International Trade Law and the Economics of Climate Policy: Evaluating the Legality and Effectiveness of Proposals to Address Competitiveness and Leakage Concerns

There is a growing consensus that a market mechanism that puts a price on carbon, such as a cap-and-trade system or a carbon tax, should be at the heart of the most flexible and cost-effective way to address climate change.¹ Ideally, such an approach would be adopted as part of a multilateral agreement. The reason is that carbon is a global pollutant, so a ton of carbon emitted in Beijing contributes to climate change just as much as a ton of carbon emitted in New York. This tragedy-of-the-commons nature of climate change raises concerns that any unilateral effort by the United States to put a price on carbon could disadvantage U.S. industrial firms or undermine the measure's environmental objective. These two concerns, in effect flip sides of the same coin, are referred to as "competitiveness" and "leakage," respectively. The competitiveness concern is that U.S. products—particularly carbon-intensive ones like steel, cement, chemicals, glass, and paper—will be at a competitive disadvantage relative to foreign-made goods if the United States unilaterally imposes a carbon price policy and thus raises production costs for U.S. firms.² The second, related concern—emissions leakage—occurs when a policy that raises the price of carbon-intensive domestic goods causes domestic production to shift abroad and domestic consumption to shift to more carbon-intensive imports, thus undermining the policy's effect on reducing global levels of greenhouse gases (GHGs). Leakage also may occur as a result of reduced domestic demand for fossil fuel products, which depresses fuel prices in the global market and thus results in increased consumption.

An often-proposed response to the related concerns about competitiveness and leakage, which indeed has been incorporated into the leading cap-and-trade legislation, is to level the carbon playing field and encourage developing countries to adopt climate change policies by imposing a border adjustment that puts a price on the carbon contained in imports from countries without similarly stringent climate policies. Under a cap-and-trade system, this border measure could take the form of a requirement that importers from countries without comparable emissions reduction policies purchase emissions allowances to cover the carbon content of their products (or, alternatively, pay a tax equal to the allowance price). In theory, U.S. exporters might also be provided with allowances as rebates for the price of the embedded carbon in their products (though no proposal today calls for this).

Though perhaps sound in theory, the wisdom of leveling the carbon playing field by imposing border adjustments is more debatable when the expected benefits are weighed against the potential harms. The second section of this chapter briefly outlines these benefits and harms, and finds that one of the oft-cited benefits (and one that is most relevant under international law)—the reduction in GHG emissions—is likely to be quite small. To help fully explain the expected costs, and thus better compare them with the expected benefits of competitiveness and leakage prevention measures, the third section then analyzes one particular concern regarding the compatibility with World Trade Organization's (WTO's) law of border adjustments. Given space constraints, this chapter does not explore all the novel issues or claims that might be raised in evaluating such a complex legal question. Rather, the purpose of this section is to highlight the key questions that a WTO panel would raise in its analysis, focusing on how that legal analysis should be informed by the economics of a cap-and-trade system. As with any complex legal question, it is difficult to predict with any certainty how a WTO panel would rule, but the section identifies several ways in which a border adjustment might not be compliant with WTO law. Viewing border adjustments through the lens of WTO law also raises broader questions about the wisdom of imposing border adjustments as a policy matter. As an alternative, some have proposed the use of free allocation to address competitiveness...