Trading for a Better Climate

Concerns over climate change took center stage at this year’s World Bank annual meetings. The message was clear: there doesn’t have to be a tradeoff between economic growth and a cleaner, healthier environment.

“We can make the right choice and still see robust growth,” World Bank President Jim Yong Kim said during the opening panel discussion, October 8.

With the next United Nations Framework Convention on Climate Change (UNFCCC) conference set to get underway in Warsaw in just a few weeks, Kim and International Monetary Fund Managing Director Christine Lagarde have now clearly laid out the economic case for shifting development strategy into a greener gear.

But as he pointed out in his remarks, many policymakers around the globe still consider action on climate change to be an economy-killer. Nobody wants to be the first to impose mitigation costs on their own producers, potentially creating competitive disadvantages. Add to this the opportunity to free-ride and benefit without taking action, and one can see why creating consensus on a comprehensive climate deal has been difficult thus far.

So what needs to be done to help people better understand that growth can be green?  A better understanding of the complex two-way relationship between trade and climate change may help in this case.

As we show in some recent studies conducted at the World Bank, many of the arguments holding back climate-smart progress are neither fully understood nor empirically proven. So, it’s worth looking a bit further at how trade and climate actually work.

First, as pointed out by Kim, research shows that greenhouse gas emissions do not necessarily rise when countries trade more. Access to capital, human and natural resources, and production characteristics vary across countries, and these crucial drivers determine whether emissions will increase—or decrease—as an economy grows.

In most cases, trade liberalization is associated with increases in production, transportation, and consumption of goods. This “scale effect” can drive up emissions. Yet, changes in trade policy can also alter relative prices, which can lead to a greater share of “clean” industries in the economy. This “composition effect” will then reduce pollution. Finally, trade liberalization may also facilitate greater technology transfer—a key issue in the UNFCCC negotiations—allowing others to adopt more efficient, cleaner processes and products. The net impact on aggregate pollution will be determined by these three effects.

Research also shows that demand for environmentally-friendly goods rises as trade raises incomes. So as markets open up to new products and incomes increase, consumers may be willing to pay more for, or “purchase,” a cleaner environment. There is also evidence to suggest this “demand” may help build momentum behind new, more stringent environmental regulation.

The oft-cited Environmental Kuznets Curve holds that a country’s emissions profile naturally rises and falls as it develops, in a trajectory resembling an inverted-U. Once a country reaches a certain threshold level of income, its emissions should decrease. However, when country-specific factors are properly taken into account, this is no guarantee.

The fact that this relationship is not as tight as expected has led to two common concerns. On the one hand, arguments are made that the nature of international trade enables rich countries to clean up their economies at the expense of poorer countries. At the same time, others argue that underdeveloped countries lacking strong institutions and regulatory policies can economically benefit from non-compliance to international agreements by becoming “pollution havens.”

But these arguments fail to collect strong evidence in empirical studies. The bottom line is that different countries are affected differently by increased trade and trade liberalization. Whether or not emissions will increase or decrease depends on their relative factor endowments, policy choices, and the rigidity of these policies.

Effective trade policies are therefore critical tools in the effort to limit climate change. So how will they work their way into the conversation next month in Warsaw?

Technology transfer, as mentioned, will certainly be a key point of contention. Further eliminating tariffs and non-tariff barriers against imports and foreign direct investment could improve technology transfer through mechanisms already established under the Kyoto Protocol.

Border tax measures (BTMs) are also likely to be discussed at length. BTMs have been proposed as one potential solution to concerns over trade competitiveness and “leakage” of emissions to countries with weaker environmental regulations. If they are designed right, BTMs could help level the playing field. They could also be used to generate revenue for climate-smart subsidies, or be applied as a form of trade sanctions to facilitate compliance with any international climate agreement. Each of these options have a number of crucial caveats that must be further considered, not least of which is the potential harm of using trade agreements as an enforcement tool.

Finally, with governments around the world moving ahead with carbon pricing and emissions trading schemes, establishing a price on carbon and determining who should be paying that price is another major issue. Properly designed trade policy could help effectively regulate trading schemes and finance flows. But they may also trigger protectionist measures. There is little consensus on how—or even if—to impose BTMs or other trade policies.

As Kim said, trade policy can be harmonized with climate mitigation efforts to effect change both domestically and internationally. But it needs to be done in the right way. Agreeing on what exactly is right may still take time.