Environmental tariffs could be a game changer

Environmental tariffs may be humanity’s last hope for mitigating climate change, which is on course to become increasingly devastating if we do not curb our greenhouse-gas (GHG) emissions.

The most straightforward way to confront this unprecedented global threat is through a multilateral agreement that locks in a ‘green transition’ in all (or most) countries. The key is to boost renewable-energy production while significantly reducing fossil-fuel consumption, a process that calls for coordinated policies on three fronts: regulation, subsidies for cleaner technologies (including renewables), and carbon taxes.

Unfortunately, this type of global agreement seems out of reach because the fossil-fuel industry remains politically powerful, and some of the world’s biggest emitters – including the United States, China, and India – are not adopting the necessary policies.

Although regulation and subsidies are essential to achieve an effective energy transition, the carbon tax is the bedrock because that is what will increase the costs of emitting carbon dioxide, methane, and other GHGs. Several countries have already adopted such taxes, including Sweden, which has the world’s highest carbon tax (approximately US$117 per tonne). But many others, including the US and China, have not followed suit.

This lack of consistency gives rise to ‘carbon leakage’. High-emissions activities tend to move away from countries with carbon taxes to those without. While a country that unilaterally adopts a higher carbon tax benefits everyone (by reducing its own GHG emissions), it also unwittingly encourages others to do less. Or, as an economist would put it, one should expect that unilateral climate-mitigation policies function as ‘strategic substitutes’ across countries: The higher one country’s carbon tax, the less other countries will do for mitigation.

A high carbon tax creates an opportunity for ‘carbon arbitrage’. Since the steel industry emits 1.85 tonnes of carbon for every tonne of steel produced, Sweden’s carbon tax increases the cost of its steel production by about US$210 per tonne, which in turn makes Chinese steel imports much more attractive for steel-users and their customers.

Worse, Chinese authorities have an incentive to maintain this arrangement. Without a Chinese carbon tax, Chinese steel exports will thrive, and that will help Chinese industry, workers, and politicians (who can claim credit for generating an economic boom). Even if they recognise the need to combat climate change, Chinese authorities may end up doing less than they might have done without Sweden’s carbon tax.

Hence, the need for environmental tariffs, which would reverse this logic by imposing a carbon tax on imports. Sweden would apply a border tax adjustment equivalent to the difference between its carbon tax and the carbon tax of the exporting country, multiplied by the tonnage of the CO2 emissions generated in the production of the imported products.

An environmental tariff’s most obvious benefit is that it reduces carbon leakage. By nullifying the artificial cost advantage of imports from low-carbon-tax countries, it encourages steel consumption to shift toward cleaner domestic sources or less-polluting exporters.

But an environmental tariff’s indirect effects may be even more important. Most importantly, a tariff makes climate-change mitigation policies ‘strategic complements’ rather than strategic substitutes; this means that Swedish carbon taxes will encourage, rather than discourage, other countries to adopt similar policies of their own.

The logic is simple. Without environmental tariffs, Sweden’s carbon tax gives Chinese steel producers an arbitrage opportunity. But once more countries have begun to apply border adjustments on imports, the Chinese authorities will want to help China’s steel exporters clean up their operations. Regardless of whether they do this through carbon taxes, regulations, or subsidies for clean energy, Chinese CO2 emissions will decline. And once Chinese producers start meaningfully reducing their emissions, China’s authorities will have an incentive to introduce environmental tariffs of their own.

For the most part, what’s standing in the way of aggressive environmental tariffs are excuses and misleading arguments. The fossil-fuel industry and major polluters, including China, are dead set against environmental tariffs and have been campaigning aggressively to block them. But this position is wholly selfish and, thus, should be disregarded.

A second argument is that environmental tariffs are protectionist measures, and that we should not “risk giving protectionists another opening,” as The Economist puts it. This claim does not hold water. Because carbon tariffs level the playing field, they do not function like traditional protectionist measures. Moreover, the classic theory of trade does not imply that arbitraging domestic policies produces welfare gains – especially considering that such policies are essential for combating climate change.

A third objection is that environmental tariffs may not be legal under World Trade Organisation rules. In fact, a straightforward reading of the General Agreement on Tariffs and Trade (GATT) suggests that they are indeed legal. Article III allows for environmental taxes, stating that: “[Imported products] shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.” It follows that if a country has a domestic carbon tax on “like domestic products,” it is permitted to apply the same tax to imports through border adjustments.

This rule has long provided the basis for border adjustments on value-added taxes, and it was also the reasoning behind a GATT panel’s 1987 ruling (in United States – Taxes on Petroleum and Certain Important Substances) that border tax adjustments could be applied to chemicals. Furthermore, Article XX of the GATT provides additional exemptions for trade restrictions “necessary to protect human, animal or plant life or health,” and there is now a strong scientific case that carbon taxes meet that criteria.

Finally, some commentators worry that in a ‘liberal international order’, important global policy decisions should be pursued primarily through multilateral cooperation. That may well be true. But the fact is that multilateral agreements are not going to work fast enough to keep the world anywhere close to the Paris climate agreement’s 1.5° Celsius warming pathway. We cannot allow faith in multilateralism to become an alibi for inaction. Environmental tariffs could create a positive cascade of climate-mitigation policies around the world. There should be no delay in implementing them.

Daron Acemoglu, Professor of Economics at MIT, is co-author (with James A. Robinson) of Why Nations Fail: The Origins of Power, Prosperity and Poverty (Profile, 2019) and The Narrow Corridor: States, Societies, and the Fate of Liberty (Penguin, 2020).

Copyright: Project Syndicate, 2022. www.project-syndicate.org