Inevitable Clash When Climate Meets Trade at the Border

As the evolution of climate policy sees carbon-neutral targets and climate taxes going more mainstream, the trade regime is being put under increasing pressure.

Expert comment Updated 15 September 2023 Published 8 November 2020 3 minute READ

Scott Vaughan

Senior Fellow, International Institute for Sustainable Development (IISD); International Chief Advisor, China Council for International Cooperation on Environment and Development (CCICED)

Trade policy has long included reassuring references to appease environmentalists, such as including sustainable development in the preamble to the Marrakesh Declaration of the World Trade Organization (WTO) and in provisions related to domestic environmental protection and conservation, as well as largely respecting global environmental norms, national policies and processes — especially those demonstrating a consistency of intent and commitment.

But this uneasy peace is likely to be tested sharply by fast-evolving climate policies, with a growing number of jurisdictions setting target dates to become carbon-neutral, using carbon taxes and other market-based measures as well as regulations, standards, and subsidies to get there.

As a result, an interesting — albeit so far theoretical — debate about the role of border carbon adjustment (BCA) as part of this ‘climate toolbox’ may soon become reality, challenging trade policy and raising broader question over how best to ensure the trade regime is climate-compatible.

Shadows from the past

Trade has long sat uncomfortably with differing environmental pricing. Back in 1992, the General Agreement on Tariffs and Trade (GATT) — the precursor to the WTO — first considered the green agenda, its highly-respected head Arthur Dunkel warned that a ‘proliferation of different national environmental standards leading to trade friction is very real’ and that any actions which forced a reconciliation of pricing differences posed ‘dangers’ to the trading system.

Although the GATT/WTO recommended market-based instruments such as pricing and taxation as ‘first-best’ measures in addressing environmental issues, they remained silent on how substantive differences between countries’ pricing of the carbon content of traded goods ought to be handled. Instead, the trade regime hoped a coherent multilateral solution would emerge via UN climate negotiations — but so far it has not.

The 2015 Paris Climate Agreement did revive multilateral action but, at the centre of that deal is heterogeneity, leaving countries free to establish their own policies and levels of stringency — through NDCs (nationally-determined contributions) — as opposed to previous attempts at top-down targets and implementation timetables, such as the Kyoto Protocol.

Dunkel’s concerns about pricing differences posing a danger to the system has never been closer to reality than now. The EU Green Deal, aiming to achieve carbon neutrality by 2050 and to reach interim carbon emission reductions targets of 55 percent by 2030, has an ambitious plan to phase-out carbon-intensive sectors, scale-up the electrification of transport, buildings and other sectors, and ratchet-up its primary carbon pricing mechanism — the EU Emissions Trading System — including a phase-out of free allocation of emission permits.

None of this comes cheap. Companies have long worried about competing in export markets against similar goods with either no or much lower carbon pricing — especially those with a high carbon footprint. Concerns about competitiveness go to the heart of border carbon policies, with the European Commission promising its Carbon Border Adjustment Mechanism will be one plank of the EU Green Deal, and consultations are well underway.

The broad principles of Europe’s approach also include creating a level carbon-pricing field between domestic and imported goods, but specific technical details of this are immensely important and complex. Which sectors? Which industries within a sector? Which tools to calculate carbon footprint? Which administrative rules to ensure transparency? The debacle of the first try at the EU Emissions Trading Scheme show how tricky it is to design an even-handed border adjustment tool.

The recent report by the European Roundtable on Climate and Sustainable Transition impressively set out options for these and other questions, such as the proposed scope of any border adjustment based both on geography and sectors, and the legal feasibility of such action, as ways to calculate the environmental benefits — measured by avoided greenhouse gas emissions first — against the economic effects.

EU, US and China all on the move

Brussels may not be alone for long in setting a border carbon policy, as climate issues are on the rise in the US with both sides in the presidential election race advocating change. President-elect Joe Biden promises an ambitious climate agenda similar to the EU Green Plan, while several Republicans have talked up the need for carbon taxes, and the Climate Leadership council — chaired by Republican elders James Baker and George Schultz — is lobbying for an ambitious national carbon tax, coupled with BCA to protect jobs.

In addition to the trading system having to deal with two of the world’s largest trading blocs advancing a BCA system, China has announced it intends to peak greenhouse gas emissions on or before 2030 and become carbon-neutral by 2060, with work already underway on a decarbonization roadmap — a major game-changer.

Carbon markets, including pilot emissions trading systems, have functioned within China for several years, and it has been a powerhouse for renewable energy — albeit as much to curb choking levels of air pollution as to reduce carbon emissions.

China is now preparing the world’s largest national carbon market and is ramping up a series of other low-carbon measures, such as expanding electric public transport, investing in a clean energy infrastructure, and focusing on consumption opportunities as the carbon-neutrality commitment puts new urgency on how to phase-out coal and decarbonize heavy industry.

The transition to carbon neutrality raises similar challenges everywhere, especially for hard-to-abate, energy- and export-intensive heavy industries such as steel, aluminium, and cement. And therefore the same logic should be applied to deliver a level-playing carbon field and address carbon-related competitiveness — but signs suggest China is unsupportive of BCA.

Part of this reservation is justifiable concern that carbon adjustment pledges are simply cloaks for old-fashioned protectionism. With the current waves of unilateral tariff hikes being largely against China, it is understandable Beijing views emerging BCA measures with skepticism. China has also been a steady voice supporting a rules-based trading system and the World Trade Organization (WTO).

The EU promises its carbon border adjustment measures will conform with WTO norms, but this may be easier said than done. GATT Article II.2 (a) does allow tax adjustments at the border but adjusting taxes for carbon is far trickier than products such as alcohol.

Tariffs and tax rebate practices are adept at handling different physical goods across borders, but struggle when asked to differentiate the same end products which are made differently. If the trading system continues to treat a tonne of aluminium the same, whether it is made with coal or renewable energy, the aim of achieving carbon neutrality becomes obsolete.

A border tax adjustment measure may end up as a WTO dispute as, at first glance, the purpose of any BCA is to overturn principles of non-discrimination, which is one of the pillars of the GATT-WTO rules.

But other considerations would inevitably be taken into account, such as national treatment, and whether the environmental and sustainable development language embedded in WTO text as well as dispute and appellate body findings, makes border tax adjustment compatible with a rules-based system.

Some legal scholars and former appellate body members believe an actual case could uphold border adjustment measures, so waiting for a case is one option.

Alternatively, opening informal technical discussions between China, Europe, and the US to better align trade and climate policies would be welcome, especially as any trade dispute that rules a border adjustment measure is illegal may undermine the already shaky WTO order. For example, what would any BCA mechanisms do to accommodate different carbon prices in different countries/regions?

While support for ambitious climate action has never been higher, any clash over this issue now could lead to finally fulfilling Arthur Dunkel’s prophesies of danger from long ago.

This article is part of the Chatham House Global Trade Policy Forum, promoting research and policy recommendations on the future of global trade.