1. Introduction

1I confine my attention to two issues. First, I discuss the effects of environmental policy objectives on trade and welfare. Second, I show how trade agreements can be integrated with environmental concerns and particularly how the production of an international trade in carbon-intensive outputs can be sensibly regulated. Some of the discussion is related to China.

2. Environmental threats to trade

2Environmental concerns are seen by some as a threat to the continued growth of world trade particularly if trade itself promotes environmental degradation (Tamiotti et al. 2009). This continued growth is seen as improving the economic welfare of nations so that the pursuit of environmental objectives is seen by some as restricting the range of possible trades and thereby impeding sought-after welfare gains. These implied losses are seen as particularly important for developing countries who seek higher standards of non-environmental consumption per capita and who place a relatively low valuation on the natural environment.

3This is an unsound economics. The efficiency case for internalizing global external costs is premised on maximizing global economic welfare. Internalizing externalities, such as those associated with greenhouse gas emissions (GGEs), maximizes global welfare and, provided the right compensations are paid, will advantage all. This case is not diminished by the fact that some countries in the developing world might have low willingness-to-pay for environmental quality. As is the case with respect to externalities in a closed economy with poor and wealthy citizens, it makes sense to internalize external costs by attaching a uniform price on the externalities—or by allowing free trade in the efficient level of emissions permits—and by then addressing distributional concerns using compensatory transfers. This isn’t just abstract economic theory. If one reviews the UN climate change negotiations in Copenhagen, it is clear that the negotiation issues were as much about negotiating compensations and development assistance—including technology and financial transfers—to developing countries from developed countries as it was about mitigating GGEs. Indeed, the Copenhagen Accord refers to mitigation actions in Articles 2, 4 and 5 and compensation issues are addressed in Article 8 partly via the establishment of a Copenhagen Green Climate Fund (Article 10) and a Technology Mechanism (Article 11) (United Nations 2009). This broad perspective makes sense.

4There are global inefficiency costs if trade expands along with trade-induced external costs. The global gains from trade can be increased with appropriate policies for addressing the externalities. Given this increase and the possibility of appropriate transfers, all countries can be made better off. This should be the starting point for thinking about global environmental issues.

5This entirely elementary argument—a direct implication of the idea that externalities imply deadweight losses—is disbelieved by many in both developing and developed countries. Carmody (2009), for example, argues that free international trade in GGE permits “reduce the selling country’s capacity for ETS-compliant economic growth” and that “growth capacity is added to the initial growth capacity of the countries buying the permits”. Carmody sees revenues to permit sellers (developing countries) being used to buy goods from permit buyers (developed countries) so growth in developed countries occurs at “the expense of” less growth in developing countries.

6This is an extreme variant of the thesis that efficient environmental policies inevitably damage growth, and is incorrect. Free international trade in permits helps to ensure that cleanup occurs at minimum global cost—it is estimated that global costs of GGE cleanup will be cut by 20 per cent with such trade (The Climate Group 2009). This efficiency might be distributionally unfair to developing countries because to achieve it, the costs of cleanup end up being as high in developing as developed countries, even though the latter have a higher willingness-to-pay for it. Hence the need for compensations to developing countries, either by assigning an initial allocation of emissions permits that remains restrictive enough to enforce a hefty carbon price or, conceivably, via technology transfer or a direct monetary transfer. Such compensations are feasible because eliminating the distortion increases the correctly-calculated value of world output. Provided the transfer is large enough—whatever the specific form it takes—all countries gain from the globally efficient move to mitigate.

7Put equivalently, growth with emissions is inefficient growth. The value of world output is not being maximized. The global social marginal benefit of GGE mitigation is the aggregate of benefits obtained in all countries since GGE reductions are a global public good. Thus it makes sense for these reductions globally to occur to the point where costs of mitigation equal this common aggregated benefit. Low mitigation cost options should be cut back first and higher cost options pursued subsequently. Longer-term reduction efforts require an 80-90 per cent eventual cut in emissions in developed countries and reduced growth in emissions prior to an eventual phase of emissions stabilisation in developing countries. Accompanying such cuts with appropriate transfers ensures that the global efficiency gains are shared so all are better off.

8Carmody points out that increased revenues to developing countries will increase their ability to import from developed countries so developed countries have the opportunity to export more. This boosts consumption and investment opportunities in developing countries and compensates them for the higher prices induced as a consequence of emissions control. Incomes in developed countries are lowered through the need to purchase permits. This restricts consumption and investment opportunities although these countries are more than compensated through reduced damages from climate change so that they too gain. This is not a difficulty but is exactly what is sought.

9Nor does this analysis change if one country (call it China) sets emission targets for industry whereas other countries (e.g. the US) set the globally efficient carbon tax. The only issue then is whether China sets targets that are consistent with those that, in conjunction with US measures, deliver optimal global emissions levels. If it does then, while China may impose deadweight losses on itself by not mitigating at minimum cost, the same compensatory transfers need to be provided were it the case that both countries levied the efficient tax.

• developing countries for whom the economic gains from not mitigating GGEs plus the carbon leakage gains received (corresponding to the leakage losses incurred by countries which do mitigate) exceed the gains these countries would get from mitigating emissions and perhaps receiving compensatory transfers;

• developed countries for whom the gains generated from mitigation do not cover the costs of carbon leakages to developing countries (for discussion see Clarke, 2010) plus the costs of making compensatory transfers to developing countries.

12I argue below that the problem of carbon leakages can be dealt with by appropriately defining the GGE base in terms of national consumption rather than production. Then, even ignoring the issue of the willingness of developed countries to pay compensations, it can be argued that there remain strong arguments for unilateralist pursuit of mitigation. In short, the objections to unilateralism, when subject to scrutiny, are less persuasive than might be first thought.

13There are three reasons for this:

14First, with respect to ‘large’ countries (China, India, the European Union, the United States, for whom GGEs in each country comprise around 20 per cent of total GGEs, individual country mitigation decisions provide some direct climate control benefits to the country that mitigates. For example, China’s mitigation of Chinese GGEs provides perceptible climate control benefits to China. China contributed 55 per cent of the growth in world emissions from 2000-2005 and on a business as usual policy strategy will double its current emissions levels to nearly 40 per cent of global emissions from 2005-2030 (Garnaut et al. 2008).  Developing countries and China in particular will by their own actions substantially impact future rates of global warming. This is particularly so because Chinese emissions, by themselves, have a significant impact on Chinese welfare and because of the substantial costs a country like China would face with unmitigated climate change, particularly with respect to water supply issues in rural areas.

15Second, carbon control measures provide some ‘no regrets’ benefits, unrelated to climate control, in countries which incur local air pollution problems, such as SO₂ pollution. China, for example, has substantial air pollution problems in its major cities: it is claimed that 16 out of 20 of the world’s most polluted cities are in China. The World Bank has estimated the human and economic costs of this air pollution to be substantial (World Bank 2007). To a large extent, the pollution reflects increased atmospheric SO₂ concentrations associated with burning coal for electricity generation. The claimed costs of such pollution have proven controversial but there is no question that there are substantial ‘no regrets’ environmental benefits from GGE reductions that simultaneously reduce SO₂ emissions.

16Third, for countries whose emissions significantly impact on global GGEs there is a strong a priori case to address the prospects of catastrophic risk that impact on all countries. If a country implements a cost-benefit study to assess the case for mitigation and determines that, in at least one state of the world, there is the prospect of catastrophic climate change with non-negligible probability, then it makes sense to address that concern without any attention at all to ‘free-rider’ strategic policy complications or even such controversial issues as choice of discount rate (Clarke and Reed 2006). In short, unilateralism makes sense. There are compelling arguments that the world is indeed faced with the prospects of catastrophic climate change with non-negligible probability. In widely-cited work, Weitzman (2009) has estimated a 5 per cent chance of warming of 10^oC over the next 200 years if countries only gradually ramp-up their responses to warming; with a 1 per cent probability there will be 20^oC warming. These would be catastrophic events for all nations and the probabilities are definitely non-negligible, again implying a rational case for unilateralism.

17Thus, the argument that individually rational countries might ‘opt out’ of a mutually advantageous global deal on climate control for reasons of perverse incentives is not unambiguous. There is a case for unilateralism among large countries, even putting to one side the issue of compensations. With the compensations that should be paid, on the practical basis that this secures a mutually advantageous global deal, this case becomes even stronger. In short, global environmental agreements with respect to climate change should be strategically straightforward if countries accept the pessimistic implications of the mainstream science of climate change and understand the costs and benefits of active policy. As Whalley and Walsh (2009) have argued, the ‘perception of damages is critical to the concludability of negotiations’ (p.264).    There remains a task of communicating such information to decision-makers.

3. Integrating environmental objectives into trade agreements.

18I concentrate on the case for using border tax adjustments (BTAs) as an auxiliary policy to national climate change mitigation policies. These policies are of particular interest because, provided BTAs are levied as consumption taxes, they seem to be consistent both with the rules of the GATT (Tamiotti et al. 2009) and the objective of eliminating many carbon leakage issues. This latter feature assists in achieving international agreement on climate change mitigation.

19If carbon charges are computed on a consumption basis then exports of carbon-intensive goods would be exempt from charging but imports of carbon-intensive goods would be subject to a BTA. This arrangement eliminates carbon leakages associated with unfair competition from imports not subject to carbon charges and leaves exports competitive with foreign-produced goods in destination markets where charging does not occur. It also eliminates foreign capital flows that are purely based on seeking ‘pollution havens’ free from the impact of carbon charging. The only leakage issue not resolved by this choice of tax base is that due to the induced fall in the global prices of carbon-based fuels that will result from carbon-charging and hence reduced carbon-based fuel use in mitigating countries. These reduced prices provide non-mitigating countries with incentives to increase their carbon-based energy use and hence their carbon emission—a type of ‘general macroeconomic leakage’ (GML).

20Taxing carbon emissions on a consumption basis in a world where not all countries levy the same carbon price is a useful ‘second-best’ prelude to the best policy of uniform production-based carbon taxes thart are universally applied and which will internalise all externalities including GML. Indeed, countries which are net exporters of carbon have incentives to switch from consumption-based to production-based charging to access the tax revenues that would otherwise accrue to destination economies. Countries which do not mitigate at all will not experience increased pressure to mitigate on a consumption basis as a consequence of consumption-based charging elsewhere since they will be subject to BTAs regardless. However, in its favor, such a tax base means that countries which do seek to mitigate intensively will not face real or perceived disincentives to do so on the basis of implied carbon leakages. In short, the case for unilaterally moving toward active mitigation strategies is enhanced.

21Many developing countries have reacted strongly to the proposed use of BTAs. What is the rational basis for this objection? On economic efficiency grounds no non-mitigating country has any reasonable basis for opposing correctly imposed BTAs as an unjustified restriction on world trade, provided such charges only internalize the external costs associated with consumption in a nation. This means that the core issue is the possible misuse of BTAs by using them illegitimately as a basis for a revival of protectionism.  The best way to ensure that capture by protectionists does not occur is to ensure that the imposition of BTAs is subject to WTO regulation and that these regulations are respected and agreed to in future global climate agreements.

22Otherwise there are ‘ambiguity’ reasons for fearing BTAs might be misused. A difficulty is the computation of the appropriate BTA when exporting countries apply non-price-based measures to control carbon emissions. Countries might prefer publicly-supported, renewable technologies, investments in improved energy efficiency or direct controls on emissions rather than carbon charges. This means that the compensations negotiated cannot take the form of additional GGE entitlements but must be taken as alternative income or technology transfer benefits.

23Even if, however, countries did apply uniform carbon charges and exemption policies there remains the core issue of computing BTAs when imports are produced using distinctive technologies, particularly when complex manufactures are imported with components imported from a range of countries. There are ambiguities in these areas that private interest groups will seek to exploit to advance individually rational though ultimately destructive protectionist agendas. In fact carbon leakages are only of real concern in a handful of energy intensive industries that produce internationally traded goods where there is substantial product and process uniformity—certain steel mills, primary aluminium smelters, some chemical plants and cement and clinker kilns (Reinaud 2009, p.7).

25A particular practical focus is on the policies that should be adopted to derive trade strategies that reflect embodied carbon content. The issue is ‘carbon’ not ‘energy’ content since greenhouse externalities do not arise with non-carbon-based power technologies.

26With a mix of trading countries that are thinking of mitigation and those who will not, production-based carbon charges will, as argued in the previous section, induce carbon leakages, thereby reducing the unilateral incentive to mitigate. Consumption-based charging will prevent most of these leakage effects from developing, hence providing additional impulse to unilaterally mitigate.

27Non-mitigating countries will enjoy extra consumption benefits if other countries do not levy charges on their carbon-based exports. Such non-mitigators will not face extra incentives to mitigate on a consumption basis since BTAs will apply to their own exports regardless. They do face possible incentives to mitigate on a production basis to regain revenue that would otherwise accrue to mitigating destination countries for their own exports. Whether these incentives will be strong enough depends on the foregone energy consumption benefits they forego with such charging.

4. Final remarks

28The key issue confronting all nations is that GGEs must be cut. Developing nations such as China have low per capita energy consumption levels compared to the US but high aggregate GGEs. They are also among the countries most likely to experience severe costs of unmitigated climate change because of the substantial dependence of their economies on agriculture and looming water supply issues that climate change will aggravate. China is being dragged in two directions: it has a strong unilateral impulse to mitigate that is tempered by its development objectives.

29The best initial basis for dealing with climate change is via a tax on a consumption basis with compensations sought from developed countries in terms of financial aid, finance or generous initial carbon emission quotas. Ultimately the world is best off with a uniform carbon price regime administered on a production basis. An initial step is to tax on a consumption basis to help motivate a strong mitigation response by developed countries.