Provoking a clash between trade and climate change? edit

Is it really in Europe’s interest to provoke a trade war with other countries on the basis of climate change? Some people think so, notably Nicolas Sarkozy and Silvio Berlusconi, who recently wrote a letter to European Union leaders arguing in favour of carbon tariffs against countries that don’t go as far as Europe in their ambitions to reduce carbon emissions. But this is a short-sighted view that, if turned into policy, would harm Europe’s economy (which is highly dependent on import of input goods for refinement) as well as its ability to effectively reduce emissions of carbon dioxide in a way that would not be extremely costly.

Even if Sarkozy’s and Berlusconi’s letter amounts to little more than political grandstanding, the European Union has now thrown down the gauntlet and is about to introduce the first legislation in the world that restricts trade on the basis of climate change. It is the Renewable Energy Directive (RED), a directive which aims at radically increasing the use of biofuels in Europe, that embodies Europe’s willingness to test how far it can go without provoking a dispute in the World Trade Organisation (WTO) or triggering an outright trade conflict with countries which would be discriminated against by RED.

This is high politics – and of great interest to many other countries who are considering trade-restrictive measures with the aim of protecting its climate change policy. Regardless the legal part of it, it is obvious that Europe’s new policy on biofuels is unsustainable and will do little more than slowing down the shift away from fossil fuels.

Green protectionism

Europe’s biofuels policy is a good example of the recent trend towards green protectionism. Biofuels production in Europe is heavily subsidised. It is protected by tariffs, especially ethanol with tariffs up to 63 percent, and enjoys subsidies that, according to the last study of the Global Subsidy Initiative, an initiative by the International Institute for Sustainable Development (IISD), adds up to 0,5 EUR per litre biodiesel and 0,74 EUR per litre ethanol produced.

Yet a big (but not the entire) part of the European biofuels industry remains uncompetitive and cannot produce to world-market prices. That is problematic, to say the least, in view of the planned increase in the use of biofuels. It is impossible for Europe to continue with current levels of direct subsidization when volume grows. Not only will Europe lack resources to pay for the subsidies needed to increase the production volume; it borders to economic madness to subsidise biofuels so heavily when it is much cheaper to buy a carbon offset on the Climate Exchanges. For example, EU support per tonne of CO2-equivalent emission avoided is 600-800 EUR for rapeseed biodiesel; the price of a similar offset is less than 10 percent of that support.

A cheaper way to expand the use of biofuels is to increase import. This has happened – and will continue to do so. But Europe’s biofuels policy is not only based on environmental concerns. Far from it. Europe has industrial policy ambitions to expand domestic biofuels production. What is particularly sensitive in this regard is competition to rapeseed biodiesel – the main type of biodiesel in Europe. Biodiesel made of rapeseed does not get much protection from tariffs: tariffs on biodiesel are generally low as Europe always been a net-importer of diesel. Nor is the subsidy intensity in biodiesel as high as in production of ethanol. Furthermore, European production is very costly and has difficulties competing with more efficient biodiesel outside Europe, despite the subsidies. And, the conversion of farmland into production of rapeseed biodiesel is a central tenet in the ambition to make the Common Agricultural Policy (CAP) in Europe more conducive to market conditions, or at least less wasteful than the current version of the CAP. Hence, there is a big interest on the part of many actors in Europe to ensure the rise of rapeseed biodiesel production will continue.

The Renewable Energy Directive can prove to be very helpful for this ambition. RED adds a new type of policy to Europe’s box of trade restrictive measures in biofuels: technical regulations concerning the methodology of production. At the heart of this regulation is the tax-excise exemption for biofuels, and the obligation for each EU member to reach an agreed level of biofuels in its energy mix by 2020 (the target varies between countries). To qualify for the tax-excise exemption for biofuels, the greenhouse gas savings of shifting to biofuels must be higher than 35 percent. From 2017 greenhouse gas reductions should be 50 percent, and 60 percent thereafter for refineries beginning operation in 2017 and beyond. The same requirement also applies for biofuels to be accounted for in each European country’s national obligation for the use of biofuels. Furthermore, RED regulates that new biofuels cannot be made from land with high biodiversity value and high carbon stock, or peatland. Hence, the Renewable Energy Directive sets out an emission-based criterion and a land-based criterion for biofuels to qualify for favourable treatment in Europe.

But what will it achieve?

Unless there are changes made to the way RED will be introduced, some foreign biodiesel will next year not qualify for favourable treatment. If that happens, the EU is likely to be taken to the WTO for a trade dispute – a dispute it is likely to lose because of RED’s blatant discrimination and biased methodologies for assessing GHG savings (foreign biofuels are assessed by a tougher standard than domestic biofuels). But even if it would win such a dispute, Europe would not achieve much on the environmental front. In fact, a plausible outcome is that it would rather corrupt Europe’s ambition to reduce carbon emissions.

There are two aspects that will prove vexing. Firstly, biofuels that cannot be sold on the European market can instead be shuffled to other markets with less stringent environmental standards, or with less biased methods for assessing conformity with sustainability criteria. Rather than producing biodiesel, an exporter can use the same crop to produce a vegetable oil and sell to Europe without risk of discrimination. And if the producer continues with energy production, the biodiesel can be exported to other countries. Hence, the notion that Europe through its use of RED can change the behaviour of others is false. Europe’s market power is not that big. For instance, it represents only 15 percent of the global demand of palm oil, the main competitor to rapeseed biodiesel, and its share is declining fast for the simple reason that growth outside Europe is so much bigger. Power is the ability to get other actors to do what they do not want to do. Europe simply does not have that power.

Secondly, the more foreign biofuels that will be discriminated, the less the supply of biofuels on the European market will be. Limited supply reduces competition and pushes prices upwards. It further disconnects the European pricing system from the world-market pricing system. Taken to its extreme, this could fracture and fragment the market for biofuels to such a degree that market autarky will rule. But even in the milder form, one of the casualties of this policy will be the ambition to rapidly reduce the use of fossil fuels. The higher the price of biofuels, the higher is the cost of shifting away from fossil fuels.

The nexus of trade and climate change policy is potentially explosive. Carbon tariffs, or similar measures, would strike a blow to the global economy. And it would not help Europe. Europe is fundamentally dependent on import. Raising the cost of import not only hurts consumers, it will also hurt producers; approximately two thirds of Europe’s import is input goods that are used in production. The main economic consequence of carbon-based import barriers is then to increase the societal welfare cost of reducing carbon emissions. Nor would such measures change environmental behaviour in other countries. The sectors that today have to pay for extra emission allowances – like cement, pulp and paper, et cetera – are heavy industries. Trade only represent a small portion of a country’s production in those sectors. Of China’s total export of pulp and paper, for instance, Europe represents a little more than four percent. But it is only eight percent of China’s production of pulp and paper that is exported. Europe’s market share is simply too small to push Chinese producers to change environmental behaviour. If Europe puts prohibitively high tariffs on them, they will simply reshuffle trade to other destinations.

A conflict between trade rules and climate change policy can be avoided if policy is rationally and diligently pursued. But in the event a country opts for trade-restrictive measures, other countries will swiftly take it to the WTO for dispute resolutions. Hence, there is a very clear risk of a sharp trade conflict with severe ramifications in the event a conflict arises. That is also why many countries are paying close attention to an arguably “smaller” issue like biofuels and the Renewable Energy Directive. It is a harbinger of future policy directions. Europe can safely assume it will have to defend the RED in court since it is used to discriminate against foreign biofuels. It is also likely it will lose. That would be a high price for a trade-restrictive policy with only small potential environmental benefits in the biofuels sector but that would slow down the shift away from fossil fuels.