In a world in which nations adopt heterogeneous climate policies to reduce emissions of greenhouse gases, a nation that adopts a more stringent policy than its trading partners may place its producers at a competitive disadvantage when imports come from nations in which emissions are subject to relatively lax regulations.  Proponents of a carbon tax or a cap-and-trade system as a national climate policy often advocate a “border adjustment” as an instrument to address this disadvantage.  A border adjustment may take the form of a tax imposed on imports that is designed to offset the competitive disadvantage imposed on domestic producers by national climate policies.  Such a border adjustment would help mitigate climate change through at least two channels:

First, by offsetting the competitive disadvantage imposed by relatively ambitious climate policies, this border adjustment would remove an incentive for consumers to shift their demand from domestic producers subject to strict regulations to foreign producers subject to more lax regulation.  Without this border adjustment, domestic demand would shift toward imports, thereby expanding production in relatively unregulated economies and causing increased emissions abroad, which would undermine the effectiveness of the importing country’s climate policies.  One environmental purpose served by this border adjustment would be the prevention of this “carbon leakage.”

Second, by restricting imports from relatively unregulated countries, border adjustments would reduce demand for the exports from those countries, and the threat of this economic harm may promote political support for more ambitious climate policies in exporting countries.  More stringent regulations in an exporting country would reduce emissions in that country, which the importing country could reward with relief from the import tax imposed as a border adjustment.  Border adjustment could thereby create incentives for exporting countries to adopt more stringent climate policies and reduce the incentives for these countries to enjoy a “free ride” on the more ambitious climate policies adopted by importing countries.

As these remarks suggest, an importing country would have to design its border adjustment carefully to serve these two environmental objectives effectively.  To prevent carbon leakage and to create incentives for more stringent climate policies, a border adjustment must be sensitive to the climate policies adopted by the exporting country.  If the exporting country has climate policies equivalent to those adopted by the importing country, for example, then the importing country has no environmental rationale for a tax on imports from that exporting country.  An import tax on this exporting country would only protect domestic producers from legitimate import competition and would represent the type of protectionist measure that the architects of the international trade regime sought to prevent through the adoption of the General Agreement on Tariffs and Trade (GATT) and the creation of the World Trade Organization (WTO).

The GATT imposes various legal restrictions on tariffs, including the Most Favored Nation (MFN) obligation in GATT Article I and the tariff commitments in GATT Article II.  Some advocates of a carbon tax have suggested that GATT parties could justify border adjustments for carbon taxes as border tax adjustments authorized by an explicit exception to the Article II tariff commitment.  This exception appears in GATT Article II:2(a) and allows parties to impose “on the importation of any product … a charge equivalent to an internal tax … in respect of the like domestic product or in respect of an article from which the imported product has been manufactured or produced in whole or in part.”  Proponents of this theory claim that energy may be “an article from which the imported product has been manufactured,” so that a carbon tax on energy sources may be “an internal tax” that qualifies for a border tax adjustment.

This claim is questionable as a legal matter.  Skeptics believe that an input like energy, which is consumed in the production process, is not “an article” that qualifies for the Article II:2(a) exception because it is not physically incorporated into the imported product.  The French version of the GATT, which is as authoritative as the English version, seems to be more explicit in requiring physical incorporation of the taxed input into the imported product.  Furthermore, the use of the Article II:2(a) exception would be even more dubious if national climate policy takes the form of a cap-and-trade system or command-and-control regulations rather than a carbon tax.  It would be difficult to characterize these regulations as “an internal tax.”

Moreover, the legal doctrines that apply to border tax adjustments, which the GATT parties designed for sales taxes and other taxes applied to products, are poorly suited to the policy objectives of border adjustments for national climate policies.  In particular, nothing in the law of border tax adjustments under Article II:2(a) would require an importing country to consider the climate policies of the exporting country when imposing a charge on imports from that country.  Indeed, discrimination based on the policies of the exporting country would violate the MFN obligation in GATT Article I.  Thus, the use of the GATT Article II:2(a) exception for climate policies would be misguided as a normative matter, and the WTO should read this exception narrowly to require physical incorporation of “an article” to qualify for this exception.

The WTO should instead evaluate border adjustments for climate policies under the exception in GATT Article XX(g) for “conservation” measures, and importing countries should design border adjustments for climate policies with this exception in mind, not the exception in Article II:2(a).  WTO case law indicates that in order to justify a trade restriction as a measure to protect natural resources in the global commons under Article XX, the importing country must take into account “policies and measures that an exporting country may have adopted,” so as not to discriminate against countries with environmental policies “comparable in effectiveness.”  Under this Article XX case law, the WTO should give its members broad leeway to impose import restrictions designed appropriately to promote reductions in greenhouse gas emissions in exporting countries.

Howard F. Chang is the Earle Hepburn Professor of Law at the University of Pennsylvania Law School

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