UK: EU, Competition And Trade Alert - Environment Protection Or Trade Protectionism?

Last Updated: 16 April 2008
Article by Jochen Beck

Would a carbon equalisation system to offset carbon leakage comply with international laws?

Interested entrepreneurs have claimed that a greenhouse gas emission allowance trading scheme (ETS) imposes high cost on Community industries. This could lead to a loss of market share to installations outside the Community not taking comparable action to reduce emissions. The European Commission's proposal for amending the ETS takes account of such claims and discusses – albeit vaguely – the introduction of a carbon equalisation system to prevent carbon leakage. Similar considerations are currently underway in the United States.

On 23 January 2008, the European Commission published its long awaited proposal for an amendment of the European Community's (EC) ETS Directive1 (the proposal). The proposal addresses concerns expressed by entrepreneurs that energy intensive industries subject to the ETS could be exposed to a significant risk of carbon leakage. If industries are not able to pass on the cost of required allowances in product prices, they might lose market share to installations outside the Community not taking comparable action to reduce emissions. Recitals (19) and (20) of the proposal address this issue. The Commission aims to identify the energy intensive industries likely to be subject to carbon leakage by no later than 30 June 2010. By June 2011, having consulted with social partners and in the light of the outcome of the international negotiations, it would then submit a report accompanied by the necessary proposals. Community industries at risk of carbon leakage could receive a higher amount of free allocation or an effective carbon equalisation system could be introduced with a view to putting Community installations and those from third countries on a comparable footing. The Commission demonstratively suggests that such a system could be applied by requiring the surrender of allowances. Any system would, however, have to be compliant with the international obligations of the EC, in particular the laws of the World Trade Organisation (WTO). Similarly, the U.S. Senate is currently looking into the possibility of subjecting importers to emission charges similar to those applicable to domestic producers2.

The Commission's approach is rather conservative and certainly does not fulfil the hopes of some entrepreneurs who had wished for a system of equalisation eg, in the form of border measures, to be included in the current proposal. In a recent letter to the European Union (EU), France and Germany, with the support of other Member States, have requested clarification on the ETS reform proposal3.

Legal Aspects

The views on whether a carbon equalisation system (whether in the form of taxes, laws or other measures applied at the border or internally) to counter potential carbon leakage would be compliant with WTO law vary widely. While some see little or no compliance issues arising, others fear that such measures are motivated by protectionist considerations and contest their legality under WTO laws. There is no doubt that such a system would, therefore, require its legal foundation to be embedded in an international agreement. Given the controversial views, it is worth looking at the legal basis of a carbon equalisation system under WTO law. An analysis of the compliance with WTO law of a carbon equalisation system imposed by a WTO Member as to offset carbon leakage, will likely include a review of such measures under Articles I, III, XI and XX of the General Agreement on Tariffs and Trade (GATT) depending on how such a system is constructed eg, in the form of taxes, laws or other measures and whether the measures apply at the border or internally.

Article I establishes the so-called 'general most favoured nation treatment' (MFN). Accordingly, WTO Members must apply duties, customs duties, taxes, regulations and import rules and internal laws and taxes equally to all other Members and cannot discriminate among like products imported from different Members. Article III establishes the so-called 'national treatment principle' whereby WTO Members cannot discriminate between imported and domestic products with regard to the imposition of internal taxes or the application of internal laws and measures. Under Article III:2 imported products shall not be subject to taxes of any kind in excess of those applied to like domestic products. Under Article III:4, imported products shall be accorded treatment no less favourable than that accorded to domestic like products. Article XI of the GATT prohibits quantitative import restrictions. Article XX of the GATT establishes general exceptions from these provisions.

From the relevant parts of Articles I and III of the GATT, it follows that any measures (whether laws, taxes, duties or other measures) applied at the border or internally must neither discriminate between like products originating in different WTO Members nor between imported and domestic like products. The emphasis hereby lies on the "likeness" of products. The WTO Dispute Settlement Body (DSB) established that the likeness of products is defined by physical characteristics, properties, nature and quality, end uses, tariff classification and consumers' perceptions and behavior but not by process and production methods (PPMs). Consequently, different PPMs per se cannot render two like products unalike.

While this distinction might appear academic, it has important consequences. Under Article III of the GATT, a WTO Member would be allowed to impose a 5% tax on eg, domestic desktop computers and a 10% tax on (imported) laptops. This would not be a violation of Article III if desktops and laptops were not considered like products. On the other hand, laptops manufactured domestically and abroad could not be subject to different taxes based on the manufacturing process used eg, more or less labour intensive. The same applies under Article I of the GATT with regard to laptops imported from different WTO Members.

This principle would also apply to any carbon equalisation system designed to contravene carbon leakage. Different types of steel for example, such as stainless or metallic coated steel, would not be considered like products. They could therefore be subject to a differential treatment eg, different duties or taxes. Stainless steel produced in an environmentally friendly way would, by contrast, be a like product to stainless steel produced with high carbon emissions. Articles I and III of the GATT, as currently interpreted by WTO case law, would not allow different treatment of those products based on PPMs only.

Given the meaning of the term "like product", it is possible that a carbon equalisation system is found incompliant with Articles I and/or III (and in the case of quantitative import restrictions with Article XI) of the GATT. However, national measures by a WTO Member to offset carbon leakage may find a legal justification under Article XX.

Article XX of the GATT allows WTO Members to adopt or enforce measures necessary to protect human, animal or plant life or health (Article XX(b)) and relating to the conservation of exhaustible natural resources (Article XX(g)). Such measures must, however, not be applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail or as a disguised restriction on international trade (chapeau of Article XX).

Compliance of a carbon equalisation system with Article XX of the GATT will very likely stand or fall with the exact wording and structure of the law. From the wording and past case law it appears that to be compliant with Article XX(b) and/or (g) and the chapeau of the GATT, a carbon equalisation system must aim at protecting human, animal or plant life or health and/or relate to conserving exhaustible natural resources and not at protecting a domestic industry's market share by raising its competitors' costs. It should also not be drafted so as to discriminate based on government policy (ie, whether a country has a system comparable to the EC ETS system in place) but rather be based on objectively determined production methods ensuring that individual producers/exporters produce in a manner that achieves the desired environment protection standard. It is furthermore questionable whether a carbon equalisation system that applies to a limited number of industries only fulfils the strict requirements of Article XX of the GATT. This could be interpreted as a protectionist measure if there is eg, a risk that the system would merely shift carbon leakage to other sectors rather than preventing it entirely.

However, given the restrictive trade impact of such measures, it seems unavoidable that the WTO dispute settlement system will be called upon to clarify the application of the relevant GATT Articles mentioned earlier and existing case law to carbon equalisation systems established to prevent carbon leakage.

Additional considerations

In this context, one must not forget that the WTO is a trade organisation. It establishes rules on trade in goods and services. It has, however, no competence to rule on environment protection. Such competence would need to be given to the WTO through an agreement by its Members. Furthermore, the decision making power given to the DSB is limited to reviewing the compliance of measures by WTO Members with the existing WTO law ie, whether these measures affect trade between WTO Members. The DSB can thereby interpret existing rules but cannot invent new law. Therefore, statements in the public domain to the effect that the DSB is unlikely to rule against or should not declare unlawful any measures implemented to protect the environment are misleading and overlook the very nature of the WTO. The DSB can only review whether a measure taken by a WTO Member affects trade and, if so, whether it might be justified under Article XX of the GATT for reasons of protecting human, animal or plant life or health and conserving exhaustible natural resources.

Relating to the legal implications under Article XX of the GATT discussed above, it is also questionable whether a carbon equalisation system that only applies to carbon intensive industry sectors makes economic sense. While such an equalisation system would probably help reduce or prevent carbon leakage in those industry sectors, they might harm downstream industries which are dependent on price efficient raw materials. If raw materials for the manufacture of downstream products are subject to increased costs, this will increase the production costs of domestic downstream products. Imports of a like downstream product from a country that does not have a system similar to the ETS in place will not bear these costs. There might consequently be a risk that a carbon equalisation system for energy intensive industries only will merely shift the carbon leakage from energy intensive products to downstream products. In the worst case this might encourage downstream industries to relocate their production outside of the country imposing a carbon equalisation system.

In the absence of international environment protection agreements establishing, as a side effect, a level playing field regarding environment protection related production costs, an effective system would, therefore, need to comprise all products, not only energy intensive products. Managing such a system poses significant difficulties at an administrative level.

Conclusion

Whilst beneficial to domestic energy intensive industries, a carbon equalisation system might have negative impact on downstream industries and consequently merely shift carbon leakage to such industries. Furthermore, any such system would be vulnerable to challenges under WTO law by negatively affected WTO Members. Past case law is not clear as to whether a carbon equalisation system could be found in compliance with WTO law. Considering the current stagnation of the Doha Round and the international controversial political debate on carbon emission reductions, unilaterally introducing a carbon equalisation system will likely become a very controversial issue globally that will push the WTO, a Trade Organisation, to its limits, as this has been the case in the past. Such a system should best be embedded in an international environment protection agreement rather than on unilateral measures.

Footnotes

1 Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading system of the Community, COM(2008) 16 final, 23 January 2008.

2 See Financial Times, Carbon import tax could provoke trade war, 23 January 2008; Financial Times, Green barricade: Trade faces a new test as carbon taxes go global, 23 January 2008.

3 See Financial Times, EU urged to clarify emissions trading reforms, 17 February 2008.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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