Common Tragedies

Thoughts on Environmental Economics

Competitiveness under climate policy

Posted by Daniel Hall on February 4, 2008

One of the debates surrounding climate policy in the United States is how to address concerns about international competitiveness — a climate policy here will raise prices for domestic manufacturers, leaving them at a disadvantage relative to producers in countries without comparable policies. (This sometimes gets raised in Washington as the “China problem”; I think in Brussels they may currently refer to this (with justice) as the “America problem.”) This is not only a problem for domestic manufacturers; shifting production and associated emissions overseas to unregulated regions won’t mitigate a global pollutant.

Congressmen John Dingell (D-MI) and Rick Boucher (D-VA) last week released a white paper summarizing this competitiveness issue and proposing policy solutions. They describe three specific approaches: 1. border adjustments, 2. performance standards, and 3. (dis)preferential carbon market access. Their discussion of border adjustments focuses on the idea of a kind of “carbon border tax” as proposed by American Electric Power and the International Brotherhood of Electrical Workers. The second option they discuss is “carbon intensity standards” that would apply to both domestic and imported products. In the discussion the white paper notes that such standards could be either separate from, or in addition to, obligations under a domestic cap-and-trade program. Their third option, carbon market access, is a proposal to either limit or give preferential access to carbon offset markets to developing nations depending on their actions to reduce emissions.

Reading the paper gives the sense that there has been little structured thinking on the Hill about the competitiveness issue. The focus rather is on tossing around whatever policy proposals are already on the table and musing on what is politically feasible.

So to step back and provide a simple framework for competitiveness concerns: the short version is that climate policy raises the price of energy and energy-intensive goods for domestic manufacturers, and thus leads to a input cost gap between domestic and overseas manufacturers. (This implies that competitiveness concerns loom largest in those industries which are most energy-intensive and internationally competitive.) Fundamentally, policy to address competitiveness must either lower the costs of domestic manufacturers, or raise the cost of imported goods. Further, to lower domestic manufacturing costs, you can either significantly weaken the program requirements for domestic manufacturers, or you can subsidize them directly. Those three broad categories of response — two ways to lower domestic manufacturing costs and the option of raising importers’ prices — can be used to classify any of the various specific proposals.

Border adjustments attempt to raise the price of imported goods. The legitimate concern with such “adjustments” is that they will lead to retaliatory trade policies that will be harmful to the world economy. (See the FT article linked previously for more discussion.) Further, there’s every reason to suspect that they will mainly be used by domestic manufacturers as political cover for protectionist policies in industries that are not so much feeling the pressure of energy prices as wage and health care costs.

Performance (product) standards also raise importers’ prices. Depending on how they are structured and whether they are used for domestic manufacturers in lieu of (rather than in addition to) inclusion in a mandatory economy-wide (e.g., cap-and-trade or tax) program, they may also reduce costs for domestic manufacturers (relative to full inclusion in the larger climate program). Note, however, if such standards are weaker than the economy-wide policy that while domestic manufacturers will not feel as large a pinch, the net social cost will be higher because there will not be as strong an incentive for reducing consumption of GHG-intensive goods among end users.

Limiting other countries’ access to a potential U.S. carbon market is an intriguing idea, but it’s a misguided implement for addressing competitiveness policy. It does not address the prices of either domestic or imported goods, affecting instead the relative prices of carbon offsets, an entirely market. Such a proposal relies on setting the interests of offset generators against those of manufacturers in a developing country, and hoping that internal politics resolves this dispute in favor of offset generators. To me it appears the likeliest outcome of such a proposal will be to create distortions in two markets rather than one — GHG-intensive manufactured goods, and carbon offsets.

Surprisingly, the white paper fails to address one of the more likely possibilities for addressing competitiveness: using allowance allocation within a cap-and-trade system to subsidize domestic manufacturers. (The paper acknowledges in a footnote that this could be done but leaves any discussion for a later white paper.) While most entities regulated under a cap-and-trade program will be able to pass cost increases through and thus do not need to receive free allowances (just ask Europe about how embarrassing it is to explain those windfall profits for electric utilities which got free permits), giving away allowances to a limited number of domestic manufacturers in internationally competitive industries may make sense. While domestic manufacturers would still have increased costs (of fuel, electricity, inputs, etc.), they could use the free allowances to subsidize product prices and thus remain competitive in international markets in the near-term. Further, most current proposals gradually phase out free allocation in favor of auctions. This gives the U.S. further time to encourage developing countries to gradually come alongside and join international climate policy, while providing manufacturers time to adjust and prepare for the end of free allowances. Further, while some political observers will hold their nose at the political horse-trading that must be done to eventually pass a bill, I would argue that it’s preferable to include domestic manufacturers, thus reducing the distortions that would be created by giving exemptions to certain industries, and have to worry instead only about the distributional consequences of giving away some of the allowances.

Here is Dick Morgenstern (and others) at RFF with some analysis attempting to quantify cost increases for manufacturers under climate policy. Here is Dick with a longer discussion of policy options for competitiveness. Here is Ray Kopp at RFF discussing allowance allocation more generally.

Update: One of the Free Exchange bloggers seems to think I have given up the game by providing a sheen of economic respectability to what amounts to unnecessary market interventions.  I don’t think the differences between us are quite as large as they initially appear, however.  Perhaps I didn’t make it sufficiently clear in the post, but I assume that some type of competitiveness policy will be a political prerequisite to the passage of a climate bill.  The question then becomes, “What is the best (or least bad) competitiveness policy we can feasibly achieve?”  I freely admit that some may find this a depressingly low hurdle.

2 Responses to “Competitiveness under climate policy”

  1. […] little consensus on the macroeconomic impact of climate-change legislation pending on the Hill, reports Common Tragedies. Cap-and-trade schemes will likely affect U.S. competitiveness, but how? Badly, answers Planet […]

  2. […] “Competitiveness Under Climate Policy,” a blog post by Daniel Hall at the environmental economics blog Common Tragedies. […]

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