Climate versus trade? Reconciling international subsidy rules with industrial decarbonisation

Executive summary

The vast environmental subsidies that may be required for the transition to net-zero greenhouse gas emissions are starting to generate international trade and political frictions between the world’s largest economies. This puts (supra-)national industrial decarbonisation efforts on a collision course with international subsidies rules and national countervailing duty (ie anti-foreign subsidy) laws and regulations.

International cooperation will be essential to defuse such tensions before they escalate and impede effective climate policy rollouts, and before they lead to economic countermeasures that create new barriers to trade in environmental goods. This requires agreement on permissible environmental subsidy practices that minimise distortions. Meanwhile, it will be crucial to provide financial transfers to assist poorer economies with industrial decarbonisation at the same time as those poorer economies are suffering from the cross-border negative economic impacts of otherwise net-global-welfare enhancing environmental subsidies paid out by wealthy countries.

Various forums can host the technical and political negotiations necessary to set the parameters of net global-welfare enhancing subsidies. These include the G7, the G20, the Organisation for Economic Co-operation and Development, the World Trade Organisation’s Trade and Environment Committee and WTO Trade and Environmental Sustainability Structured Discussions, and the Coalition of Trade Ministers on Climate.

_{The author thanks Ronald Steenblik, Jeromin Zettelmeyer, Rebecca Christie, Uri Dadush, Alicia García-Herrero, Alexander Lehmann, Marie Le Mouel, Ben McWilliams, André Sapir and Nicolas Véron for their most helpful comments and critique. Luca Moffat is thanked for excellent research assistance.}

Introduction

Environmental subsidies are typically conceptualised as public spending (including governmental revenue foregone and in-kind contributions) that supports the attainment of environmental objectives that would remain elusive if left to market forces (Charnovitz, 2014). There is a strong economic argument that subsidies are an essential instrument in the transformation towards the net-zero global economy. While taxation can address the negative environmental externalities of emissions (reflecting the polluter-pays principle), it cannot simultaneously correct the externalities associated with green innovation. As the United Nations Environment Programme (UNEP) pointed out in 2003: “public financing is essential for the transition to a green economy and more than justified by the positive externalities that would be generated” (UNEP, 2003).

Environmental subsidies could also be justified when emissions taxation (carbon prices) is not feasible or is insufficient due to political economy constraints. In such cases, decarbonisation may require consumer incentives to purchase low-carbon goods and services, and/or producer incentives to invest in the decarbonisation of industrial production processes or increase renewable energy production capacity.

However, this category of subsidies may – proportional to their volume – impact international trade and investment. First, public investment directly linked to the decarbonisation of energy generation and other industrial processes, as well as government incentives for purchases of low-carbon goods and services, will enhance national economies’ international competitiveness in decarbonised merchandise trade. For instance, government funding for the replacement of blast furnaces with electric arc furnaces for steel-making, or incentives for the use of clean hydrogen as an input to steel production, will give a competitive edge to producers of clean steel. This distortion of competitive conditions will be even greater in jurisdictions that disincentivise high-carbon steel consumption and production through taxation and enforceable carbon intensity standards. In turn, certain subsidy schemes that are geared towards industrial decarbonisation are likely to distort the distribution across countries of benefits derived from international trade. The greater the benefit conferred on domestic industries, the more likely it is that such subsidies will alter competitive conditions in the international marketplace in favour of the companies on which the benefit is conferred.

These circumstances can be expected to generate political tensions. Transatlantic tensions have already surfaced over the United States Inflation Reduction Act (IRA), which subsidises production and investment in renewable technology in the US. Depending on how the US’s trading partners react, this could trigger a global subsidies race to attract investments in clean technology and production. This would be particularly problematic in a world in which governments have widely diverging access to the public resources needed to finance national decarbonisation efforts. Economies characterised by public-resource scarcity could be expected to be hit particularly hard by a subsidised race in clean-technology innovation and industrial decarbonisation. Trade and investment effects could be reinforced by carbon border adjustment mechanisms and other border measures that restrict imports on the basis of the carbon intensity of traded goods, resulting in further market segmentation.

Crucially, however, the negative cross-border economic impacts of environmental subsidies may be outweighed by positive cross-border effects that arise from the same policies. The potential benefits include trade-induced technology transfers, domestic emission abatement and the cost-effective supply of environmental goods. In other words, environmental subsidies that alter cross-border competitive conditions may not be all bad. They may tackle market failures in a net-global-welfare enhancing manner and may therefore be entirely appropriate. Public financing of this category, however, leaves policymakers with a distributional challenge: they must mitigate immediate negative cross-border impacts through least-trade-distortive policy design and/or provide cross-border transfers to finance industrial decarbonisation in public resource-poor jurisdictions, with the goal of ensuring a just net-zero transition for all countries and their citizens.