Climate and Trade in a World of Resurgent Industrial Policy



Milan Elkerbout, Katarina Nehrkorn, & William Pizer | Resources for the Future

Few citizens and governments consider the current system of international trade beneficial to climate action today, and many worry about the distribution of outcomes. Although free trade has been instrumental in the reduction of global poverty and the expansion of the global middle class, many in industrialized nations feel that the international trade system has shipped manufacturing jobs and activity overseas and left behind a weakened middle class. In the world of climate policy, international competition between firms is making industrial decarbonization more difficult, due to the risk (or fear) that firms operating in nations with more stringent climate policies simply may relocate to nations where emissions are less stringently regulated, yielding a situation known as carbon leakage.

Can the trade system change? Radical changes have tended to reflect major shifts in geopolitics or macroeconomics. The Bretton Woods system of trade rules was shaped by the United States, which reflected the nation’s new role as a superpower following World War II and an interest in avoiding the mistakes following World War I; namely, the protectionist tariffs that fomented economic depression. The General Agreement on Tariffs and Trade grew into the World Trade Organization after many rounds of liberalizing trade by reducing tariff and non-tariff barriers, with the hope that the gains of trade would spread to the developing world in the era after the Cold War.

Today, geopolitical realities and the goals in the Paris Agreement may call for a further institutional overhaul of the global trade system. The global push to achieve net-zero emissions demands unprecedented action, albeit at different speeds in different countries, given the Paris Agreement’s bottom-up architecture based on nationally determined contributions, and the United Nations Framework Convention on Climate Change principle of “common but differentiated responsibilities.” The goals of the agreement require policy choices that are not easily reconciled with the trading system that has existed since 1989.

Climate and Trade: More Policies, More Policy Priorities?

As countries expand climate action to meet the Paris Agreement, a willingness to accept a wide diversity of approaches to climate policy from trade partners would be beneficial. Experimentation with various policies in the real world is crucial for nations to discover the policies that are most effective, efficient, and equitable. Policy approaches also inevitably will differ between regions, given constraints related to local economies, politics, and cultures, along with differences in legal systems. For example, the United States, which is backed by the Federal Reserve and the strength of the US dollar, will offer generous subsidies, while the European Union, which has decades of experience incrementally integrating dozens of national markets, will regulate and price greenhouse gas emissions.

The international trade system (and the institutions associated with the Washington Consensus, such as the World Bank and the International Monetary Fund) needs to evolve and enable policies that reflect new political and geopolitical priorities, if the trade system is to support the goals in the Paris Agreement. For example, a rekindled international trade system needs to reflect the legitimate role for industrial policy, given that industrial policy, though long maligned, has returned with a vengeance to nations in the West. This return of industrial policy requires a rethinking of subsidies; the traditional impulse is to constrain subsidies, rather than encourage a design with positive spillovers, such as innovation or regional development.

Some industrial policies are considered attractive—or even essential—climate policies, like subsidies that support reductions to the cost of clean energy technologies or trigger investments in firms that emit little or no greenhouse gases. But industrial policy in the 2020s has a mercantilist bent to it, as well. Some governments face electorates that reject the value of open trade. Governments also may face geopolitical tensions that encourage increased resilience against global economic shifts and perturbations, or motivate the domestic manufacturing of goods that are considered important to national security and the national economy. Industrial policies in these nations seem to aim to protect domestic economic interests above all else.

Border adjustment mechanisms are another type of climate policy that is potentially controversial. These policies, which impose fees, tariffs, or other costs on importers of a good based on the emissions associated with the production of that good, can be a way to both mitigate carbon leakage and incentivize other nations to mitigate emissions in response to the policy.

A reformed international trade system ideally would recognize the political motivations behind new green industrial policies and trade policies, while still encouraging restraint, fairness, and the scope of any policy to stay in proportion to its purpose. A tax credit in the Inflation Reduction Act may be a fantastic incentive to produce clean hydrogen, but if the tax credit becomes the sole business case for clean hydrogen, few countries will be able to compete with firms in the United States. Border adjustment mechanisms may be legally legitimate to level the playing field between firms that operate in nations with more stringent climate policies and firms in nations with less stringent climate policies, but the costs of complying with border adjustment mechanisms may be disproportionate, especially for countries in the Global South or for smaller producers. These challenges are not cause for such policies to be avoided or abandoned, but policymakers may want to account for the impacts of these policies on trade partners or political partners, as well.

When countries, individually or collectively, weigh the merits of industrial policy and policies that address climate and trade, they may not want to merely consider whether a policy is justified, as if justification were a dichotomy. The reductions in cost for renewables, including reductions spurred by subsidies, have provided a rare glimmer of hope for the achievement of lofty emissions-reduction goals. However, cost reductions also have been the result of China’s manufacturing prowess, given that China has a comparative advantage in scaling up manufacturing from certain industries such as solar energy. Replicating subsidies for other low-carbon technologies would not necessarily yield the same results as have been achieved for solar. In addition, some technologies inherently are better suited to rapid reductions in cost; for example, the commodification of components that are critical to production helps lead to economies of scale. For other technologies, such as carbon capture, for which customization and systems integration are more important, costs may not necessarily decline at the same pace.

Subsidies and industrial policies long have been deployed with the purpose of protecting industry incumbents. However, in a political environment where domestic interests and industrial competitiveness take priority, policies that compensate and protect incumbents may risk crowding out strategies of industrial policy that focus on investments and impacts that would benefit the climate or other societal goals. The economist Dani Rodrik, who has been more favorably disposed toward industrial policies than many other economists and politicians since before the current renaissance of these policies, emphasizes that the key consideration for industrial policy should be to “let the losers go [rather than] picking winners.” This attitude may be particularly crucial for climate policy, given that a low-carbon economy likely will be built on new forms of energy and industrial production that may be best suited to regions that differ from the regions where some industries currently are clustered.

What Is the Role of Multilateral Institutions?

International institutions could focus on more germane technical considerations. “Interoperability,” which is shorthand for the ability of nations to design climate and trade policies that affect trade without creating barriers to trade in terms of administrative costs, has become an oft-used keyword. International trade institutions, including the World Trade Organization, could contribute solutions to challenges regarding interoperability.

In the past, the coexistence of many different free trade agreements actually has led to a reduction in trade, due to the so-called “spaghetti bowl” effect: the costs of complying with overlapping agreements are higher for countries that are not party to these agreements. Free trade agreements also allow for deeper integration or alignment between nations, but reaching agreement on rules (or a larger set of rules) with a larger group of countries can become more difficult than with smaller groups.

The risk of a “green spaghetti bowl” emerges in the context of climate policy. (We apologize for the mental image this phrase may conjure.) Firms and importers have to navigate myriad border adjustment mechanisms; rules for subsidies; requirements for how much of a good must be produced domestically; product standards based on emissions intensity; and regulations in the domain of environmental, social, and corporate governance. These factors all contribute to the transaction costs that companies and importers have to deal with. While multinational firms are well-versed in navigating multiple complex regimes of regulations, smaller companies may see transaction costs rise to the extent that those companies stop trading internationally.

A desire undoubtedly exists among nations for a forum (or fora) to discuss interoperability and, ideally and eventually, some form of alignment on the many climate polices that affect international trade. The international community should continue to consider what the most appropriate venues could be, if this dialogue really is a priority. One of these venues could be the World Trade Organization, but this choice would require willingness both from current political leaders, who have critiqued how the organization currently is functioning, and traditional supporters of the organization, who would need to accept that member nations of the organization have policy goals that go beyond free and open trade. The United Nations Framework Convention on Climate Change might be another option for a venue, following the first-ever “Trade Day” at the 28th Conference of the Parties. Other intergovernmental initiatives such as the Climate Club might offer the most promising venue, though these initiatives may be insufficiently inclusive and comprise countries that already are like-minded, thereby not addressing the trade relationships in which interoperability might be most critical.

Finally, a particularly important role may exist for the world’s middle powers, such as Canada and Indonesia, in the ongoing debate about climate and trade. These nations are at risk of being squeezed in a subsidy race or a tariff tit for tat between the largest economies—the United States, China, and the European Union—while often being aligned with one of them. Middle powers can encourage economic superpowers to consider the better angels of their nature, practice restraint, and be measured when crafting policies that impact trade. Policies that fulfill these criteria can help extend the gains of trade to future generations while the trade system continues to support sustainable growth across the globe.

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