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As U.S. and Canadian Climate Policies Diverge, How Do We Ensure Canada’s Competitiveness?

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By Aaron Cosbey, Damon Vis-Dunbar, January 27, 2017

With relatively new administrations on both sides of the border, the United States and Canada have staked out opposing views on climate change. That has environmentalists and businesses worried.

The former fear a downgrading of environmental protection in the world’s biggest economy. The latter point to the risk of increasingly divergent regulatory regimes in the two countries, with potentially damaging consequences for Canada’s trade competitiveness. We spoke with Aaron Cosbey, an IISD senior associate, to understand the consequences of that divergence, and what Canada might do to safeguard its economic and environmental interests. What follows is an edited transcript of the conversation.

Let’s start with the gap that appears to be forming between U.S. and Canadian climate policies. In broad strokes, what do we know?

Well the new U.S. president hasn’t announced his climate change policies yet. But we have a pretty good indication that we won’t be seeing an activist administration, or Congress, over the next four years when it comes to climate change. For example, President Donald Trump's choice for the Environmental Protection Agency’s administrator has spent his career fighting that agency’s regulations, such as the Clean Air Act. We therefore expect that we won’t see high carbon prices attached to U.S. production or exports. On the other hand, the Canadian government has announced that all provinces and territories will need to introduce a carbon tax, or some sort of equivalent, by 2018. That will result in a distinct difference in the costs borne by some U.S. and Canadian producers—and that matters in Canada because over half of our imports come from the United States, and over three quarters of our exports go there.  

What industries are most vulnerable?

Basically, industries producing goods that are highly energy intensive and highly traded. Energy intensity means carbon pricing will increase costs. And being highly traded means that producers can’t just pass on those costs to their consumers because a foreign producer will undercut them. There is a small number of goods that actually pass that filter. For example, it probably excludes most manufactured goods, because the cost of the embodied carbon in those goods is minor relative to the overall cost of the good. In other words, there is so much that goes into the value of that good other than the steel (or other energy-intensive components) of which it is made. 

However, it does hit some well-known sectors, including cement, aluminum, iron and steel, paper, plastics and some chemicals—and Canada’s top 10 imports from the United States include some items on that list. It includes iron and steel, at over USD 5 billion a year. It includes plastics at over USD 11 billion a year. It includes pulp and paper at over USD 4 billion a year. If we want to know exactly which sectors will be vulnerable, we need a pretty sophisticated analysis of what the trade patterns and emission profiles look like in those sectors. However, the starting point would be sectors like these.

What options does Canada have to preserve its competiveness, and at the same time nudge the United States into taking action to curb climate change?

One option is a levy on goods imported from the United States that tries to make up for the burden that Canada’s industries bear for their carbon pollution. This is what we call a border carbon adjustment (or BCA). In effect, it is a levy that tries to level the playing field of the costs of abating climate change between domestic and foreign industries. You can also use a BCA to reduce that levy on your industry’s exports by rebating that tax at the point of export.

How would it work in practice?

The concept itself is simple, but when you get down to the details, it is devilishly difficult. For example, you can’t just target the United States; that would be illegal under the World Trade Organization (WTO) rules. You also can’t make exceptions for other countries—you have to apply it to everyone equally. That is a problem, because you might want, for example, to exempt less developed countries. Or you might also want to exempt those countries that are party to the Paris Climate Change Agreement, and that are implementing their commitments faithfully. But again, trade law doesn’t allow that unless there is a strong environmental argument for doing so, and it is not clear the Paris Climate Change Agreement obligations actually amount to a strong enough argument of that type.

Another challenge is measurement. Ultimately, you are trying to figure out how much carbon is embedded in each good that arrives at your border, and set your charges accordingly. However, different producers have different carbon emissions for the same goods. Producers in different countries buy their electricity from a whole bunch of different producers that, in turn, have different carbon emission profiles. It becomes very complicated when you get down to trying to figure out exactly what you are going to charge each producer in different countries.

As well, you would ideally adjust the BCA levy to take account of any carbon price that foreign producers face, even if it is less than what your own producers face.  But it is not simple to calculate the amount of the adjustment: how do you translate a raft of foreign climate policies into a single dollar figure for a given good?

Keep in mind though, that to be administratively feasible, a BCA would not apply to every good. It would target those that we discussed earlier—energy-intensive and highly traded products.

This points to how a BCA could run afoul with international trade law. Is it possible to design a scheme that would be compliant with WTO rules?

There is a tension between international trade law and any BCA scheme. You can design a very simple scheme that will be effective in incentivizing your competitors to mitigate their carbon emissions, but it will be illegal under WTO rules. The more you strive for legality, the more complex your scheme gets. That’s because the WTO demands that your scheme is based only on environmental objectives. To be 100 per cent safe under WTO law, you would need a scheme that accounted for exactly how much carbon is embedded in every good. It may be possible—but certainly difficult—to find a balance somewhere in the middle: a scheme that is WTO-legal and environmentally effective.

To sum up, what is the biggest benefit and risk of a BCA?

The headline benefit is preventing leakage. If you put in place a carbon tax, but all you do is chase away your industries that then go and emit carbon somewhere else, then you haven’t achieved your environmental objectives. The big risk is that you have done it in a way that is illegal under international trade law, and therefore you are going to have to dismantle the scheme. And also that you have done it in a way that is politically fractious, in which case it could backfire. If your ultimate goal is to encourage your trade partners to take more action on climate change, a BCA could do the opposite by poisoning the waters of international cooperation on climate change matters.

Thank you Aaron. Where can our readers learn more?

This is a paper that I co-authored that explains what BCAs are all about, and explores the different sorts of options available to policy-makers.

Another good resource is a shorter piece I authored that explores the challenges a government would have to consider in setting up a BCA regime.