News and Analysis • Volume 1 • Number 1 • October 2007

The effects of climate change policies on international trade and competitiveness

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Efforts to reduce emissions to meet Kyoto and future climate targets have raised competitiveness concerns in countries implementing these policies, as well as fears that carbon-intensive industries will relocate to non-implementing countries.

This article examines the implications of climate change policies on competitiveness across industries, as well as issues related to leakage, if any, of carbon-intensive industries to developing countries.

Competitiveness

There is a widespread concern regarding the international competitiveness of major industries, especially in the energyintensive sector, among countries that have undertaken measures to reduce (GHG) emissions. They especially worry that higher energy costs not only burden them domestically, but also give competitors in countries without such measures (especially the US and China) and an unfair advantage.

To test the hypothesis, we looked at the impacts of OECD measures to reduce GHG emissions on export competitiveness of energy-intensive sectors. The focus was on two types of instruments: (1) carbon taxes as a fiscal measure, and (2) energy efficiency standards as a regulatory measure. The reason for choosing these was that both have existed for quite some time in many countries, and hence their impacts on competitiveness are much more traceable than those of more recent emissions trading and voluntary regimes. While both carbon taxes and energy efficiency standards aim at reducing energy consumption, they use very different mechanisms to do so.

In a country that imposes a carbon tax (or a similar energy input tax), one would expect energy-intensive industries to suffer significant increases in production costs compared to those of their trading partners. Consequently, these industries would either become less competitive internationally and lose some of their market share or, in order to avoid this loss, migrate to countries with no such taxes. In each case, exports of energy-intensive commodities hit with the carbon tax would decrease, while their imports would be expected to increase. Conversely, a carbon tax levied by an importing country would increase exports of the exporting country, thereby making it more competitive.

Similarly, the cost and time needed to comply with different energy efficiency programme requirements could add to the cost of internationally traded products. However, since such regulations in principle could be applied equally to imports and locally manufactured products, effects on trade in countries with higher energy efficiency standards could be nullified to some extent. On the other hand, it could adversely impact trade from countries with lower or no standards to countries that have higher efficiency standards.

Our results using an econometric modelling exercise show that when a carbon tax is imposed only by the importing countries, it adversely affects the competitiveness of exporting countries. This could be due to the offsetting measures applied by importing countries to mitigate and nullify the impact of such taxes on domestic industries. On the other hand, when a carbon tax is imposed by exporting countries, or by both importing and exporting countries, then the overall trade between countries increases. This suggests that subsidies and other exemptions for the energy-intensive industries may be overcompensating for the disadvantages arising from the imposition of the carbon tax. When we look at the effects of energy efficiency standards we find strong negative effects on export competitiveness — irrespective of whether the standard is imposed by exporting countries, importing countries, or both.

When we examine how these policies affect specific industries that use energy intensively, the results suggest that the net effect varies considerably across industries. Trade competitiveness is adversely impacted by a carbon tax in the case of the cement industry, but the paper and steel industries actually benefit from a carbon tax. Similarly, energy efficiency standards mainly impact transport equipment and metal products industries.

The results emerging from our analysis suggest that carbon taxation policies do not impact on the competitiveness of energy-intensive industries. This suggests that complementary policies (implicit subsidies, exemptions etc.)—which are used in conjunction with carbon taxation policies levied by these countries, particularly on energy-intensive industries— could be negating any impact of carbon taxation. A more detailed study of this issue is warranted, as it will yield a greater understanding of the implicit subsidies/costs that are associated with each industry. The importance of this finding cannot be understated, as trade measures are justified based on perceptions of higher costs and associated loss of competitiveness on account of these costs on energy-intensive industries in developed countries.

Carbon Leakage

Many industrialised countries are concerned about the potential impact that mandatory carbon reduction targets would have on their economies. Among these concerns is the one that any plan that exempts developing countries from emissions limits would be ineffective because carbon-intensive industries would simply shift their operations to one of the exempt countries. A “leakage” would not only undercut the environmental benefits of the Kyoto Protocol or successor agreement; in addition, the competitiveness of industrialised-country industries could suffer.

Most emissions in industrialised countries result from inherently domestic activities such as transportation, heating, cooling and lighting, where leakage is either difficult or impossible. On the other hand, for energy-intensive industries such as cement, chemicals, and others, international competitiveness is an important concern. This leads to a debate somewhat akin to the “pollution havens” debate that dominated the environment literature in the 1990s.

Is such leakage really happening? We examined the evidence for any relocation of carbon-intensive industries due to more stringent climate policies, mostly in the OECD countries. We identified industries that would be most impacted by carbon reduction targets. These were energy-intensive industries— pulp and paper, industrial chemicals, iron and steel, nonmetallic mineral products, and nonferrous metals—that would have an incentive to relocate to avoid more stringent energy/carbon pricing policies.

When the actual data is examined on imports and exports across various income groups and regions since the 1990s, this provides some interesting results. The import-export ratio of energy-intensive production in high-income OECD countries shows an increasing trend (probably reflecting an increase in imports and decrease in exports). When the same ratio is examined for low- and middle-income developing economies, there is almost a mirror image of the OECD graph (Figure 1). This could be a reflection of some relocation of energy-intensive industries to developing economies, that did not impose any additional constraints on these industries on account of climate change.

Among the developing country regions we find an indication of some industrial relocation from the US, mainly to East Asia, and especially to China.

Our analysis suggests a gradual increase in the import-export ratio of energy-intensive industries in developed countries, and a gradual decline in the ratio in some developing regions. There is some evidence—although it is not very pronounced—of leakage of carbon/energy-intensive industries to developing economies that could be attributed to more stringent climate change policies and energy efficiency standards.

Implications

There is no conclusive evidence to suggest a loss in competitiveness from climate change measures adopted in OECD countries or of leakage or an exodus of carbon/ energy intensive industries to developing countries. Developed countries have implemented various policies and measures to achieve their targets and showed some progress in mitigating climate change. However, in a number of cases economic considerations far outweighed climate considerations. Many of the incentives, especially for energy-intensive industries to reduce their emissions, have been nullified through special tax concessions, rebates, exemptions, and other such measures.

However, in the medium-to-long run, the increasingly stringent climate policies in some industrial countries and increased economic growth in some developing countries could accentuate the existing trends. The increased concentration of energy-intensive sectors in some developing countries, such as China and India, could signal not only for their greater future involvement in any global post-Kyoto scheme, but could also subject them to punitive trade sanctions for not participating in global efforts to address climate change.

While the implementation of the Kyoto Protocol may have brought to light some inherent conflicts between economic growth and environmental protection, the objectives of Kyoto also provide an opportunity for aligning development and energy policies in such a way that they could stimulate production, trade, and investment in cleaner technology options. Similarly, the WTO negotiations on environmental goods and services could potentially be used as a vehicle for broadening trade in cleaner technology options and thereby help developing countries to reduce their greenhouse gas emissions and adapt to climate change.

Muthukumara Mani is Senior Environmental Economist, The World Bank.