What Does Trade Have to Do with Climate Change?

As multilateral attempts for climate-change mitigation stall, the two-way relationship between trade and climate change is likely to come under further scrutiny. This column explains how liberalised trade has several climate-related consequences. It argues that trade policy could enforce mitigation policies but that multilateral conventions are crucial in preventing undesired protectionist consequences.

The last few decades have witnessed a rapid expansion of international trade and global output (Figure 1). This growth was partially enabled by a gradual reduction in trade barriers in the major export destinations. According to Baldwin (2006), average tariffs were reduced from 18% in Europe and 15% in North America in the late 1950s to about 4% in North Atlantic countries by the end of the 20th century. In parallel, carbon dioxide (CO2) concentration in the atmosphere increased drastically. However, to what extent is trade responsible for the escalating emissions?

Figure 1. Trends in output, openness, and emissions

Source: World Development Indicators Database.

Do emissions increase when countries trade more?

Emissions of greenhouse gases do not necessarily rise when countries trade more. Trade theory suggests that a marginal change in trade affects the emission level through three major channels: the scale effect, the composition effect, and the technique effect (see Grossman and Krueger 1992 and Copeland and Taylor 2003 for a detailed analysis).

The scale effect refers to an increase in emissions due to a higher level of economic activity, holding other factors constant. Therefore, the sign of the scale effect is generally positive. The composition effect refers to a change in emissions because of a change in the relative shares of different goods in production. If the exported good is relatively greenhouse-gas intensive, then the overall emissions will increase with trade liberalisation. With a comparative advantage in ‘clean’ industries, however, trade liberalisation will cause a reduction in emissions. Finally, the technique effect refers to the impact on emissions due to a change in production methods. Trade can reduce emissions per unit of output by facilitating the transfer of cleaner technologies or by inducing changes in regulations as demand for environmental quality will increase with income.

The net change in aggregate emissions is determined by the interaction of these three effects. For instance, in the case of sulfur dioxide (SO2), Antweiler et al. (2001) report that a 1% increase in the economic activity due to trade liberalisation raises emission by 0.25 to 0.5% through the scale effect for an average country, whereas it is driven down by 1.25 to 1.5% by the technique effect. The composition effect is found to be country specific and insignificant.

Figure 2 shows that openness is positively correlated with aggregate emissions, per-capita GDP, industry-share of the economy, and emission intensity per unit of energy use. Note that, however, cross-country comparisons using this decomposition methodology do not necessarily reflect the causality between openness and emissions unless country-specific factors are accounted for.

Figure 2. A cross-country analogy of the decomposition methodology

(click to enlarge)

Source: World Development Indicators Database. Notes: The sample includes 161 countries in top panels, 141 countries in bottom left quadrant, and 102 countries in the bottom right quadrant based on data availability. Oil-rich countries (countries with oil rents greater than 30% of GDP) and two outliers (Singapore and Hong Kong SAR, China) with high trade openness were excluded.

Does trade enable rich countries to become cleaner at the expense of poorer countries?

It is theoretically possible that both rich and poor countries reduce their emissions when trade is liberalised. However, the comparative advantages of the countries will determine the outcome.

Comparative advantage, in this case, is shaped by two forces: the pollution-haven effect and the factor-endowment effect. If the polluting sector is capital intensive then, all else being equal, a capital-abundant country with relatively loose pollution regulations will have a comparative advantage in the dirty industry. Given fixed emission policies, trade liberalisation will increase emissions since both the scale effect and the composition effect will be positive. However, pollution may be reduced in the clean-good-exporting country if the composition effect is strong enough.

In practice, developed countries are both capital abundant and more likely to have stricter climate policies. In this case, if the developed country is sufficiently capital abundant, the factor-endowment effect will dominate the pollution-haven effect, and trade will increase emissions in the developed country. In comparison, if the capital abundance is below a certain threshold and the pollution policy is responsive to income changes, then trade can reduce emissions both in developed and developing countries (see Copeland and Taylor 2003 for model details.). Therefore, the net impact is country-specific.

Trade policy for climate change mitigation

Current multilateral efforts to reduce greenhouse-gas emissions are considered ineffective because of insufficient participation and lack of enforcement (Barrett 2008). Trade policy is, therefore, suggested as a mechanism to facilitate compliance and participation by serving four purposes under a global climate regime (De Melo and Mathys 2010):

1. address leakage and competitiveness issues;
2. generate sanctions against nonparticipation and noncompliance;
3. help separate the abatement location and the bearer of the cost of abatement; and,
4. maintain a free-trade regime that is crucial for technology transfers.

The following sections investigate these roles.

Can trade policy ‘level the playing field’?

Taxing greenhouse gas emissions unilaterally raises concerns on leakage and competitiveness. Leakage refers to an increase in greenhouse gas emissions in non-participating countries, as taxes would cause the dirty industries in regulated economies to shrink and the ones in unregulated economies to expand. Competitiveness, on the other hand, refers to raising the costs of firms in regulated economies because of the higher emission taxes.

Border tax measures, which impose taxes on imports and subsidies on exports based on carbon content, are proposed as a mechanism to address these concerns by levelling the playing field. A uniform tax on both domestic and imported goods is trade neutral if exporters in the implementing country are reimbursed (Grossman 1980; Lockwood and Whalley 2008). However, the neutrality is no longer valid when traded goods have different carbon contents. Policymakers need to choose either the carbon content of domestic production or the one of foreign (actual) production as the basis for border tax measures. Mattoo et al. (2009) show that the latter are more damaging to developing countries. Moreover, it has several implementation problems including potential incompatibilities with WTO legislation and the difficulty of tracing the carbon content of inputs.¹

Therefore, border tax measures may be costly and inefficient. The next option on the table suggests using border measures only in the case of noncompliance.

Can trade sanctions facilitate compliance?

Using trade sanctions for environmental purposes is essentially equivalent to linking the trade and climate change mitigation agreements. The main purpose is to transfer enforcement power from the former agreement to the latter. However, this method has not been tested for WTO compatibility. Chisik and Onder (2012) show that linking two seemingly independent agreements could reduce the cooperation in both of them under the prevailing rules that regulate trade disputes in the WTO.

Moreover, trade sanctions might not have the desired impact hoped for on non-members. A carbon-based tariff on imports from non-members would affect the exporting country significantly. However, this cost might be small in comparison to the loss of GDP growth had the exporter ratified the mitigation agreement and employed the entailed mitigation policies.²

How can trade policy help separate the location of abatement and the bearer of the cost?

The World Development Report (2010) suggests separating the location of abatement and the bearer of the cost of abatement. The idea is that countries with low marginal cost of abatement can ‘export’ the abatement. Moreover, saving future emissions might cost less than reducing current emissions if technology is irreversible to a certain extent. Therefore, the ‘no-regret’ approach highlights the importance of mitigation efforts in developing countries. However, this entails compensation for mitigation efforts beyond unilaterally optimal levels.

Trade policy can help provide the necessary financing for developing country mitigation through international tradability of carbon allowances and technology transfers. Eliminating the tariff and non-tariff barriers against imports of clean technologies and against foreign direct investment might significantly improve the transfer of technology through the Clear Development Mechanism and similar mechanisms.

Will trade be free after all?

Trade measures carry a significant risk of triggering waves of protectionist policies. Developing countries would be tempted to increase their current tariff rates on imports from the respective partners to the bound rates without facing any legal restraint. Moreover, technical complexities in the implementation of trade measures such as the difficulties in the assessment of product-specific emissions might induce a government to take retaliatory action when it mistakenly believes that the partner is pursuing a protectionist policy. Therefore, multilateral conventions on trade and climate policies are crucial in preventing the undesired protectionist consequences of trade policies.

The analysis in this column is based on the most recent Economic Premise by the World Bank (Onder, 2012). The views expressed here are those of the author and do not necessarily reflect those of the World Bank.

References

•Antweiler, W., B. Copeland, and S. Taylor. 2001. “Is Free Trade Good for the Environment?” American Economic Review 91 (4): 877–908.
•Baldwin, R. 2006. “Multilateralising Regionalism: Spaghetti Bowls and Building Blocks on the Path to Global Free Trade.” World Economy 29 (11): 1451-–1518.
•Barrett, S. 2008. “Climate Treaties and Imperative of Enforcement.” Oxford Review of Economic Policy 24 (2): 239–58.
•Chisik, R., and H. Onder. 2012. “Limiting Cross-Retaliation When Punishment Is Limited: How DSU Article 22.4 Complements GATT Article XXVIII.” Ryerson University Working Paper Series 025, Ontario.
•Copeland, B., and S. Taylor. 2003, Trade and Environment: Theory and Evidence, Princeton University Press, Princeton.
•De Melo, J., and N. A. Mathys. 2010. “Trade and Climate Change: The Challenges Ahead”, CEPR Discussion Paper Series 3083, London.
•Grossman, G. 1980. “Border Tax Adjustments: Do They Distort Trade?” Journal of International Economics 10(1): 117–28.
•Grossman, G., and A. B. Krueger. 1992. “Environmental Impacts of a North American Free Trade Agreement”, CEPR Discussion Papers 644, London.
•Lockwood, B., and J. Whalley. 2008. “Carbon Motivated Border Tax Adjustments: Old Wine in Green Bottles?” NBER Working Paper Series w14025, Cambridge, MA.
•Mattoo, A., A. Subramanian, D. van der Mensbrugghe, and J. He. 2009. “Can Global De-Carbonization Inhibit Developing Country Industrialization?” World Bank Policy Research Working Paper Series 5121, Washington, DC.
•Onder, H. 2012. “Trade and Climate Change: An Analytical Review of Key Issues.” Economic Premise no: 86, the World Bank, Washington, DC.
•Panagariya, A., 2010. Climate Change and India: Implications for Policy options. University of Columbia, mimeo.
•World Bank. 2010. World Development Report: Development and Climate Change. Washington, DC.

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¹ The multilateral trading system’s experience with trade barriers on the basis of process and production methods has been mixed. GATT ruled against U.S. barriers based on the processes and production methods in the United States–Mexico dolphin–tuna case; however, a WTO panel ruled that measures can target processes and production methods in the USA–India shrimp–turtle case.

² Panagariya (2010) anticipates a loss of US$2.1 trillion in net present value terms in 2020 for India, if ratification causes one percentage point of loss in the current 8% growth rate.

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