Levelling the Playing Field in a Fragmented Carbon Market: Do Carbon-Based Border Tax Adjustments Work?

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Image by {link:http://commons.wikimedia.org/wiki/File:Tehran_Pollution.jpg} Matthias Blume on WikiMedia Commons {/link}

Image by {link:http://commons.wikimedia.org/wiki/File:Tehran_Pollution.jpg} Matthias Blume on WikiMedia Commons {/link}

* The views of the authors do not necessarily represent the views of the OECD or of its member countries.

After Copenhagen, concerns over an uneven playing field for producers, caused by regional differences in climate mitigation policies, appear to be heightened. Consequently, the debate over protective measures continues, focusing largely on carbon-based border tax adjustments (BTAs).

In Europe, citing concerns over fair play for industries and jobs, French President Sarkozy has repeated calls for a carbon tax on imports into Europe, to be applied to countries that fail to implement a climate change mitigation policy. Yet the European Commissioner for Trade, Karel De Gucht, opposes this approach, citing apprehension about inciting trade wars (Chaffin et al, 2010). While the European Council concluded in October 2009 that the first-best solution to address carbon leakage is with a broad and deep climate deal, it left the option available to use appropriate measures to address the risk of leakage, and continues to evaluate additional approaches to address competitiveness (EC, 2009 and EC, 2010).

In the United States, similar fears have resulted in provisions for BTAs in the Waxman-Markey bill passed by the House of Representatives in 2009, and the Kerry-Lieberman bill introduced (and subsequently abandoned) in the Senate in 2010. The draft cap and trade policy in both bills included additional allowances for affected industries based on output (Waxman-Markey, 2009; Kerry-Lieberman, 2010). The extent of competitiveness concerns in the Congress was underscored in a letter to President Obama from nine Democrat Senators in December 2009, noting that “any new US climate change laws should establish a national system of border adjustments, in concert with emission allowances or rebates to trade- and energy-intensive sectors of the economy” (Broder, 2009).

In response, key trading partners are voicing their concerns. India along with the G-77 and China have been calling for language in the draft text of the UN climate negotiations that would caution against developed countries resorting to BTAs and other countervailing border measures (Khor, 2009).

Political debates about BTAs confuse several of the underlying issues. To clarify, there are two related issues of concern for countries taking on climate action:

  1. that some of their domestic industrial production will lose competitiveness, and
  2. that part of their efforts will be undermined by an increase in greenhouse gas (GHG) emissions elsewhere, or “carbon leakage”.

In economic terms, loss of competitiveness stems from relative price differentials in traded goods: companies confronted with a relatively stringent climate policy will have higher production costs than competitors without such constraints. Insofar as this leads to a shift in economic activity towards regions with a less stringent or no climate policy, this will increase emissions in these new locations (leakage). There is, however, a second indirect channel driving leakage: policy dampens world energy demand, which puts downward pressure on global energy prices that in turn increases demand for GHG-emitting fuels in locations where emissions are not constrained.

carbon_leakage_1

Figure 1 – Carbon leakage with and without BTAs in 2030

Source: OECD ENV-Linkages model (Burniaux et al, 2010)
Note:
Results shown for scenarios with US, Japan, EU and Annex I respectively acting alone to reach a target of a 50% emission reduction by 2050. Leakage rates are calculated as the ratio of emission changes in non-acting countries over the emission reduction in acting countries or regions.
Click to enlarge

The degree of carbon leakage depends on which countries are taking climate action and on differences in the level of stringency of policies. In an illustrative simulation using the OECD ENV-Linkages model, the leakage rate is estimated at almost 12% when the European Union cuts emissions unilaterally by 50% in 2050 from 2005 levels (OECD, 2009). Recent research (Burniaux et al, 2010) shows that similar results would occur if the US or Japan would act alone.  Figure 1 shows these leakage rates for 2030. However, if the effort to achieve a similar level of emission reduction is spread across all Annex I countries simultaneously, carbon leakage becomes negligible, falling to less than 2%. This reflects both the broader country coverage (fewer countries where leakage occurs) and reduced mitigation costs (as efforts are shared). Moreover, not only the magnitude but also the nature of carbon leakage changes with the size and composition of the mitigating coalition: larger coalitions have smaller losses in competitive position but a stronger effect on global fossil fuel prices.

While leakage and competitiveness concerns are inter-related, they can stem from different causes and may require separate policy treatment. Although BTAs could be effective to address leakage stemming from the competitiveness channel for a small group of acting countries, they do not address leakage that occurs through the world fossil fuel markets, nor do they directly address the loss of domestic production. And BTAs come with other costs: they can be damaging to the economy, costly to implement, and could instigate trade wars. The perhaps greater concern of loss of competitiveness for domestic industry should therefore be addressed with more targeted and effective policy levers. This article investigates each of these issues in more detail.

BTAs may reduce carbon leakage from the competitiveness channel

BTAs help to reduce the leakage rate when the coalition of acting countries is small by limiting the competitiveness channel. As the number of acting countries increases, the role and the effectiveness of BTAs decline rapidly, because leakage rates are much lower and tariffs address a smaller share of remaining leakage.

The effectiveness of BTAs in reducing leakage also depends on which channel of leakage is dominant. OECD (2009) analysis shows that if the EU were to act alone, and were to supplement its domestic action with a carbon-based border tax adjustment (calculated on the imported direct and indirect carbon content), then leakage disappears. Burniaux et al (2010) find that BTAs are also effective at limiting leakage when Japan acts alone. But if the USA implements a BTA, or all Annex1 countries together, then a BTA is less effective at reducing leakage; in the case of the USA acting alone, the BTA would reduce the amount of leakage by an estimated 2.5 percentage-points (Ross et al, 2009; Burniaux et al, 2010). This is because in these cases the major channel of leakage is not the loss of competitive position, but rather the second channel through international fossil fuel prices.

carbon_leakage_2

Figure 2: Impact of BTAs on production volumes of energy-intensive industries in 2030

Source: OECD ENV-Linkages model (Burniaux et al, 2010)
Note: Results shown for scenarios with EU and US respectively acting alone to reach a target of a 50% emission reduction by 2050.
Click to enlarge

BTAs fail to protect domestic industry

Although addressing competitiveness concerns is often voiced as a rationale for BTAs, analysis shows that BTAs may not curb the output losses incurred by domestic energy‑intensive industries. While carbon leakage may become very small with a large acting coalition, the impact of carbon pricing on the output of energy‑intensive industries in domestic and international markets may still be large in some countries, reflecting a shift in economic structure away from carbon‑intensive production. As Figure 2 shows, in certain cases (e.g. when the EU acts alone), BTAs can actually worsen the impact on the domestic energy-intensive industry. This is due to several factors, including the impact of BTAs on exchange rates and terms of trade, and the (usually large) share of imports of energy-intensive goods demanded by a number of domestic energy-intensive industries (for instance, car companies import huge amounts of steel products). The impact of BTAs on trading partners depends, in part, on the degree of international linkage and the relative energy-efficiency of trading partner industries.  For example, if the EU implements a BTA, Canada and the USA may actually benefit in comparison to less energy-efficient competitors, such as China, who will be impacted negatively.

carbon_leakage_3

Figure 3: Real GDP and welfare impacts in 2030

Source: OECD ENV-Linkages model (Burniaux et al, 2010)
Note: Results shown for acting countries, the rest of the world (‘Non-Acting’) and global average for simulation scenarios with US, Japan, EU and Annex I respectively acting alone to reach a target of 50% emission reduction by 2050. Welfare is measured by equivalent variation in household income; it does not incorporate impacts of climate change. GDP and welfare are expressed in percentage change from the baseline.
Click to enlarge

BTAs come at a cost

Clearly, BTAs can entail substantial economic losses when looking globally and particularly for non‑participating trading partners. For instance, in a scenario where Annex I countries cut their emissions unilaterally by 50% by 2050, BTAs help reduce world emissions, but the cost to non-acting countries’ GDP in 2030 would increase substantially as shown in Figure 3. The costs to world GDP would also increase as the BTA policy reduces global international trade.

BTAs improve welfare for the implementing country, but negatively impact global welfare. Figure 3 illustrates results from the OECD ENV-Linkages model (Burniaux et al, 2010), showing this negative effect on global consumer welfare, as reduced losses in acting countries cannot compensate fully for the additional losses in other countries. These effects are in line with existing estimates of other recent modelling studies (Mattoo et al, 2009; Dong and Whalley, 2009).

An interesting result for acting countries is that even if welfare is improved by imposing BTAs, they still have a negative impact on GDP (Figure 3). In the ENV-Linkages model the welfare improvement is the consequence of a positive effect on terms of trade; even though the policy increases import prices, export prices increase relatively more.

BTAs have additional complications

Apart from the disadvantages of BTAs in terms of aggregate mitigation costs and failure to protect domestic industry, they are also likely to be difficult and costly to implement. There are inherent challenges in measuring the emissions embodied in the full production cycle of goods abroad, including foreign emissions from production, combustion and indirect electricity use.

In addition, there are potential political implications of BTAs. Protectionist policies could incite retaliation from trading partners. BTAs could also face legal challenges by members of the World Trade Organisation. On the other hand, the “threat” of using BTAs may incite broader and deeper participation in a carbon market by trading partners. While this may hold to some extent for certain countries, it is uncertain that it will be credible for strong trading partners such as China.

More effective policy levers

Clearly the first-best option to address carbon leakage and loss of competitiveness would be to have global coverage of a climate policy. But given these uncertain times for the carbon market, the threat of BTAs is likely to remain. Yet considering the wide range of countries that have associated with the Copenhagen Accord and/or pledged mitigation targets and actions for 2020, even as a fragmented carbon market develops, leakage is likely to be very limited. BTAs are only effective in addressing leakage through one of the channels, do not directly address the loss of domestic production, and are costly. Thus the real focus should be on exploring more effective policy options to level the playing field than BTAs.

References:
  • Broder, John M. (2009), “In Letter to Obama, Senators State Conditions for Supporting Climate Bill”, The New York Times, 3 December, (web).
  • Burniaux J.M., J. Chateau, and R. Duval (2010), “Is there a case for carbon-based border tax adjustment? An applied general equilibrium analysis”, OECD Economic Department Working Paper No. 794, July 2010, (web)
  • Chaffin, J., N. Tait and T. Barber (2010), “Trade War Fears Raised on Carbon Border Tax”, Financial Times, 12 January.
  • Dong, Y. and J. Whalley (2009), “How Large Are the Impacts of Carbon Motivated Border Tax Adjustments”, Working Paper 15613, National Bureau of Economic Research, Cambridge, Massachusetts, (web)
  • EC (2009), “Presidency Conclusions of the Brussels European Council (29/30 October 2009)”, 15265/1/09 REV 1, (web).
  • EC (2010), “Analysis of options to move beyond 20% greenhouse gas emission reductions and assessing the risk of carbon leakage”, COM(2010) 265 final, Brussels 26.5.2010.
  • Khor, M. and H. Jhamtani (2009), “India, G77 Propose Text Against Trade Protection in Copenhagen Draft”, South Bulletin (Issue 40), South Centre, 10 September 2009,  (web).
  • Kerry-Lieberman (2010), “American Power Act”, http://kerry.senate.gov/work/issues/issue/?id=7f6b4d4a-da4a-409e-a5e7-15567cc9e95c.
  • Mattoo, A., A. Subramanian, D. van der Mensbrugghe, and J. He. (2009), “Reconciling Climate Change and trade Policy”, World Bank, CGD Working Paper No 189, November 2009.
  • OECD (2009), Economics of Climate Change Mitigation: Policies and Options for Global Action beyond 2010, (web).
  • Ross, M., A. Fawcett, A. and C. Clapp (2009), “U.S. Climate Mitigation Pathways Post-2012: Transition Scenarios in ADAGE.” Energy Economics, (web).
  • Waxman-Markey (2009), “The American Clean Energy and Security Act (H.R. 2454)”, (web).
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