How we can stop exporting carbon emissions and lead the way to real carbon savings

The Peru climate change talks started today and negotiators are optimistic that this conference will start the ball rolling for final agreement in Paris next year. But how can we make commitments to reduce carbon emissions that might damage our delicate economies? Stronger carbon emissions control hits our industry while our carbon emissions 'leak' to other countries. In this post I explore a way forward  - using border tax adjustments to allow our manufacturers to trade fairly in world markets, even though we have carbon controls at home.



We have somewhat reduced carbon emissions at home – but not when you count the carbon emissions to make the stuff we buy from abroad.
It is often said that even though the UK and other EU countries have apparently been good about meeting our Kyoto obligations for greenhouse gas reductions, this isn’t really true – because even though we have reduced GHGs emitted from within our country boundaries, we have increased the amount of carbon emitted abroad, by importing more carbon intensive goods. In other words we have met our targets in terms of carbon production but not in terms of consumption. Exporting our emissions may make them worse because big manufacturing economies such as China and India use more coal and fossil fuels than we do in their fuel mix. So when we buy goods from there we ‘consume’ more carbon emissions than we would have if they were made here.

This chart is from the IPCC Fifth Assessment Report Working Group III Technical summary. It shows that high income countries like the EU have increased carbon emissions when you take consumption into account (though the main increase is actually from upper middle income countries like China increasing home consumption.

The EU Emissions Trading System should be helping to make us more efficient.
Power companies and other carbon intensive industries in the EU have to trade in carbon allowances through the Emissions Trading System (EUETS). The idea is to gradually reduce the number of allowances over time and force our industry to use less fossil fuel. There are real savings to be made. For example we can be more efficient – the best cement making factories produce only half the global average emissions. Also we can reduce waste – for example we can design our buildings more intelligently to use less steel, cement and concrete [1].

But without carbon accounting at the border you get carbon leakage - bad for the planet and bad for our economy.
However, there is no accounting for the carbon in goods that we import. So EU steel and cement manufacturers have to compete with cheaper Chinese and Indian cement made in old, inefficient factories.  More stuff gets imported and our carbon emissions go up.  Personally I think carbon taxes are a better idea than cap and trade schemes like the EUETS - mainly because there is more certainty for investors  - but the same problem arises. If there aren’t border controls then carbon ‘leaks’ across as we import stuff that isn’t subject to the regulations. This is bad for the planet – and also bad for domestic industry, bad for our balance of payments and bad for our economic growth.

The three forms of carbon leakage

1. People buy imported goods because they are cheaper – because the manufacturers have not had to pay a carbon tax or buy carbon allowances.
2. Manufacturers that use a lot of energy are given free allowances to start with so they don’t have to raise their prices – but they can’t be sure this will continue forever, so when they are building a new factory they are more likely to choose to build it abroad, where there is more certainty about their operating costs. So they will produce goods abroad and import them instead of producing them locally.
3. When we reduce our carbon emissions by using less fossil fuel, this means there is more to go round in countries that haven’t restricted their emissions. Global fuel prices drop. Foreign manufacturers pay less for their energy and their goods can work out cheaper again. So we end up buying more imported goods.

Even though the EUETS is weakened by the recession, there is carbon leakage due to uncertainty.
For the moment the EUETS in particular has been scuppered by the recession. People aren‘t buying much, production is down, so manufacturers have not had to do anything to keep their carbon emissions below their carbon allowances. At one time EUETS allowances cost €32/tonne but in January last year the carbon price crashed to less than €3/tonne [2].

Even now, though there must be some carbon leakage simply due to uncertainty – the second type of leakage (see box). Allowances are cheap as chips now but as the economy grows the price will rise and it is very hard to know how much. Companies that want to build new factories are likely to choose to build them abroad where they have a better idea of their operating costs in the future.

The WTO rules permit border tax adjustments – if they are fair.
So why don’t we have carbon accounting across borders? It is often said that the WTO won’t allow it, that border taxes are not permitted. However, the WTO does allow border tax adjustments. You can put charges on imported goods as long as these are the same as the charges you apply to your domestic goods. If everyone pays the same, no particular nations have an advantage over the others – that is allowed. You can also give your exporters a rebate for their costs in conforming to local regulations, so that they aren’t penalised when they sell their goods abroad [3]. This fixes the first two types of carbon leakage described in the box. The last one is harder - but global fuel prices are always hard to predict.

What does it mean to be fair? You can charge for steel, but maybe not for the coke that was burned to make the steel.
The problem is, how to define the import charges to be the same for imported goods as for domestic production. Back in June I reported on an interesting study by Regional Economic Models Inc (REMI) for the Climate Citizen's Lobby [3]. (See Carbon taxes can be good for jobs). I  was surprised at the time but I now understand why they modelled border adjustments in the way they did. Full carbon accounting for imported goods is impractical and quite possibly would not conform to WTO rules anyway. It is OK to charge imported products the same as those that are produced locally but it is not quite clear if it is OK to charge for resources used to make them that don’t end up in the final product. So it is OK to charge, say, for steel but possibly not for the coke that was burned to make the steel. In fact there are precedents to suggest that it is – but every case has to be argued on its own merits. So the REMI model said that imported goods would pay the same tax as the average paid by domestic producers for the same products.

How do you compare imported Toyota cars with locally produced Bentleys
Even so, the rules have to allow for when there aren’t any similar products produced locally – and even for products of the same type the definition of similar is not exactly straightforward. How do you compare imported Toyota cars with locally produced Bentley? (I fear you might have to do it by weight, even though both manufacturers would probably consider that rather insulting).

WTO members will be on the lookout for subtle advantages.
Since it isn’t totally obvious how to define the rules, WTO members are going to be on the lookout for any subtleties that give the local industry an advantage. This is particularly the case for the big carbon intensive sectors such as steel, chemicals, paper, cement and aluminium because these industries have been quick to accuse their competitors of unfair practices in the past. For example, the US has just approved anti-dumping duties against South Korea for producers of steel pipe [5].

If a challenge succeeds, retaliation would affect many sectors.
If the border tax adjustment rules are challenged and found to be unfair, retaliation could be expensive and affect all sectors. A complaining country can apply tariffs on goods imported from the offender so as to reduce the volume of imports by an amount similar to what it claims to have lost. This can be in any sector. For example, if the US or China complains that the EU is penalising their steel industry they can reduce imports of agricultural goods from the EU. This will make the EU very unpopular with their farmers, as well as all the EU industries that use imported steel [6].

Even if there is no challenge, there will be some impacts – but probably small.
Even if there is no challenge, there will be some impacts on the economy. It is likely the rise in price of carbon intensive goods in the EU – both locally produced and imported - will depress EU consumption. This will reduce the amount of goods imported and encourage foreign traders to send their goods elsewhere, so the EU exporters will have more competition. There will be impacts on jobs and the balance of payments as well as GDP.  However, these effects are small. For example an analysis by Netherlands Bureau for Economic Analysis found that border tax adjustments in both directions would convert a 3.2% loss in jobs (with just the ETS) to a 2.3% increase with adjustment. They also looked at welfare and found an overall drop of 0.72% without the adjustments becomes only 0.12% with them [7].

It is very difficult to model all this of course, partly because it is so hard to estimate how much it will cost industry to adjust. Past experience shows the industry lobbyists overstate the difficulties. For example when a cap and trade system for sulphur emissions was introduced in the US, price of allowances was expected to be $650 - $850 – in fact they were only a fraction of this, at $100 - $200 [8].

But if the border adjustments are allowed, game theory suggests that other countries will follow suit by implementing their own carbon regulations – enabling emissions reductions across the world.
Some UK researchers have applied game theory to see what other countries would do if the EU implemented border tax adjustments. Game theory can be used to work out what is the optimal strategy in a real life ‘game’ – such as war or trade. It does assume that the players are rational, which may be a bit of a stretch in this case. However assuming they are, the game showed the most advantageous response for other countries would be to follow the EU example by implementing their own equivalent carbon regulations. This allows them to raise revenue without damaging their own exports.  This response is especially helpful if the rules of the border adjustment are flexible, allowing imports to be exempt if they are from a country with rules that are ‘comparable in effectiveness’ even if not quite the same.  So one country can apply cap and trade style regulations and another can use taxes – provided the overall costs are the same they can exempt each other from border adjustments [9].

All it takes is for one or two large countries or blocs to set up their own carbon schemes with border adjustments – and the rest of the world will follow. It is possible to implement strong market incentives to protect the climate, without getting tied up in knots trying to agree the same rules everywhere.

What kinds of rules are likely to be accepted?
The rules need to be such that:

• Importers pay in the same manner as domestic producers (e.g. purchase and retire permits under the EUETS);
• The terms faced by importers are “no less favourable” than those given to domestic producers;
• The assessment of other countries’ climate policies is based on a formal judgment that is able to be appealed and which has involved some degree of input from the affected countries; and
• (Partial) exemption from the adjustment is given to countries who take efforts that are “comparable in effectiveness”, even if they don’t enact policies of exactly the same form.

What now?
There are risks but the potential benefits are huge. What we need now, then, is for the EU to prepare some border adjustments for the EUETS and get the WTO to approve them. Then we can be confident that the EUETS can be made to work properly and set an example for the rest of the world to follow. Better still, if the Citizen’s Climate Lobby can persuade the US to implement their carbon ‘fee and dividend’ scheme at the same time – then that will be two major economies leading the way for the developing world.

[1] Julian Allwood and Jonathan M Cullen  - Sustainable Materials with Both Eyes Open, 2012
[2] EU Carbon Price crashes to record low (Guardian) Jan 2013
[3] Trade and Climate Change WTO-UNEP report (WTO) 2009
[4] The Economic, Climate, Fiscal, Power, and Demographic Impact of a National Fee-and-Dividend Carbon Tax (Resources for the Future Library Blog) Jun 10th 2014
[5] US Steel pipe makers win key anti-dumping  case against cheap imports (Reuters) August 2014
[6] Ton Manders (PBL), Paul Veenendaal (CPB) (2008)   Border Tax Adjustments and the ETS
[7]  Working Paper CEPii Border Carbon Adjustments in Europe and Trade Retaliation: what would be the cost for European Union? 2013
[8] Michael Grubb (2014). Planetary Economics. Routledge
[9] Dieter Helm, Cameron Hepburn and Giovanni Ruta (2012) Trade, climate change and the political game theory of border carbon adjustments (Centre for Climate Change Economics and Policy – Grantham Research Institute on Climate Change and the Environment)