain from cheaper solar panels, wind turbines, batteries and electric cars.

Instead of an environmental trade war, a revived WTO could foster new norms for beneficial CO2 border taxes and generate a wave of trade in green goods and services. WTO director-general Ngozi Okonjo-Iweala wants to revive lapsed negotiations to liberalize trade in environmental equipment. The resulting green globalization would benefit every country – and above all the planet.

Jeffrey Frankel is a professor of capital formation and growth at Harvard University, a research associate at the US National Bureau of Economic Research and a former member of President Bill Clinton’s Council of Economic Advisers.

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