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Withdrawal from Paris Agreement Introduces a Climate of Uncertainty in Trade

A Frosty Reaction

President Trump acted on a campaign promise when he announced the United States would formally withdraw from the Paris Climate Agreement.

Bringing together 197 nations, including for the first time China and India, the Paris Agreement is comprised of voluntary national commitments, including self-determined limits on greenhouse gas emissions. The U.S. move to withdraw drew criticism from some key trading partners in Europe. As leaders from around the world assess the impacts, some previously rejected proposals are resurfacing.

One such proposal making the rounds in European press is a “carbon tariff” on imports from the United States. The idea of carbon tariffs is not new. However, such tariffs are subject to a complex framework of rules under the WTO.

“Cap and Trade” Schemes

The concept of carbon tariffs first emerged with the advent of so-called “cap and trade” systems, such as the EU’s Emissions Trading System (ETS). Under the ETS, each EU Member State is allocated a percentage of the total EU carbon emissions cap based on that country’s emissions the previous year. EU Members then issue allowances for CO2 emissions to their producers on a per ton basis. These licenses can be traded on secondary markets, and each year producers must procure sufficient allowances for their carbon emissions or face hefty fines. Over time, the overall EU cap is lowered and Members issue fewer allowances, incentivizing cleaner production by raising the cost of emissions.

Critics of these kinds of cap and trade schemes cite concerns about “carbon leakage,” which they say happens when companies choose instead to move production to countries not participating in the scheme. As a consequence, investments and associated jobs leave the country, and the carbon emissions from that production instead end up on the ledger of other countries, which may be less equipped to address remediation. One proposed solution to the leakage problem is to implement a carbon tariff. Carbon tariffs are based on the CO2 emissions associated with an imported product. Those in favor of carbon tariffs argue they help offset these incentives by re-introducing the cost elsewhere in the transaction, and in theory, equalizing costs between domestic and international producers.

There is an irony in all of this. Whereas American industry was once concerned about competitors taking advantage of foreign “carbon havens,” they could instead face carbon tariffs on their exports as other countries come to view the United States as a carbon haven.

Can a Country Put a Tariff on Carbon?

As we’ve written in TradeVistas Essentials, the foundational principle of the global trading rules is non-discrimination. A carbon tariff would be subject to the WTO obligations of “national treatment” and “Most Favored Nation” or MFN.

How to Assess the Duty? The Requirement of National Treatment

The first challenge facing a carbon tariff is the issue of measurement. A “carbon tariff” is not a tariff in the traditional sense. Instead, a carbon tariff is better understood as a “border adjustment duty.” In the simplest terms, this is a duty on imports intended to adjust for the difference between taxes at home and abroad. Under WTO rules, such an adjustment duty must abide by the obligation of National Treatment – that imported and domestic goods should not be treated differently under internal taxation and regulation. This means that importers paying a “carbon tariff” cannot face significantly more onerous taxes and regulations than domestic producers.

In practice, treating domestic and foreign producers equally is harder than it sounds. For example, under Europe’s Emissions Trading System, domestic producers simply procure allowances for their total emissions, but foreign producers are inherently measured differently – they can only be charged for emissions tied to the imported good at the border. This poses difficulties in measuring and verifying the actual carbon intensity of a given import. To be in line with WTO rules, a carbon tax scheme must administer the duty in such a way as to ensure they don’t charge importers substantially higher rates on CO2 emissions than domestic producers are paying in the allowance market.

Could U.S. Imports be Singled Out? The Requirement of Most Favored Nation

The other major issue facing a carbon tariff targeting the United States is just that – it is targeting the United States. Under WTO rules, all member countries grant each other “Most Favored Nation” status, meaning they agree to treat all members “no worse” than any other member. While there are exceptions, as a general rule, countries cannot single out specific countries to face uniquely high tariffs.

This does not mean a carbon tariff scheme would be impossible. But it does mean that it would need to be broadly applied. The EU could implement a carbon tariff for imports into the European market using a WTO-compliant emissions measurement scheme as mentioned above. However, it would have to apply to all imports, not just those from the United States.

If, for example, the EU were to impose such a tariff, it might prevent American companies from gaining an “unfair advantage” in carbon emissions, but it would also impose costs on trading partners who remain committed to the Paris Agreement. This could be counterproductive, as countries currently considering their own cap and trade programs may shy away in the face of “double taxation, ” wherein their producers buy allowances at home and face border duties abroad.

Always Apply the Golden Rule

It remains to be seen how our trading partners will respond to the U.S. Government withdrawal from the Paris Agreement. For those who advocate for levying a carbon tariff on American producers, they will need to think carefully how to design such a system so as not to violate the rules of international trade. This means going to lengths to treat American producers and domestic producers equitably, and to apply those rules universally to WTO members, not just on the United States.