Climate Change and WTO Rules - Guidance for Legislative Design

If the United States chooses to accept mandatory restrictions on greenhouse gas (GHG) emissions, while other large-scale emitter nations, like India and China, do not agree to such restrictions, three types of concerns will arise. First, the U.S. economy - or at least those industrial sectors that are particularly carbon-intensive - could become less competitive by taking on costs not borne by other countries. Second, U.S. firms may move abroad in order to escape the U.S. environmental regulations, a situation known as leakage. Leakage exacerbates the damage done to the environment by industries, as well as the damage done to the domestic economy by increased foreign competition. Finally, U.S. GHG regulations would be rendered ineffective as unrestricted industries abroad would continue to damage the global environment. These concerns have created significant political difficulties for the U.S. in adopting GHG emissions restrictions.

Two approaches, in particular, are currently being discussed in the U.S. to curb GHG emissions. One is a domestic carbon tax and the other is a cap-and-trade system, similar to the European Union emissions trading scheme. They both aim to remedy the fact that there is no natural price of carbon, a market failure in economic parlance.

The most straightforward economic solution is to tax carbon, thus giving it a price. Creating a market for carbon, like in a cap-and-trade system, is a more subtle option. In this system, the government puts a cap on carbon emissions and distributes a finite number of carbon allowances among emitters. This creates a market which will set its own price for those emissions and flow allowances to those firms that can reduce emissions most efficiently. Because of the political unpopularity of taxes, there are currently no carbon tax bills under serious consideration. All of the leading bills would employ a cap-and-trade approach.

While U.S. policymakers discuss these approaches to creating disciplines on carbon use within the U.S., several ideas have been posited to address the problem of persuading other large emitters to accept restrictions at the same time as the U.S. One of the measures discussed was a border tax; if the U.S. were to create restrictions on GHG emissions, a tax would be placed on imports from countries that do not share such restrictions. This has the initial effect of working to offset the competitiveness and leakage issues, but also puts pressures on large emitting countries to regulate themselves.

Imposing a standard is another idea to induce large emitters to agree to restrictions. This idea places minimum standards of production on imported goods. If a given product is not produced by a process that emits carbon at or below a standard level, it will not be cleared for import into the country. This system does not pay heed to the location of production, only to the emissions generated during production. Carbon-intensive products that would come under the most scrutiny in this system include steel, aluminum, glass and paper. Each would have a carbon-intensity standard applied to all products in each class. This addresses the leakage and ineffectiveness problems by regulating carbon intensity in the U.S. marketplace.

Another idea is to give away allowances for free. Giving away allowances largely addresses the problem of the initial cost of regulation for firms that may not be able to afford buying allowances or curbing emissions. This will alleviate the most direct competitiveness concerns and reduce the incentive for leakage. This does not, however, solve the ineffectiveness problem as foreign firms will still be emitting at their previous rates. Furthermore, the political choices involved in giving away only some of the allowances create complications with respect to implementation.

A variation on the border tax is to require importers from countries without equivalent GHG emissions standards to buy allowances in the same way domestic producers do. This method will be discussed further.

These ideas are under discussion in the U.S., and some have already been imposed in Europe, including the cap-and-trade and free allowances systems. The competitiveness discussion is also under way in Europe, as in the U.S. Industries are already debating whether to reduce capacity in Europe or to give up Europe altogether and find unregulated economies in which to set up shop.

There are two parallel environmental policy tracks in the U.S., one is through Congress, a legislative track; the other is in the Environmental Protection Agency (EPA), an administrative track. Following either of these tracks will lead to regulation in the U.S.

Congress has yet to pass legislation on such forms of environmental regulation due to political concerns. Both presidential candidates favor some form of mandatory GHG restrictions and Senator John McCain has already sponsored such legislation. The last Senate debate on these issues in June did not generate much real interest. The pending bill was simply too expensive and unpalatable at a time of high gasoline prices. Due to lack of support, the bill was taken out of consideration after only 3 days. Most legislators would favor not voting on GHG restrictions before the elections due to concerns that it would hamper economic growth, especially in light of recent economic crises.

The EPA, on the other hand, may act regardless of moves Congress may or may not make. It has an existing mandate from the U.S. Supreme Court to regulate GHG as a pollutant under the Clean Air Act, which is, unfortunately, a very inefficient regulatory tool. This summer the EPA put out a notice of proposed rulemaking with an invitation for public comment until the end of November.

Even though there may be no action in Congress, there are still debates on competitiveness and leakage going on within the government. Under the mandate set by the Supreme Court, the EPA may have to develop regulations, and if Congress does not act quickly, the regulations would have to be based on inefficient existing legislation. In 2009, legislation may not pass both houses of Congress, but there may well be a regulatory response. Either prospective president will push the new EPA administrator to resolve that regulatory process.

In February 2007, the chairman and CEO of American Electric Power, a large U.S. coal-fired electrical utility, joined with the president of the International Brotherhood of Electrical Workers, its principal labor union, and published a proposal that said that trade is the answer to climate change. In their proposal they raised the competitiveness and leakage problems. They assumed that the U.S. would be negotiating for a replacement to the Kyoto Protocol with other countries. This replacement would have to secure the support of developing countries, like China and India, to reduce GHG emissions. The Kyoto Protocol did not impose an obligation on developing countries to commit to reducing GHG emissions, and for this reason the U.S. Senate voted against ratifying the Kyoto Protocol. With this in mind, the two suggested that in order to make real progress on climate change, a new agreement would need to impose real disciplines on large emitting developing countries.

The request for countries like India and China to accept mandatory GHG reductions is not something to be taken lightly. India, for example, is a country that is underpowered. Many villages still do not have electricity. Accepting reductions would have a very significant impact on India's ability to grow economically. The same can be said for China.

The initial idea in February 2007 was to ensure that if countries did not make these commitments in the international negotiations, their imports would have an allowance requirement imposed on them. This way their steel, paper and aluminum, for example, would have essentially the same type of regulatory measures imposed on them as would those in the U.S. Very quickly, however, the assumption changed. Now, the assumption is that the U.S. will legislate in the absence of an international agreement. Basically, the U.S. would move before an agreement is reached on a post-Kyoto framework.

Under such an assumption, Congress would mandate that imports of carbon-intensive products have the same allowance requirements as steel, aluminum, or any other products in the U.S. This proposal addresses the initial three policy concerns, but the proponents hoped to do so without this import measure ever having to be enforced. It would change the dynamic by putting costs on the export side such that the logical response would be for those countries to make meaningful commitments with respect to GHG emissions. Essentially, it would create a credible threat.

One of the main concerns behind this proposal is to design it so that it will be consistent with World Trade Organization (WTO) rules. If it is not WTO-consistent, it will not retain credibility, thus reducing the value of the threat. The countries affected by such legislation would be able to take their complaints to the WTO, which would rule in their favor. In order to be successful, this proposal needs legislative language that keeps WTO jurisprudence in mind.

There are two ways to do this - two approaches to incorporating WTO jurisprudence into climate change legislation. The first, more "courageous" way would be to say that it is acceptable under the WTO to regulate based on how a product was made, i.e., by a process or production method (PPM) that emits more or less carbon. This argument relies on the belief that WTO jurisprudence had evolved to recognize that as long as you do not discriminate on the basis of national origin, it is permissible under Article III:4 of the General Agreement on Tariffs and Trade (GATT) to regulate materials made in a carbon-intensive way. When evaluating the consistency under GATT Article III:4 of a difference in regulation of an imported product and a domestic product made using a different process, WTO lawyers will first use the four criteria for "like product" under the "Border Tax Adjustment" decisions: tariff classification, physical characteristics, uses and consumer preferences. If the imported product is exactly the same in all four ways to its domestic counterpart, then an aggressive WTO lawyer would argue that the U.S. can permissibly distinguish between the two otherwise identical products based on their PPMs, as long as it does not discriminate based on the country of origin.

While this method may be theoretically sound, there are no WTO cases in which WTO panels or the Appellate Body have crossed the line and fully ignored the product process doctrine and distinction. Moreover, in legislation that would seek to reward countries for taking effective action on GHG emissions, the national origin of products would be a key criterion. Thus, if the argument were based solely on GATT Article III:4, it is doubtful that the WTO Appellate Body would approve of such a measure.

The other, less "courageous" but safer method is to rely on the general exception from the normal rules for measures relating to the conservation of exhaustible natural resources. GATT recognizes in Article XX(g) that such measures, even if they would otherwise be inconsistent with GATT rules, are permissible when they are carried out in conjunction with restrictions on domestic production or consumption. In order to rely on Article XX(g), the measure must be primarily aimed at environmental protection, not trade.

This second approach - the use of the Article XX(g) exception - has formed the basis for a proposal that has been included in several draft U.S. climate change bills that would create "cap-and-trade" programs to restrict GHG emissions domestically. The legislation would establish a domestic cap on GHG emissions in the U.S. The Congress would establish "allowances" that permit the holder to emit a ton of GHG emissions and would have to be submitted at the end of a regulatory compliance period to demonstrate compliance with the cap. These allowances could be traded.

Under the international proposal, the allowance requirement would be applied to certain goods imported from those foreign countries that are large emitters of GHG emissions and are not taking actions comparable to the actions taken in the U.S.

The implementation of such a measure would have a set timeline. From the first day of the legislation's enactment, the president would notify all foreign countries of the U.S. caps so foreign countries would have a basis for gauging comparable action. Comparable action need not require foreign governments to regulate in the same way or form as the U.S. The objective would be that countries achieve comparable effects on their GHG emissions. Also, the U.S. would initiate negotiations with all foreign countries. Past cases reveal that in order to be truly nondiscriminatory, the U.S. may not confine the scope of its negotiations, and therefore, if the U.S. negotiates with some countries, it must negotiate with all WTO member countries regarding the upcoming import requirements. While negotiations need not be completed, the U.S. must show that it is making a good faith effort to negotiate a solution.

Next, an international climate change commission would be set up. This commission would be a U.S. agency independent of the executive branch, roughly based on the model of the International Trade Commission. This commission would be charged with making the decisions on which countries have taken comparable action.

After three years (at a minimum), the regulations necessary to implement the law will have been put in place. During this time, most negotiations will have time to run their course and be completed. At the beginning of year four of the process, emissions caps will be applied to U.S. producers. They will have to secure allowances through auctions, or receive free allowances by allocation, or other methods. At the end of year four, U.S. producers will have had to secure their allowances and submit them to the government to cover their emissions for year four. The first six months of year five would allow time to collect data and measure GHG reductions in the U.S. as well as record foreign countries' emissions. After analyzing the data, the commission will release its comparability determinations by the middle of year five. At the beginning of year six, allowances will begin to be imposed on imports.

The hope is that these international allowance requirements will never have to be enforced. Within the five years between enactment of the law and the imposition of import requirements, foreign countries will have had ample time and knowledge of the impending regulations to make the necessary preparations. This proposed measure aims to induce foreign emitters to control their own emissions without having to resort to coercive or trade-distorting measures.

Q: If China and India did not implement GHG emissions restrictions, could this be viewed as a countervailing subsidy? Also, if exporters are not paying the same standard costs, would this be viewed as a case of dumping?

A: I will first answer your questions with a few other questions. Does the failure of another government to regulate present a countervailing subsidy? If a government is giving away free allowances, is that a countervailing subsidy? Is it challengeable under Article VI of the subsidies agreement as an actionable subsidy?

The answer to the first question is no. If the U.S. legislates in the absence of an international agreement, there is no prevailing international norm that would have a foreign government impose these kinds of regulations. If the U.S. were to, for example, regulate everything produced using the color red, the U.S. could not claim that China's failure to regulate red things is a countervailing subsidy. A choice by one government to regulate activity in the absence of an applicable international norm does not mean that the failure of another government to regulate said activity would be a countervailing subsidy. While there has been pressure within the U.S. to prove that China's failure to regulate certain things is a countervailing subsidy, citing section 301, the U.S. has resisted and not taken such action. Outside the criteria set forth in Article 1 of the WTO Agreement on Subsidies and Countervailing Measures, it seems to be a difficult argument to make.

The more challenging situation is where a government normally charges for allowances (e.g., through an auction) but gives allowances away for free to certain producers. Under those circumstances, it seems like a fairly clear subsidy. While it is not a prohibited subsidy - not being tied to exports or local content - it seems like an actionable subsidy. The question is then, is there serious prejudice? The answer depends on the facts of the case.

All in all, it is difficult to argue that the failure of a government to regulate, where one chooses to regulate in the absence of an international norm, is a countervailing subsidy.

Q: With regards to this program, what discussions have you had with European countries and what has been their response?

A: I can only speak about the discussions I have been involved in personally. Surely there are many people who have been involved at various levels, but from my discussions with the European Commission's Directorate-General for Trade, I know that those officials are aware of these types of proposals.

The European dynamic is very interesting right now. France holds the Presidency of the EU for this six-month period, and it have been the most aggressive supporter of trade-based measures for the successor of the Kyoto Protocol. France has put forth a proposal similar to the one I described, though I believe it has some issues that would bring up real WTO concerns.

In Europe, people tend to see border measures and free allowances as alternatives; they are focusing primarily on competitiveness. Since they have a cap-and-trade system in place, they are already experiencing complaints from industry. One proposal is to increase the number of free allowances as a form of subsidies.

The U.S. is far behind Europe in terms of environmental regulations. Most stakeholders have not seriously engaged on this issue. As a result, it is very hard to say what many people think. Those involved in the debate would like some aspect of free allowances but also want to address the ineffectiveness problem with some kind of measure that would induce action in India and China. Competitiveness alone will not induce change in China and India.

Q: Could a program based on the Clean Air Act be a full-fledged cap-and-trade system, or would it be very different?

What is your take on concerns that, regardless of WTO compatibility, this measure would draw retaliatory actions from countries like India and China?

A: As for the second question, my belief is that many companies and industry groups are concerned that if the U.S. adopts this type of measure, whether or not it is WTO-consistent, it will create a backlash abroad and will invite retaliation. Many would argue that those countries that would be affected would not wait for the WTO to render its decision to act in a retaliatory fashion. The question is thus, are these concerns worth the risk of the possible backlash from our trading partners?

During June's Senate debate on this issue, I got the impression that most of the stakeholders did not engage. I do not think we have had a really serious debate where all the stakeholders are involved. As such, it is difficult to predict what will happen.

In regards to the first question, my knowledge of the Clean Air Act is not as deep as an environmental lawyer's might be, but it probably does not create a legal basis to support a cap-and-trade system. The revenue side of this measure would create the need for further legislation.

In addition, there are already state-level attempts to create regional approaches like cap-and-trade measures. State governments are at the forefront of such measures, California being a prime example.

Q: When you talk about the comparability of eco-friendly actions, are you talking about the comparability at a national, industry or company level?

What happens to this scheme, in terms of comparability, when complex assembled products like automobiles or electronics come under its umbrella?

A: We chose the country level because what we are trying to do with this measure is improve the state of the global environment. The tool we use is access to the U.S. market. The legislation judges comparability on the economy as a whole. Our goal is to get entire economies to control GHG emissions.

Some have argued that GATT Article III or Article XX that individual producers abroad be given individual treatment. My concern with that argument is that we import relatively little from China or India in carbon-intensive sectors. Many of those products we get primarily from Canada. We may end up importing only from the cleanest Indian producers, thus leaving the very dirty producers to other markets or their domestic market. In the end, the effects of their GHG emissions will be felt by the entire world and we will have achieved very little.

By applying pressure on the economy as a whole, emitters like China and India will not be given an easy way out - selecting producer by producer who will export to the U.S. and who will not. Such practices would undercut the environmental impact of such a scheme.

Admittedly, this is very unpopular with many importers in the U.S. Many importers impose very sophisticated standards on their producers, in terms of things like labor and environmental standards. If supplier economies begin to impose economy-wide emissions standards, the work by individual companies to reduce the emissions of their individual suppliers will have gone to waste.

As for the second question, the commission to be set up under this legislation will be given the authority to determine that if there is a feasible way to judge the carbon intensity of a finished good, it will consider imposing the regulation on it.

The concern is that there may not be a way to determine the carbon-intensity of something as complex as an automobile. If the carbon intensity cannot be determined, Article XX does not apply because regulating such a product could not be linked to preserving natural resources. Presumably, one could judge the carbon intensity by the content of steel, aluminum, rubber, glass, or the most carbon-intensive aspects of an automobile's design. With respect to most finished goods, it is not possible to go beyond that.

There is an active debate on this issue in the U.S. Some observers hold that this may be a good idea, but our imports of carbon-intensive materials from India and China are relatively small. If the U.S. does not import enough of these carbon-intensive products, the threat level to the producer country is very low. Expanding the allowance requirements to finished goods would address these concerns.

Q: What exactly is meant by "regulatory program" in terms of criteria for comparability? Is this measure open to regulatory measures that differ from the cap-and-trade system?

If the EU has a similar program in place, it may not be induced to reduce GHG emissions for fear of breaking WTO rules. Do you have any comment?

A: Much of this depends on how comparability is determined. Under the current formulation of the international allowance requirement, a country's actions are subject to two tests. The first, relatively simple quantitative test asks if the country achieved a reduction in GHG emissions that is as good as or better than the U.S. in the test period. If so, they are comparable. The expectation that the EU achieves this is probably correct.

Before determining that the country had not taken comparable action, however, the commission would apply another test that would analyze a more qualitative rather than quantitative set of factors in assessing a country's comparability. It is written this way because of an understanding of the chapeau of Article XX. As it was interpreted in other cases, the prevailing conditions in each country are to be analyzed. Each country has to be looked at differently in terms of environment, economy, and even level of development. For example, in an attempt to encourage countries to grow smarter and cleaner, prominence may be given to their use of state-of-the-art technology.

Your second point is critical. WTO case law shows that the U.S. cannot impose the use of a specific technology on another country and prevail under the GATT Article XX exception. In one case, the U.S. tried to mandate the use of turtle exclusion devices for foreign fishermen. The Appellate Body rejected the mandate, but the Appellate Body's reasoning would have allowed the U.S. to ask the producers to achieve comparable outcomes by a method of their choice in a manner consistent with the particular conditions prevailing in that country.

Under the proposal I described, the U.S. would not impose regulations that other countries must implement specific regulatory emissions programs in order to gain access to the U.S. market. Comparable outcomes in regards to climate change are the intended goal of this measure.