February 23, 2009
Series Editor: Ian Parry
Managing Editor: Felicia Day
Assistant Editors: John Anderson and Adrienne Foerster
Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.
One of the obstacles to implementing climate policy in the United States has been the worry that domestic firms competing in global markets will be disadvantaged by the program. In turn, this might cause increases in emissions in other countries as footloose capital relocates to countries with no policies to control greenhouse gases. This week, Carolyn Fischer and Richard Morgenstern discuss the seriousness of these concerns and what measures might be taken to limit the problem of emissions leakage.
Competitiveness, Emissions Leakage, and Climate Policy
By Carolyn Fischer and Richard D. Morgenstern
|In the debate over the design of mandatory federal carbon pricing policies, the potential for adverse effects on energy-intensive, import-sensitive industries, on domestic jobs, and on the nation’s trade balance consistently emerge as significant concerns. Equally important is the potential for erosion of the environmental benefits if an increase in domestic production costs causes more production activities to shift to nations with weaker climate mitigation policies, or none at all. Various policy options have been advanced to address these concerns, although none is without its own problems.
In assessing the seriousness of the issue, recent analyses by Mun Ho, Richard Morgenstern, and Jhih-Shyang Shih have considered the different kinds of adjustments that can be made over different time scales:
- In the very short run, firms cannot adjust prices or production techniques and profits fall accordingly.
- In the short run, firms can raise prices to reflect higher energy costs, with a corresponding decline in sales as a result of product or import substitution.
- In the medium run, when in addition to the changes in output prices, firms can change the mix of energy, labor, and other inputs in their production processes, but capital remains in place; economywide effects are considered.
- In the long run, capital may also be reallocated across the economy.
Based on their modeling results using an assumed carbon dioxide price of $10 per ton, several findings can be made:
Measured by the reduction in domestic output, a readily identifiable set of industries is at greatest risk of contraction over both the short and long terms. Within the manufacturing sector, hardest hit industries are chemicals and plastics, primary metals, and nonmetallic minerals. Another hard hit industry, petroleum refining, will likely be able to pass along most cost increases, thereby muting the impacts.
Although the short-run output reductions are relatively large in these industries, the reductions shrink over time as firms adjust inputs and adopt carbon- and energy-saving strategies. The industries that continue to bear the impacts are generally the same ones affected initially, albeit at reduced levels. While profits drop in the short term, competitive markets adjust to ensure market rates of return in the longer run.
Focusing on the nearer-term timeframes, the largest cost increases are concentrated in particular segments of affected industries. For example, petrochemical manufacturing and cement see very short-run cost increases of more than four percent while iron and steel mills, aluminum, and lime products see cost increases exceeding two percent.
In nonmanufacturing companies, the overall size of the production losses also declines over time in most sectors, although a more diverse pattern applies. The initially significant impact on electric utilities, for example, does not substantially change over time compared to an industry such as mining, which experiences a continuing erosion of sales as broader adjustments occur throughout the economy. Agriculture faces modest but persistent output declines over time due to higher prices for fertilizer and other inputs.
Carolyn Fischer is a senior fellow at Resources for the Future. Her research focuses on policy mechanisms and modeling tools that cut across environmental issues, including environmental policy design and technological change, international trade and environmental policies, and resource economics.
Richard Morgenstern is a senior fellow at Resources for the Future. His research focuses on the economic analysis of environmental issues with an emphasis on the costs, benefits, evaluation, and design of environmental policies, especially economic incentive measures.
In terms of employment, short-term job losses are modeled roughly proportional to those of output. Over the longer term, however, when labor markets are able to adjust, the remaining, relatively small losses are fully offset by gains in other industries, leaving no net change in employment.
Leakage across Borders
In time, most experts agree, the best solution to addressing climate change will be to devise binding international agreements that create parity in carbon markets. But in the interim, unilateral actions must be taken to begin addressing the global challenge. A consequence of this approach is emissions “leakage,” wherein domestic reductions are offset by increases abroad, as production, demand, and energy supplies are reallocated globally. Over the long term, the leakage rate for the few most vulnerable industries can be as high as 40 percent in the case of a unilateral $10 per-ton CO2 price.
Importantly, displacement of production through lost competitiveness is not the only source of carbon leakage—and in some models not the main source. A large-scale withdrawal of demand for carbon-intensive energy from the United States will drive down fossil fuel prices globally and expand consumption elsewhere. For example, coal will become cheaper, making electricity and steel in China less expensive and more carbon intensive. This driver of leakage can only be addressed by ensuring that all major international players take on comparable carbon policies and prices.
Still, while the leakage related to production “outsourcing” may be only part of the problem, little can be gained by allowing domestic industries to contract if the accompanying emissions reductions are offset abroad.
Policy Tools for Addressing Competitiveness and Leakage
A first response is to ensure that climate policies are cost-effective. For example, carbon pricing through a tax or cap-and-trade policy will ensure access to inexpensive mitigation opportunities throughout the United States (and potentially around the world), minimizing the economic costs of achieving any given emissions target. Beyond that, policymakers have a number of options.
A weaker overall policy—less stringent emissions caps and/or lower emissions prices—would offer relief, but to all industries, not only those facing increased competition. Meanwhile, environmental benefits and incentives for technology innovation would be smaller.
Exempting certain sectors provides more targeted relief but eliminates incentives for those sectors to deploy even inexpensive measures. More traditional forms of regulation, such as emissions standards, can be used to deliver some emissions reductions while avoiding the added burden of allowance purchases (under auctioned cap-and-trade programs) or tax payments for their remaining emissions. However, the overall cost to society will tend to be higher than under an economywide pricing policy.
Pending legislation has focused mostly on free allowance allocation and trade-related “border adjustment” policies. In particular, import adjustment proposals would require importers to purchase allowances based on actual or estimated embodied emissions, leveling the playing field at home between imported and domestic consumer goods. Full border adjustment would also level the playing field abroad between our exports and foreign goods, by adding an export rebate based on average emissions payments in the sector. On the other hand, an allocation policy that keeps domestic costs from rising in the first place would also level both playing fields. To do so, allowance allocation would need to be updated in accordance to output, and the value of that allocation would function like a domestic production rebate. This type of benchmarking with ongoing adjustments stands in contrast to the fixed allocations that were used in Title IV of the Clean Air Act, which do nothing to lower variable costs.
A recent paper by Carolyn Fischer and Alan Fox has examined these options. Not only may different border adjustment policies raise concerns within the World Trade Organization, but they also pose different economic tradeoffs. While all the options promote domestic production to some extent, none of them would necessarily be effective at reducing leakage in a given sector. That is because while they reduce emissions abroad, they expand the emissions of domestic firms. To understand the net effects requires detailed information on the relative responses of domestic and foreign producers to carbon price changes and on the relative emissions intensity of production at home and abroad. However, using plausible values for these parameters, it seems likely that for most U.S. sectors, a full border adjustment, combining an import adjustment based on actual embodied carbon emissions with an export rebate, is most effective at reducing global emissions. But when import adjustments are limited for reasons of WTO compatibility to a weaker standard, like the domestic emissions rate, the domestic rebate can be more effective at limiting emissions leakage and encouraging domestic production.
Some caveats are especially relevant: First, although an emissions cap can be effective in limiting domestic emissions, awarding additional allowances to certain sectors to compensate for competitiveness concerns will tend to raise allowance prices overall, and shift costs among sectors. In particular, it is not advised for energy-producing sectors like electricity or petroleum refining, where the production rebate undermines incentives for cost-effective conservation efforts. Second, border adjustments or other trade-related policies risk providing political cover for unwarranted and costly protectionism and may provoke trade disputes with other nations. Third, many of our largest trade partners are implementing emissions pricing; the European Union already has a cap-and-trade program and Canada has policies developing at the provincial level. For most energy-intensive manufacturing, these trade partners represent a quarter or more of the leakage from lost competitiveness. Thus, actual leakage is less of a concern, and any allocation scheme must consider how preferential treatment will be phased out.
Overall, sector-specific policies are more difficult to implement than economywide approaches and can require hard-to-obtain data. Furthermore, they create incentives for rent seeking as individual industries now seek special protection under the available mechanisms without necessarily being at significant competitive risk. Nonetheless, there is a real prospect that a unilateral or near-unilateral domestic carbon mitigation policy will cause adverse impacts on certain energy-intensive, import-sensitive industries, particularly in the short to medium term, justifying some kind of policy response.
Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.
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