Liebreich: Climate Action – It’s The Trade, Stupid

By Michael Liebreich
Senior Contributor

As world leaders gear up for November’s critical COP26 climate summit in Glasgow, carbon border adjustment mechanisms (CBAMs) have been moving rapidly toward center stage. That may not be an entirely good thing.

Although dealing with carbon leakage is certainly an important question, it is not the most important question. What is critical is to unleash trade to play its full role in support of climate action. How can trade accelerate the uptake of clean technologies? How can it help poorer countries leapfrog to low-carbon solutions? How can it help decarbonize corporate supply chains?

It is these questions – not whether a few tons of dirty steel are imported into Europe – that will decide the speed, fairness and success of the global net-zero transition. CBAMs are a bug fix, not a killer app. The current focus on CBAMs risks raising tensions that could derail climate diplomacy and trade liberalization, at a time when those are needed more than ever.

Yes, we do need a CBAM

As we go into COP26, some 54 countries responsible for 78% of global GDP have committed to net-zero emissions by 2050 or, in the case of China and a few others, 2060. That is well beyond what anyone could have expected when the Paris Agreement was signed, but the world is far from proceeding in lockstep toward a net-zero future.

Even if you assume that the countries promising net zero all pass the domestic legislation needed to deliver their transitions as promised, they are not moving at the same pace. Of the major economies, the U.K. is in the lead, reducing CO2 emissions by 28% between 2010 and 2019 despite economic growth of 18%, while emissions in China, South Korea and Brazil are still growing. Then there is the 22% of GDP in countries that have not committed to net zero – home to nearly two-thirds of global population.

Those two gaps – between countries progressing toward net zero at different speeds, and countries not yet beginning the journey – cannot be ignored.

Despite recent dramatic falls in the cost of wind, solar, batteries and other clean technologies, pushing fossil fuels out of industrial heat, chemicals and manufacturing might require a carbon price of 350 euros per metric ton of CO2 today, and perhaps 100 euros in the long term. Without the protection of a carbon border adjustment, imposing those sorts of carbon prices on domestic manufacturers would consign them to oblivion.

Some form of CBAM is therefore likely to be necessary – as I have been arguing for around a decade, and more and more free traders, including Liam Fox, former U.K. minister of trade and candidate for secretary general of the WTO, are beginning to agree.

So let’s just have a CBAM, right?

Designing a CBAM looks like a simple technocratic question – how to stop Manufacturer A, based in a country with no carbon price, from gaining an unfair advantage over Manufacturer B, based in a country with a carbon price.

To understand why it is fraught with complexity, it would be helpful to start with good data on how carbon moves through the global trade system. That turns out to be surprisingly hard: the literature quickly disappears into a thicket of diagonalized vectors, final demand matrices and Leontief inverses. The U.K.’s Overseas Development Institute has put together probably the best attempt at an overview, from which a number of key points can be gleaned: approximately 40% all of carbon crosses at least one border between extraction and emission; export of carbon in the form of fossil fuel dwarfs that embodied in agricultural produce and manufactured products; and, in general, carbon moves from non-OECD to OECD countries.

The clear implication is that CBAMs risk creating a powerful coalition of opponents among fossil fuel producers, exporters of energy-intensive manufactured goods, developing world nations, importers and consumers of cheap fossil fuels and carbon-intensive goods.

Next, tough technical questions abound. What happens if an importing country bases its climate approach on an explicit carbon price, while an exporter is taking equally effective action through regulation – is a CBAM still warranted? Should all exporters of the same commodity from one country be treated the same, or should lower-carbon manufacturers be given waivers? If so, how do you stop low-carbon output being directed towards countries with CBAMs, while the high-carbon remainder is sent to countries without? What happens if exporting nations simply rename fossil fuel royalties as carbon taxes – would that dodge the CBAM? Where is the information needed to evaluate the carbon intensity of imports, and who is responsible for verifying it? And so on.

There is a very extensive literature on how to get round these problems. Here is a starter selection, for those that want to do a deep dive: Michael Mehling of MIT and Harro van Asselt of University of Eastern Finland have written a guide to “Designing Border Carbon Adjustments for Enhanced Climate Action”; the management consultancy BCG has provided a good overview of different approaches; and John Odell, professor emeritus and former director of the School of International Relations at the University of Southern California, has put forward an interesting model mechanism.

John Kerry, President Joe Biden’s climate envoy, appears to understand the challenges. While he has said that Washington is looking into a CBAM, in recent months he has cautioned that such a move could carry risks “downstream” and that a carbon border adjustment should be “a last resort, when you’ve exhausted the possibilities of getting emission reductions and joining in some kind of compact by which everybody is bearing the burden”. His stated preference is to wait until after the COP26 climate conference in Glasgow before engaging in any discussion about border adjustments.

The charge of the CBAM brigade

Undeterred, the EU is racing ahead. Commission President Ursula von der Leyen promised last year to put forward a proposal during 2021, and to have a CBAM in place by 2023 as part of the EU drive to deliver a 55% reduction in emissions over 1990 levels by 2030. A drip-feed of leaked documents, which BloombergNEF has of course analyzed in depth, shows that the scheme will focus on sectors covered by the existing EU-ETS carbon trading scheme – most likely steel and cement first, then others like steel, cement, aluminum, paper, glass, and chemicals – with payments linked to the price of carbon credits and phased in over three years.

The controversy is in the detail. Leaked drafts say nothing about free allocations of EU-ETS credits – which have so far largely protected European industry from the costs of climate action and in some cases delivered windfall profits. If free credits are maintained until 2030, as currently envisaged, it is hard to see how importers could be charged a CBAM before then, without falling foul of WTO rules.

The proposed scheme is silent on final products made with imported commodities – cars, white goods, building products and so on – and it will be of no use to farmers, likely to be forced to start storing soil carbon while competing with farmers from nations with no such requirements. Carbon taxes paid in the exporter nation will be subtracted from any amount levied but no credit will be given for non-tax measures. And perhaps most controversially, no waiver is proposed for exports from lesser developed countries while CBAM proceeds are earmarked to go straight to the EU budget. Think of the optics: the wealthy EU, levying a charge on manufacturers in the world’s poorest nations and using it to defray the costs of running the Berlaymont building.

It is hard to see developing-world countries interpreting this proposal (unless significantly revised) as anything other than self-serving protectionism.

Indeed, at the April 2021 BASIC Ministerial Meeting on Climate Change, ministers from South Africa, Brazil, India and China “expressed grave concern regarding the proposal for introducing trade barriers, such as unilateral carbon border adjustment, that are discriminatory and against the principles of equity and CBDR-RC (common but differentiated responsibilities and respective capabilities).” And, in a call with France’s President Emmanuel Macron and Germany’s Chancellor Angela Merkel, President Xi Jinping of China stated that “tackling climate change should … not become an excuse for geopolitics, attacking other countries, or trade barriers”.

The big risk, therefore, is that the focus on CBAMs throws gasoline on international trade tensions still smoldering after President Donald Trump’s four years in office. Biden’s arrival in the White House was a balm to the soul for many in the climate community, but his rhetoric on trade has been troubling: one of his first moves was to order the tightening of the Buy American Act. Meanwhile, the EU’s Green Deal and industrial strategy look set to unleash an era of unprecedented governmental support for the bloc’s industrial players. And, of course, this is all playing out against growing western tensions with an increasingly authoritarian and assertive China.

Wealth and trade are good for the environment

Fans of “degrowth” might think that a trade war, by driving a global recession, would help the world hit its Paris Agreement targets – which translate into a 25% reduction in emissions by 2030 to stay on track for 2C of warming, or a 45% reduction for 1.5C. It would not: it might knock a few percentage points off the global economy by 2030 but it would knock a much bigger hole in the economy’s ability to deliver the innovations required for net zero, and in the capacity of developing world countries to afford them.

The ability of countries to participate fully in the transition to net zero is conditional on them becoming wealthier. CO2 emissions from OECD countries peaked in the year 2007 and have since dropped by 12.5%, while their real GDP grew by 20%. Incidentally, on a consumption basis, adding back the emissions embodied in imports, OECD emissions also peaked in 2007. Perhaps the most significant development on the climate front since the 2015 Paris Agreement – more so than the U.S. revoking its membership under President Trump and re-joining under President Biden – was China’s commitment to bring emissions to a peak before 2030 and to net-zero by 2060. Too few commentators have drawn the direct line from China’s joining of the WTO, via its per-capita GDP approaching that of a developed country, to that announcement.

The global economy will not reach net zero in 2050, 2060 or any other year unless India and the other big countries of the G77 achieve the same development in per-capita wealth as China.

It is not clear that the UN and the stakeholders that surround it have internalized the role that trade needs to play in delivering their goals. The Sustainable Development Goals are full of demands for developing countries to be protected from the impacts of trade, or to be given special treatment. You have to scroll down to point 68 of the post-amble to find this clear statement: “International trade is an engine for inclusive economic growth and poverty reduction and contributes to the promotion of sustainable development.” In a more rational world, that line would have been front and center.

Where’s the money?

The dominant discourse in the corridors of climate power is not how to help developing countries become sufficiently wealthy to become full partners in climate action, instead it is the insistence on the responsibility of the West to keep the aid taps open and to fund any and all moves toward emission reduction in the developing world.

Witness the endless negotiations about the 2009 Copenhagen Accord, by which developed countries committed to a goal of “mobilizing jointly $100 billion a year by 2020 to address the needs of developing countries”, a pledge reaffirmed at this month’s G7 meeting in Cornwall. The development community has continued to claim that the money must take the form of government-to-government grants, even though COP16 in Cancun confirmed that “it may come from a wide variety of sources, public and private, bilateral and multilateral, including alternative sources”. And it keeps up a wall of sound about the developed world reneging on its commitment, even though the most recent estimate by the OECD was that North-South climate flows had reached $78.9 billion by 2018, rising at a five-year compound annual rate of 9%.

The sturm und drang about a potential $20 billion annual shortfall obscures the fact that, for the developing world to reach net zero, within a few decades of mid-century and at a decent standard of living, investment of around $2 trillion per annum would be needed: two orders of magnitude larger than the missing $20 billion. Where could such funding possibly come from?

This is where trade comes in. 2019 global merchandise exports were estimated by the UN Committee on Trade and Development at $18.9 trillion. Which is the better use of time and political capital: haggling over the final $20 billion promised under the Copenhagen Accord (which may have already been delivered in the years since 2018) or figuring out how to help developing countries capture a bigger slice of global trade, and the associated investment required to unlock it?

A recent report by the WTO calculated that since 2006, the Aid for Trade initiative has channeled $450 billion into building developing countries’ trade capacity and infrastructure. It estimated that full implementation of the WTO’s 2013 Trade Facilitation Agreement might reduce the cost of participating in trade for African countries by as much as 16.5%, and spur an additional $1 trillion of trade volume, with the largest gains in the poorest countries.

In this context, the G7’s $40 trillion Build Back Better for the World (B3W) initiative, recently announced in Cornwall, looks far more significant than the $100 billion Copenhagen commitment. It’s critical to get it right from a climate perspective.

Free trade in environmental goods and services

Nowhere is trade more important for climate action than when it comes to high- and low-carbon goods and services.

By now, we have surely all heard that fossil fuels are more heavily subsidized than clean energy – to the tune of somewhere between $320 billion (IEA 2020, consumption subsidies only) and $5.2 trillion (IMF 2017, including externality cost of climate change, local pollution and traffic congestion) globally. In a brilliant piece of scholarship, Associate Professor Joseph Shapiro of UC Berkeley has demonstrated that the average impact of current tariff and non-tariff barriers was a further effective carbon subsidy of $90 per metric ton of CO2 embodied in traded goods, since high-carbon imports tend not to be subject to tariffs, while low-carbon ones do.

In the clean economy, silica sand mined in the United States is refined into ingots in China, turned into wafers in South Korea, assembled into solar PV modules in Dubai and exported to Saudi Arabia. Australian lithium carbonate is shipped to Japan to be processed into cathode materials, which are included in batteries made in Taiwan that end up in Mexico. Brazilian niobium is an essential component in steel ball-bearings made in Sweden for inclusion in German wind turbines that power the U.K.’s offshore wind farms.

All of the above flows are financed and serviced out of London, New York, Tokyo, Hong Kong and Sydney, by talent from around the world. And despite their importance, they are subject to a raft of tariffs, non-tariff barriers and all sorts of frictions.

In 2009, I was part of a brainstorming session hosted by the World Economic Forum, charged with coming up with fresh ideas to restart the global economy. My contribution was the idea of a free trade area for sustainable energy-related goods and services. Others took up the baton, and momentum grew bit by bit until, in 2012, President Barack Obama instructed the U.S. State Department to enter negotiations toward an Environmental Goods Agreement (EGA). Sadly, in December 2016, immediately after the election of President Trump, those negotiations collapsed amid recriminations between the EU wanting to continue protecting its bicycle industry and China demanding new categories be covered.

Last year, a group of five countries led by New Zealand and Norway began negotiations around an Agreement on Climate Change, Trade and Sustainability (ACCTS). Leaders of the great powers would be well advised either to join that effort or create their own fresh push to restart the EGA negotiations, and add services like insurance to the mix while they are at it.

Review and add to WTO rules

This is a critical juncture for the WTO under its new director general, Ngozi Okonjo-Iweala. It does not need the sort of root and branch reform that some – generally those with only a passing acquaintance with trade law – are demanding. What it does need is an urgent and systematic review of the intersection between its articles and accumulated body of law and the environment.

Contrary to common misconception, the WTO’s current rules do not force trade to be a race to the bottom. Under Article XX of the WTO, countries are within their rights to support clean solutions and block imports on environmental grounds, either via the characteristics of finished products (such as hormone levels in beef), or via processes and production methods that leave no trace in the final product (such as being made with clean energy). What is key is that interventions must not constitute a “means of arbitrary or unjustifiable discrimination”; they are particularly likely to be acceptable if they are consistent with a recognized international treaty obligation.

Nevertheless, there are areas of huge uncertainty and delay. The precedents for blocking imports on the basis of processes and production methods, the so-called Tuna-Dolphin and Shrimp-Turtle cases, took 18 years and seven years respectively to weave their way through the WTO disputes process – and that was before its appellate court was undermined by the Trump administration. Few countries or organizations have the resources to pursue litigation for decades. And no country has yet tested the legality of measures targeted at protecting specific biomes like the Great Barrier Reef or the Amazon rain forest. Meanwhile, the climate clock is relentlessly ticking.

James Bacchus, professor at the University of Central Florida and former chairman of the appellate body of the WTO, has called for a “Climate Waiver”, an explicit exemption from WTO rules for measures that address climate change. My worry is that such a waiver would open the door to a flood of climate protectionism. A better approach would be for the WTO to clarify the types of mechanism that are acceptable and the types that are not, perhaps in the form of a climate-specific multilateral or plurilateral agreement, along the lines of others made over the years between different groups of countries.

Indeed, in November 2020, some 50 WTO members launched a Structured Discussion on Trade and Environmental Sustainability (TESSD). Its initial remit is information-sharing, but the end-point could be a WTO Trade and Climate Chapter to sit alongside the other WTO Analytical Annexes, going well beyond just a free trade agreement in environmental goods and services to provide guidance across the whole traded economy, building on global low-carbon product standards and a carbon tracking system fit for the net-zero future. I guess one can always hope.

Oh what a lovely CBAM!

Finally, in the light of all this, back to CBAMs. Since it looks like we are all going to be spending the next few years debating the minutiae of proposals, let me close by offering the following principles for what a decent CBAM might look like:

  1. As William Young has argued in a Council on Geostrategy paper, the overall system must be multilateral. It may be impossible to get the sort of unanimous agreement required by the UNFCCC process, but it would be disastrous to end up with a different system in each importing bloc or country;
  2. A CBAM should only ever be introduced in a country or sector if it is the lightest-touch way of eliminating carbon leakage, defined as unfair competition from manufacturers based in countries that are not acting on emissions. Before its introduction, simpler means of achieving that goal should be explored and a transparent public benefit test must be passed;
  3. A CBAM must only ever be introduced as a way of adjusting for differential carbon prices – never as a way of masking a lack of productivity in the importing country, or in support of other policy goals such as protecting strategic industries, attempting to gain a foothold in a new one, retaliation against unfair trade practices in other sectors, and so on;
  4. A CBAM must be explicit and rules-based – so that the importing country is not tempted, for instance, to impose tariffs on geopolitical rivals while exempting friends, or to reward climate rhetoric over climate action;
  5. A CBAM must be compatible with international law, in particular WTO rules. Any disagreement must go through the WTO Dispute Settlement process;
  6. A CBAM must be compatible with market-based approaches to emission reduction, including carbon pricing and carbon fee/rebates, since these are expanding across a growing proportion of the world’s economy;
  7. A CBAM must avoid perverse incentives – for instance it must not disincentivize companies in exporting nations from beating their country’s average carbon intensity;
  8. A CBAM must be administratively simple, hard to game and inherently fraud-resistant, which, as we saw with the Clean Development Mechanism of the Kyoto Protocol, may not be trivial to achieve.
  9. A successful CBAM is not one that simply blocks high-carbon imports out of rich country markets. It should also help developing country producers attract investment and introduce low-carbon technologies, so that they can compete in rich country markets as well as reduce emissions in their home markets and other developing countries.

In summary, we should be looking at trade, not as threat to western countries’ ability to forge ahead unilaterally on climate action, but as having a vital role to play in meeting the triple challenges of human wellbeing, global inequality and climate change.

And, as Richard Cobden, the Victorian era’s so-called Apostle of Free Trade, might have said, the people of the world “must be brought into mutual dependence by the supply of each other’s net-zero technologies. It is God’s own method of producing climate action, and no other plan is worth a farthing.”

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