WTO and climate change – a clash of treaties

May 5, 2021

The emission reduction measures proposed by governments to meet their Paris Climate Agreement commitments will violate their legally binding WTO obligations. This clash of treaties will have deleterious consequences for both.

The world has just witnessed President Joe Biden’s Zoom event with 40 heads of government, announcing targets for increasingly ambitious reductions in carbon emissions within narrowing time frames.

These targets are a response to the 2015 Paris Climate Agreement that countries should  keep average global temperature increases under 2 degrees (and preferably 1.5) of an undefined “pre-industrial level”.

The Paris Agreement places no restrictions on the type of measures governments can employ and includes no mechanism to force a country to meet its target; international shaming is the only penalty for violators.

Targets are only targets, and governments will adopt different measures to achieve them. However, the key emission reduction measures now under consideration seem increasingly likely to violate legally binding obligations made by the same governments under World Trade Organisation (WTO) agreements.

If the WTO becomes the arbiter of which climate measures are legally acceptable, it will find itself in a perilous situation, precisely at a time when it is regaining its authority to deal with global trade in the post-pandemic world.

One prime example of potential conflict is a breach of the “non-discrimination” principle, which is the cornerstone of the WTO agreements that its 164 members have adopted.

Simply put, in their trading relations, each WTO member must treat another member no less favourably than any other. In practice, members can’t discriminate between supplying countries, nor between imports and locally produced goods.

The potential to breach the non-discrimination principle is most evident when dealing with “carbon leakage”, which occurs when goods, normally produced locally, are imported from countries with lower carbon taxes or less-demanding emission permit requirements.

As both taxes and permits are based on carbon prices, for simplicity, I will focus on taxes here. With different carbon prices, international companies move production to plants in countries with lower carbon taxes to maintain (or acquire) international competitiveness. Perversely, stringent domestic carbon taxes may lead to increased global emissions.

Thus, carbon leakage presents both an environmental problem (increased global emissions) and an economic problem (loss of competitiveness).

The “solution”, touted over the years but never implemented at a national level, is to adjust for the difference in carbon taxes between countries at the border. Border tax adjustment is provided for in WTO rules. Governments are free to apply domestic carbon tax (or any indirect tax, such as sales tax) on imports and rebate the same tax on exports. However, this flexibility does not extend to carbon taxes charged on inputs consumed in the production of a final good; taxes can be adjusted for trade in aluminium, but not for bicycles with aluminium frames.

This creates a problem for countries, such as EU members, wanting to apply border taxes or emission permit requirements at each stage of the production process. This requires knowledge of the carbon footprint of imported goods, which, apart from basic products such as cement, aluminium, steel or paper, is clearly infeasible. The proposed solution is to assume the carbon footprint for the imported good is the same as in the EU, where more is known about local carbon footprints.

But this assumption creates problems. The imported product may have a different input mix and tax structure (with imported inputs) compared with the EU. Also, the exporting country may have its own carbon price, requiring adjustment at the border for taxes paid in the exporting country. In addition, the exporting country may not have a carbon price at all (e.g. Australia) but employ alternative measures for controlling carbon emissions.

In the face of these problems, the proposed “solution” is for the EU to evaluate if an exporting country is doing enough to meet the Paris Accord targets. If not, and in violation of WTO rules, the EU would unilaterally apply what is effectively a penalty tariff, but with the less offensive title of a carbon border adjustment measure (CBAM).

The United States is heading in the same direction. The Biden administration intends to apply a “carbon adjustment fee against countries that are failing to meet their climate obligations”. This intention may well involve invoking Section 232 of the Trade Expansion Act of 1962, which gives the US President authority to unilaterally tax any import deemed to “harm national and economic security”.

After many years of disuse, former President Trump resorted to this Act in applying unilateral penalty tariffs on, among other things, imported aluminium and steel. This action, inconsistent with WTO rules, heralded the start of the US-China trade war. Further WTO-inconsistent taxes on carbon-emitting aluminium and steel would exacerbate the current tensions.

Imposing a CBAM challenges the foundations of the WTO. Under WTO rules, the way a product is produced – regardless of whether the labour standards, levels of ozone-depleting substances, or carbon emissions are considered unacceptable to the importing country – does not justify trade-discriminatory treatment on the part of the importing country.

This approach makes sense. Under its existing mandate, the WTO has neither the expertise nor the authority to adjudicate on preferred production processes as other organisations and treaties do. The WTO has studiously left this task to treaties and organisations with competence in the area; namely, the International Labour Office, the Montreal Protocol and the Climate Change Convention, in the case of the examples given above.

To have the authority adjudicate on the legality of trade restrictions in areas beyond its competence would make the WTO the agent of global governance that many claim it already is.

Over 400 multilateral environment agreements (MEAs) currently deal with concerns as diverse as protection of migratory species, disposal of hazardous wastes and protection of endangered species. More than 20 have trade-related provisions, but none has ever been the object of a dispute in the WTO.

What is urgently required is multilateral agreement on what climate measures violate WTO obligations, where WTO-compliant measures could arrive at the desired result, or where it is necessary to modify WTO obligations.

There are 164 signatories of the Paris Accord that are also members of the WTO. The regular work program of the WTO Committee on Trade and the Environment instructs governments to address “the relationship between the rules of the multilateral trading system and the trade measures contained in multilateral environmental agreements (MEAs)”, such as the Climate Change Convention and Kyoto Protocol. Trade officials have actively debated this instruction over the years, with no concrete outcome.

Action is needed at a far higher political level. Apparently, Prime Minister Boris Johnson has urged G-7 countries to agree to adopt border tax adjustment measures at their forthcoming June meeting in Cornwall. This call is premature, to say the least.  The first step is to settle which climate measures contravene legally binding obligations undertaken elsewhere, and what to do about it.

It would be more constructive if the G7 Communique announced the necessary steps for governments to set in motion negotiations to avoid clashes between treaties. As Prime Minister Scott Morrison is invited to attend the G7 Summit, he could make a constructive contribution by proposing – with some authority – this course of action.

Australia has worked hard over the years to ensure a strong and efficient rule-based trading system; wanting it strengthened, not further undermined. If Australia should find itself on the receiving end of carbon border adjustment measures, it is critical that those measures be applied in a non-trade distorting manner.

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