Trade and Climate Change

House passage of the American Clean Energy and Security Act on June 26 is a historic step forward in U.S. efforts to confront climate change. But as it works its way through Congress there is still much that can be improved. The bill’s approach to helping vulnerable U.S. industries through the transition to a low-carbon economy is particularly problematic: In pursuit of a sensible goal, Congress is taking steps other nations could see as protectionist. The flaws aren’t reason to reject the legislation. But Congress should be careful, in addressing climate change, to avoid undermining the global trade regime.

Concerns about the possible competitive impact of climate regulations have been grossly exaggerated. The macroeconomic impact of smart climate policy will likely be small, meaning that robust U.S. economic growth will still be able to power a vibrant and internationally competitive economy. Most companies will see at most limited changes in how they function day to day. Nonetheless, industries that use lots of energy and whose goods are traded globally have some reason to be nervous about a cap-and-trade system. High carbon prices could tilt the competitive playing field in areas like steel, aluminum, cement, and chemicals toward unregulated (or less regulated) competitors abroad. The climate bill, known as Waxman-Markey, addresses that by providing rebates to firms in those sectors to blunt the cost. That approach is, in principle, reasonable. It would cushion the blow for trade-exposed heavy industry while maintaining the integrity of a U.S. emissions cap. But the devil is in the details--and the current bill gets the details wrong.

The flaws arise in the way the bill calculates rebates. Regulators are required to determine the average greenhouse-gas emissions associated with a unit of output (such as a ton of steel or cement) in each vulnerable sector. That figure is then multiplied by the average price of an emissions permit in the cap-and-trade system to estimate the per-unit compliance cost the typical producer incurs. The amount calculated is rebated to each producer in proportion to its own output.

The problem is that some producers are more efficient than others. Imagine that the steel sector had two producers, Firm A and Firm B, each of which made one ton of steel each and faced a carbon price of $20 for each ton of emissions. Assume that Firm A emitted 1.1 tons of CO₂ in its process while Firm B  emitted only 0.9 tons. The government would calculate their rebates based on the industry average (1 ton of CO₂ per ton of steel) and send $20 to each company. Firm A would have most but not all of its costs covered--but Firm B would actually come out ahead by two dollars. The system would, in effect, be subsidizing relatively efficient production. Worse, Firm B would now have an incentive to expand its production, since doing so would net it a bigger rebate. Other countries would probably see this rebate system as an unfair trade subsidy.

The fix is simple but politically challenging: Give companies rebates based on only a fraction of their output. Imagine, for example, that rebates were provided on only 75 percent of output. In that scenario, neither firm would get a net subsidy, but both would still largely be cushioned from the impact of a cap-and-trade system. Even with that adjustment, though, there’s a second problem: The Waxman-Markey bill uses historical rather than current output to calculate rebates. Imagine that Firm A produces 1 ton of steel in 2013 and another ton in 2014. In 2015, though, it decides that its costs are too high and cuts production to half a ton. The bill as currently written still gives Firm A its full $20 rebate, even though its carbon costs have dropped from $22 to $11. This is a massive relative subsidy and a waste of taxpayer money to boot. It could also encourage some marginally profitable firms to cut production in order to reap carbon credit windfalls, killing the very jobs that the rebates were originally designed to protect. The bill should be fixed so that any excessive rebates (which are paid up front) are ultimately clawed back.

Things could certainly be worse. There has been much talk of imposing carbon tariffs at the border as a way of leveling the playing field, a step that would be enormously provocative on the trade front. The bill’s rebates to energy-intensive industries have allowed a political deal that puts that stick aside until at least 2026. On balance that’s a superior outcome. Better yet would be a more prudent rebate system that still let policymakers hold off on setting new tariffs.

[Note: The final version of Waxman-Markey as passed in the House is reported to now include near-automatic border tariffs that could come into effect in 2018. This could be easily abused for protectionist purposes and is probably a bigger problem than the rebates. In addition, if the rebates and tariffs overlap, the result would be a clean violation of World Trade Organization rules. The Senate should make sure that this is fixed.]

In the long term, though, the United States can’t cut through this thicket by itself. Over time, the problem for heavy industry--and the associated trade issues--could become worse as the United States tightens its own rules and regulated companies face steadily higher costs. But if major U.S. trade competitors all impose new and similar climate costs on their energy-intensive industries, no one country’s industries will be unfairly disadvantaged. As a result, most of the rationale for the U.S. rebates will vanish. Ultimately, then, the only solution to the competitiveness problem is global climate action. Since the United States has few sticks to bring to the climate negotiating table, progress on the international front will depend mainly on cooperative action. Congress should make sure that in crafting U.S. climate legislation, its trade measures don’t unnecessarily aggravate the external relationships that will be needed to get that done.