In the presidential campaign, President-elect Obama pledged his support to enactment of cap and trade legislation as a key solution to climate change concerns. But such legislation runs the very real risk of adversely affecting the international competitiveness of U.S. industries. Solutions to this problem are far from clear. Efforts to prevent legislation from harming American competitiveness could run afoul of the rules of international trade, and the indirect effects of climate change legislation make it difficult to fashion measures that fully offset competitive disadvantages. The current economic uncertainties also discourage immediate attention to so complex and expensive a new regulatory program. Nonetheless, before very long, the Obama Administration is going to have to address the question of climate change legislation and, from the perspective of trying to retain U.S. industrial competitiveness, none of its options are particularly attractive.

Climate Change Legislation and International Competitiveness

Climate change legislation is almost certain to impose additional costs on American manufacturing. Some of these costs will be direct, in the form of requirements that individual facilities buy emissions permit or adopt new technologies to reduce greenhouse gas (“GHG”) emissions. Most of the increase in costs, though, is likely to be indirect. In particular, climate change legislation is likely to result in higher prices for electricity and natural gas. In this way, even the multitude of manufacturing enterprises that are not subject to direct regulation will bear additional costs.

As a consequence, climate change legislation will have an immediate impact on the international competitiveness of American manufacturing. At the least, this could lead to the substitution of imports for domestically produced goods. Most proposals for climate change legislation could even bring about “emissions migration,” as production of energy-intensive products moves from the United States and other countries that regulate GHG emissions to countries like China or Brazil, with weak or no regulation. If this occurs, climate change legislation would actually backfire, resulting in higher global GHG emissions.

Manufacturing in the United States already is at a competitive disadvantage compared to industries in countries like China, Brazil and India because American manufacturing is generally subject to more stringent environmental and labor regulation. Climate change legislation is likely to increase this competitive disadvantage. If the manufacturing sector loses substantial sales to imports as a consequence, it is likely to lose millions of jobs as well. An Obama Administration and a Democratic-controlled Congress will view maintaining employment as a prime imperative. They thus will probably be receptive to proposals to minimize the impact of climate change legislation on employment.

Some have suggested that these concerns over competitiveness are exaggerated. They argue that, if the United States adopts climate change legislation, other countries like China will follow. But this assertion flies in the face of history. The developing countries have never voluntarily restricted their own competitiveness. China, Brazil, India and others are likely to see climate change legislation in the United States as offering an opportunity to increase their own exports, not a model for them to copy. Significantly, the United States is not the world leader in energy-intensive industries such as steel and cement. This makes it even more unlikely that unilateral action by the United States will, in and of itself, convince other countries to follow suit.

The Relevant International Rules

The alternative approach is to attempt to offset at least part of the cost advantage that imports would have in the U.S. market by applying the same climate change measures to imports as to domestic products. The current international obligations of the United States will make this difficult, however. The United States is a party to the General Agreement on Tariffs and Trade 1994 (“GATT 1994”) and a member of the World Trade Organization (“WTO”). As such, it is subject to a number of rules that may limit its ability to apply climate change measures to imports.

The first of these is the concept of national treatment. Under Article III of the GATT 1994, the United States must accord imports “national treatment” with respect to taxation and internal regulation. Climate change legislation would be considered to comprise internal regulation. Any measures to apply U.S. climate change legislation would have to apply exactly the same, or more favorable, measures to imports as to domestic products. Moreover, GATT Article I requires that all WTO members receive “most favored nation” treatment, so that the United States must treat imports from all WTO members identically. There is an exception to these rules under Article XX of the GATT 1994, which allows countries to violate them if needed to protect human health.

Besides the GATT, the United States is also a party to the Agreement on Technical Barriers to Trade (“TBT Agreement”). The TBT Agreement allows signatories to apply technical standards to imports so long as those standards are mandatory for all products (both domestic and imported), are non-discriminatory and do not restrict trade unnecessarily. In cases where it conflicts with the GATT, the TBT Agreement prevails.

Approaches to Climate Change Legislation and the International Rules of Trade

Most discussions of climate change legislation focus on one of three alternatives: (1) a cap and trade system; (2) a carbon tax; or (3) carbon intensity regulations. A fourth possibility would involve the EPA using its authority under the Clean Air Act to regulate GHG emissions without any legislative action. As discussed below, there are problems with the international application of all four approaches.

Cap and Trade Systems

The most commonly discussed form of climate change legislation would be a cap and trade system, where certain types of facilities, such as electric generation plants and steel mills, would be required to produce emissions allowances to emit GHGs. Emissions allowances could be allocated by the government, sold at auction or some combination of the two. Because most electricity production in the United States is from coal-fired plants that would require large numbers of allowances, a cap and trade system would affect essentially all industries in the United States in the form of higher electricity prices. In this way, even industries that would not themselves be required to produce allowances would still see their costs increase.

A cap and trade system would make U.S. manufacturers less competitive than their foreign counterparts. Obviously, the United States cannot offset this disadvantage by imposing emissions caps on industries in foreign countries. There are proposals, however, that would effectively do this by requiring importers to produce “international emissions allowances.” Under most proposals, the quantity of allowances required would depend on the average emissions intensity of the exporting country for the product in question.

Such a measure might violate Article III of the GATT 1994, however, because it would not treat U.S. and imported products identically. Allowance requirements for U.S. producers of energy-intensive products like cement and steel would be based on the producers’ actual emissions, while the allowance requirement for imported products would be based on national averages. In addition, some of the proposals would exempt from license requirements imports from the European Union and other countries with GHG regimes “substantially equivalent” to that of the United States. This measure could be considered to violate the GATT requirement of according most-favored nation treatment to all WTO members. Similarly, attempts to differentiate treatment in favor of developing countries could be considered to discriminate against developed country exporters.

The United States could seek an exemption under GATT Article XX(b) on the grounds that climate change legislation is necessary to protect human health. The exemption is not automatic, however, but would essentially require the United States to obtain permission from the WTO to impose these measures. Any application for an exemption would be fiercely contested by major exporters to the United States like China.

Besides potentially being WTO-inconsistent, the attempts thus far to apply cap and trade discipline to imports would almost certainly be ineffective. As noted above, a major impact of cap and trade on most American manufacturers would be higher electricity costs. It would be very difficult to impose allowance requirements on imports that offset this disadvantage and that are WTO compliant.

Carbon Taxes

A carbon tax would impose a tax on some or all products (including electricity) based on their GHG emissions. Many economists regard a carbon tax as the most effective means of reducing GHG emissions. As with emissions allowances, however, the greatest impact a carbon tax would have on manufacturing would be higher prices for electricity.

To be GATT-compliant, the application of a carbon tax to imports would require the United States to calculate the amount of the tax in exactly the same manner as used for domestic products. This might be technically difficult, though, because at this point there is no basis to expect the could have the same information available for emissions related to imports that it does for domestically produced products.

Thus, it would be a substantial challenge for a carbon tax on imports would fully offset the competitive disadvantage on U.S. manufacturing. The tax on imports could cover only emissions related to the production of the product itself, and not to those from the electricity consumed in its production. And attempts to expand the tax would risk violation of GATT Article III’s requirement of national treatment.

Carbon Intensity Regulations

A final possible method of climate change would be carbon intensity regulations. These regulations would fix maximum GHG emissions per unit for energy-intensive products like steel and cement. The identical limits would apply to all sources of a covered product, whether imported or domestically produced. For this reason, carbon intensity regulations would satisfy the national treatment requirement of GATT Article III and the most favored nation requirement of Article I.

Furthermore, there is a strong argument that the provisions of the GATT would not apply to carbon intensity regulations at all. These regulations could be considered technical regulations under the TBT Agreement. Because they would be mandatory and non-discriminatory, they would comply with the requirements of the TBT Agreement, and would not be subject to the GATT. In this way, carbon intensity regulations would neutralize the direct competitive disadvantage that climate change legislation might inflict on U.S. firms.

The ability of carbon intensity regulations to reach indirect costs, however, is limited. Regulations would specify the quantity of GHGs that could be emitted in the production process, but not the quantity emitted by the generation of electricity used in the production process. While carbon intensity standards would be very helpful in offsetting a large part of the competitive disadvantage from GHG regulation, they could not cancel it out completely.

Action by the EPA

Climate change legislation is not technically necessary for the U.S. government to regulate GHG emissions. The EPA arguably has authority to regulate GHG emissions under the Clean Air Act, as is discussed in one of the accompanying articles. But GHG regulations under the Clean Air Act would apply only to U.S. emissions. There is simply no way the EPA could use its regulatory power to reach imports. In terms of impact on international competitiveness, therefore, regulation by the EPA would have the worst effect on U.S. manufacturing. 

Climate Change Legislation and Indirect Costs

None of the approaches to climate change discussed above can be applied in a manner that fully offsets the competitive disadvantage that climate change legislation will inevitably create for American industry. To keep American industry competitive, therefore, climate change policy must include measures that compensate American manufacturers directly for at least some of the additional costs they will bear. One way to do this would be for the government to allocate allowances to manufacturers, which they could then either use for their own emissions or sell to offset higher electricity and natural gas costs. It would be important that such allowances be provided only to manufacturers, however, not to power generators; so that the value of the allowances is not diluted.

Conclusion

Climate change legislation will impose higher costs on American manufacturing, and will affect its international competitiveness. While extending these measures to imports may reduce this disadvantage, it is difficult to do so in a manner that is consistent with the international obligations of the United States and that reaches indirect as well as direct costs. This will be one of the new Administration’s biggest challenges: to preserve American competitiveness, while advancing the climate change policies the President-elect has endorsed.