Brian Fallow: Freeloader option is asking for trouble

As we debate what emissions target to adopt for 2020 we should heed the signals from Washington and Geneva that going for a freeloader option would be not only discreditable but dangerous.

The US House of Representatives has passed legislation to establish an emissions trading scheme, but with a scorpion's sting in its tail.

Among last-minute changes needed to muster a thin majority for the Waxman-Markey bill was one requiring the President to impose border tax adjustments on certain imports from countries deemed not to be pulling their weight in the global fight against climate change.

The impost, which would not apply until 2020, is aimed at emissions-intensive products such as steel, aluminium and cement, chemical and some pulp and paper products.

The rationale is simple enough. If the United States is to impose a cost of carbon on its own producers, it ought also to apply it to imports of the same products from countries which do not impose such a cost. Otherwise the US loses jobs and taxes, but the planet is no better off.

It is one side of the issue of "carbon leakage" more familiar to us as a problem for exporters.

Farmers, for example, dread the imposition of a new cost that their international competitors - generally heavily protected and subsidised already - will not have to bear. The only effect, they argue, would be to stunt agriculture here to the benefit of producers elsewhere.

In an ideal world there would be a single price on carbon emissions everywhere and no such distortions would arise, but that remains a distant prospect.

In the meantime, the more countries adopt measures to introduce a carbon price into their economies and the harder such measures bite, the greater the clamour for protective border tax adjustments will be.

The danger is this. The quest for progressive multilateral regimes for trade and for climate change are hard enough on their own without setting up a potentially toxic interaction between them.

President Barack Obama evidently understands this.

The New York Times quoted him as saying, following the House of Representatives' passage of the cap and trade bill, that "at a time when the economy worldwide is still deep in recession and we've seen a significant drop in world trade, I think we have to be very careful about sending any protectionist signals out there".

Mindful as he is of making sure there is a level playing field internationally, "I think there may be other ways of doing it than with a tariff approach".

One of the more troubling features of Congress's move is that border tax adjustments would be on top of, not instead of, extensive grandfathering or free allocation of emission permits to the most affected industries - which is also a feature of the scheme our Parliament enacted last year and is reviewing.

True, the US legislation has a long way to go before it becomes law. The Senate has yet to consider it. But will the senators be any less susceptible to special pleading from the folks back home?

There will then need to be a conference or negotiation between the two Houses of Congress to iron out any differences between them before the bill reaches Obama's desk.

Suppose it still contains border tax adjustment provisions, due to kick in after he has left office. Would his distaste for such measures be enough to trigger a veto of landmark legislation like this? It seems unlikely it would.

The next question is whether such measures are compatible with world trade rules. A just-released study of the intersection of trade and climate change policy by the Word Trade Organisation does not give a simple yes-or-no answer to that.

But it does not rule them out.

"Rules permit under certain conditions the use of border tax adjustments on imported and exported products," it says.

"The objective of a border tax adjustment is to level the playing field between taxed domestic industries and untaxed foreign competition by ensuring internal taxes on products are trade-neutral."

After all, value-added taxes such as GST routinely apply to imported as well as locally produced goods, but not to exports. The crucial test is equal treatment of like goods.

And there are general exceptions of venerable antiquity under WTO rules allowing governments to take trade-restrictive measures to conserve exhaustible natural resources, or to protect human, animal or plant life. Either of those could arguably apply.

Paul Krugman, whose Nobel prize was awarded for work in the economics of trade, considers border adjustments "entirely legitimate in terms of basic economics".

The objective is to reduce greenhouse gas emissions whatever or wherever their source. "If you only impose restrictions on greenhouse gas emissions from domestic sources, you give consumers no incentive to avoid purchasing products that cause emissions in other countries; as a result, you have an inefficient outcome even from a world point of view."

Such measures do not frustrate genuine comparative advantage. The advantage they address is gained by despoiling a global commons.

In principle, at least.

The risk, however, is such measures would end up being used, or abused, not to level the playing field but to protect less efficient domestic producers and voters' jobs.

The suspicion this will be used for back-door protectionism seems to underlie the opposition from major emerging markets such as China and India.

And it is they who need to be coaxed into a multilateral climate regime if it is to have any chance of being effective.

New Zealand does not face any immediate threat to its agricultural exports because of the lack of a carbon price on agriculture, says Trade and Climate Change Negotiations Minister Tim Groser, because no one else has one either.

"That doesn't mean there is not going to be a long-term threat," he said.

"The first and most important thing to protect New Zealand from any of these threats is to have in place a respectable, responsible, but also a realistic, [policy to] do what New Zealand can do to mitigate its own impact on the global climate."

To use the threat of border tax adjustments as a gun to the head of major developing country emitters would be counter-productive in his view. "There would be immediate retaliation. Let's not forget that in some of these sectors there would be Chinese or Indian companies that would have less of a carbon footprint than some of their developed country competitors."

The developed world was moving fitfully towards putting a price on carbon, Groser said. "It's not clean and it's not pretty to watch."

And it meant that the threat of measures like border tax adjustments was "a ticking time bomb under the world trade system".