Green Trade Liberalization

By
Securing the future
Green Trade Liberalization - Alireza Naghavi

Abstract

This paper explores three crucial contemporary issues to reveal the consequence of tariffs as instruments to overcome environmental concerns. In other words, we try to find under what circumstances tariffs can be considered green policy instruments. Starting with conventional trade theory, we study how country characteristics, including environmental policies, can determine each country’s comparative advantage. We then study how governments may create “pollution havens” by setting lax environmental standards in order to maintain international competitiveness. Finally, we look at the role of multilateral trade organizations such as the WTO in muddling with international environmental agreements. Using conventional theory along with contemporary environmental concerns, we argue the need for a new phase of globalization, namely one accompanied by ‘green’ trade liberalization.

Introduction

The link between globalization and environment has warranted considerable attention not only by economists, but also by environmentalists, multinational enterprises, local governments, and international policy makers. The contradicting views over the issue have raised much unresolved debate on the role of trade barriers in attempting to tackle the negative environmental spillovers of globalization. This study makes an effort to bring together different perspectives from different groups mentioned above in order to reach a better understanding of the problem. In particular, we start by showing how the viewpoints of governments in developing countries with respect to tariffs paradoxically coincide with that of multinationals, and how the interests of environmental NGOs could be in harmony with those of governments of industrialized countries. We then continue by exploring three crucial contemporary issues in detail to reveal the consequence of tariffs as instruments to overcome environmental concerns. In other words, we try to find under what circumstances tariffs can be considered green policy instruments.

Starting with conventional trade theory, we study how country characteristics, including environmental policies, can determine each country’s comparative advantage. We focus on how trade may affect the composition of industries in each country, and in turn how tariffs can reverse this trend. We then discuss whether this could have positive consequences on the environment, i.e. whether tariffs are green.

We then study how governments may purposefully set lax environmental standards in order to maintain international competitiveness. Theories have hypothesized that the increased production costs incurred by firms as a result of stricter environmental standards leads to their escape to “pollution havens”. We further build a simple model to show how tariffs could be green by blocking pollution-related delocation, while maintaining foreign investment led by other motives.

Finally, we turn towards the role of multilateral trade negotiations and organizations such as the WTO in meddling with international environmental agreements. In fact, there are about 200 multilateral environmental agreements (MEA) in place today, of which only 20 contain trade provisions. Loopholes currently allow non-signatories to use their WTO rights to protest trade restrictions put against them by a MEA. There have been suggestions to authorize the use of trade measures against non-compliance, denying a non-signatory of its WTO rights to exercise countervailing tariffs. We show how allowing rivals of a nonsignatory country to impose tariffs on its imports for having laxer environmental regulations in the case of non-compliance can clarify this relationship between WTO rules and specific trade obligations set out in MEAs.

We conclude by a discussion on the policy implication of tariffs with respect to the environment. Using conventional theory along with contemporary environmental concerns, the paper brings to light a need for a new phase of globalization, namely one accompanied by green trade liberalization.

The rest of the paper is as follows. Section 2 provides a brief discussion on the different viewpoints of governments, NGOs, and multinational enterprises on the issue of trade and environment. Section 3 looks at trade and environment in a comparative advantage context using conventional trade theory. Section 4 studies the location of firms and how “pollution havens” may be avoided through tariffs. Section 5 looks at the present conflicts between international environmental and multilateral trade agreements. Section 6 concludes by providing policy implications with respect to green tariffs.

Globalization and the Environment: A General Perspective

The link between trade liberalization and environmental protection is increasingly gaining importance with the latter constituting a bigger part of WTO rounds in recent years. The primary debate led by environmentalist NGOs is that trade liberalization damages the environment. One argument has been that in the absence of trade policy instruments, governments may be tempted to distort their environmental policies to protect their domestic economy. If allowed, they can impose a loose regime of environmental regulation for fear that tougher environmental policies may damage the competitiveness of their firms. Interestingly this argument is often shared by governments in developed countries, who tend to continuously push for a cleaner environment. At times such a move is justified and could be thought of in altruistic terms. However, there is no clear line to divide such altruism with the intention of some governments to use environmental arguments for protectionist purposes to their advantage.

Lax environmental policies may also cause domestic firms to relocate plants abroad to pollution havens, or close down altogether in response to foreign competition that faces less strict environmental regulation and hence lower production costs. This has created reluctance by developing countries, at least in the beginning stages of their development process, to adopt tougher environmental measures. They see the entry of multinationals, be it clean or dirty, as an instrument of growth and prosperity. This has created problems in the participation of many developing countries in international environmental agreements pushed by the rest of the world. Again, paradoxically, such views are shared by profitmaximizing multinationals, which base their decisions on productivity. In an era of rising foreign direct investment and capital mobility, countries with lax standards can be a useful resource for polluting firms. In addition, trade costs, for green or protectionist purposes, are viewed negatively by multinationals, which are involved in inter and intra industry trade to transport intermediate goods to the production sites, and final goods to the target markets. In the next three chapters we make an attempt to take a closer look at these contradicting viewpoints from a theoretical perspective to get a broad picture of the links between tariffs and the environment. We then hope to use the arguments to find whether there exists a justification for tariffs on environmental grounds, in a rapidly globalizing world.

Trade, Environment, and Comparative Advantage

The link between trade and environment has been widely studied in general equilibrium models, such as Copeland and Taylor (1994).1 In particular, their analysis looks at how trade liberalization between two countries could affect the environment when pollution is not trans-boundary and remains in the region where it is produced.

An easy way to summarize these effects is to consider two countries, the North and the South. The countries are assumed to be identical, apart from their environmental protection laws. The North is assumed to enforce some form of environmental standards, while the South enjoys the possibility of using environmentally unfriendly production processes at no extra costs. Finally, to keep the argument simple, we assume firms to be immobile in this section, i.e. remain in their country of origin before and after trade liberalization.

 The impact of globalization on the environment is broken into the three effects: the composition effect, the scale effect, and the technique effect.

The composition effect represents trade-induced specialization in the world, similar to the familiar comparative advantage argument studied in conventional international trade theory. Here, the comparative advantage is based on the difference in environmental standards in the two countries. When firms in the North are obliged to pay a cost to produce polluting goods, they have a comparative disadvantage against firms in the South that can do so without any penalty. This makes the North specialize in a subset of less polluting goods and import the dirty goods from the South. The South similarly specializes in the production of polluting goods and imports clean products from the North. This changes the composition of the industries in the two countries. The expanding clean export sector in the North results in a cleaner environment there, while the expanding dirty export sector in the South results in more pollution in the South. The composition effect has been summarized in Figure 1.

The scale effect on the other hand simply refers to the market size for each industry. Its impact on the environment is thought to be negative, as an expanding demand vis-à-vis globalization requires more production by each firm. As more production is in one way or another associated with more emission, all else equal pollution tends to increase in both regions.

Finally, trade liberalization is often associated with growth. Economic growth and development in turn increases the willingness of citizens in a country to pay for goods produced according to stricter environmental standards. As countries develop and the importance of the basic necessities of life turns towards a better quality of life, the technique effect gains significance. A desire for new green technologies accompanied by growth hence reduces the pollution per unit, and given the composition and the scale effect, has a positive effect on the environment. If trade makes the North grow faster, then the overall pollution in the world tends to increase as dirty production remains in the underdeveloped parts of the world. On the other hand, if trade makes the South grow faster so that the gap between the two regions decreases, overall pollution falls as environmental regulation is strengthened in regions, where most of polluting activities are located.

The total effect of trade on environment depends on the combination of these three effects and the strength of each. Copeland and Taylor (1994) for instance show that if the demand for environmental quality increases more than proportionally with income, it is possible for the technique effect to neutralize the scale effect. However, it could not neutralize both the scale and the composition effect for the South. Therefore, trade liberalization is known to mitigate environmental problems of industrialized countries and magnify those in developing countries. This gives rise to proposals to levy a green tax against the imports of dirty goods from the South. The direct effect of such action would be on the demand of dirty goods from the South, therefore creating incentives for an upgrading of production techniques, which would then go hand in hand with an expansion of the market via globalization, i.e. green trade liberalization.

Pollution Havens and Firm Location

In this section we move to a partial equilibrium model to study the decision of firms with regards to the location of their production activities, given environmental standards in the two countries and trade policy. Theoretical literature on environmental policy and the location of firms goes as far back as Markusen, et al. (1993).2 They look at exogenous trade costs and environmental policies and show that the latter can have a very strong impact on a firm’s decision about location when firms are “footloose”. Motta and Thisse (1994)3 consider a different setting where firms are initially established in their country of origin and do not incur any fixed cost when operating at home. They also examine the impact of a country’s exogenous environmental policy on the location and production choices of the firm. They show that a firm is less likely to relocate as a response to environmental policies because fixed costs of establishing a domestic plant are sunk when the game begins. Hoel (1997)4 extends the study to endogenize environmental policy demonstrating that governments have an incentive to choose loose environmental standards to attract firms as long as the disutility from pollution is not high enough to promote a ‘Not in My Back Yard’ policy. Finally, Ulph and Valentini (2001)5 show on the contrary that environmental dumping is greater when plants are ‘not’ footloose as this can create strategic rent-shifting incentives for governments.

We adopt a similar partial equilibrium approach as previous literature on environmental policy and firm location with two countries: the North and the South. The regions remain symmetric in all aspects aside from their environmental regulations. The model assumes two firms with one belonging to each country. The Northern firm observes environmental policy and tariffs and chooses a location for its production. It then competes in production with a Southern firm in the second stage.

The Model

The North is assumed to enforce environmental standards by imposing a pollution tax on emissions released by firms during production. The South in contrast can choose whether and to what extent to adopt standards.6 Lower standards allow local as well as foreign firms operating in the South to produce without any additional charges for causing pollution. There is however the possibility of a punishing tariff in this case set by the North against all dirty imports from the South, including re-exports of the Northern firm.7

The two firms produce one homogeneous good and compete in an oligopolistic manner à la Cournot. Firms compete in segmented markets and choose the optimal output for each market separately. The Northern firm is a multinational and can decide on production location. It can stay at home and serve both markets from its Northern headquarters. It can also build a subsidiary in the South to serve the Southern market, but still maintain production in the North to serve its home interests. Alternatively, it can close down home production altogether and completely delocate for pollution-related purposes to serve both markets from the South. The Southern firm on the other hand is assumed to be a local firm for simplicity and only produces in its domestic country.

Demand is assumed to be linear and takes the familiar form

where Q is the total consumption in each region, and subscripts N and S represent the North and the South. Total consumption in each region is

where the first subscript of q indicates where the good is produced and the second denotes where it is consumed. Superscript E represents the case where the Northern firm produces only in the North and exports to the South, F when it undertakes FDI to serve the Southern market locally, and D when it completely delocates and re-exports back to the North. The tilde above q denotes a situation where both firms produce in the South, while a star distinguishes Northern foreign production from local output by the Southern firm. The costs of production are divided between non-pollution related costs c and pollution tax Γ paid on emissions that are released from producing one unit of the good.

Looking at the case of non-compliance in the rest of this section, the profit function for the Northern firm when all of its production takes place in the North is

where e0 represents the unit emission discharged by each firm. It also denotes the pollution intensity of the industry at hand. This locational scenario implies that the Northern firm must pay a pollution tax on its entire production. When it builds a subsidiary in the South to serve each market locally, it only pays a pollution tax on the goods it produces in the North for the domestic market:

G is the fixed cost of setting up a plant abroad which is independent of output.

If the Northern firm completely delocates to serve both markets from the South, it avoids paying pollution taxes altogether, but is bound to pay tariffs on its exports back to the North:

The profit of the Southern firm takes the form

for each scenario that prevails subsequent to the Northern firm’s decision on production location. Recall that there is no environmental tax enforced in the South here, but a tariff is paid on Southern exports to the North.8 Adopting backward induction, section 4.2 first solves the problem of firms in the final stage where they compete in output.

PRODUCTION

In the export case, production by the Northern firm in the North for each market is

While the Southern firm produces

Inequality t > 2te0 - 1  is a constraint for qNN> 0 to hold so that the Northern firm continues to serve its home market through local production.9 Also, t < (1 +τe0 ) / 2 is a necessary condition for the Southern firm to maintain its exports to the North, i.e. for qSN> 0. This threshold value of t stops the importation of all dirty products to the North by blocking trade and gives the Northern firm a monopoly position in its home market. Such prohibitive tariff rates denote a complete ban on imports from the South making values of t above this level irrelevant for the analysis. In the case of FDI, qNN and qSN remain similar to (5) and (8) as the Northern firm keeps producing for its home market from a local plant. It however builds a subsidiary in the South to serve the latter locally, making the output aimed at the South

for both firms. When the Northern firm delocates, production for the Southern market by both firms remains the same as (7’). The Northern firm also produces for its domestic market in the South and re-exports back to the North, making production by both firms aimed at the North

If the Northern firm produces at home for the domestic market, the direct effect of tariffs is to increase local production in the North and reduce imports from the South. Stricter standards per se have the reverse effect of reducing Northern production and encouraging production by the Southern firm. When the Northern firm exports to the South, τ  affects the entire production by both firms, whereas with FDI only goods targeted at the Northern market are influenced. As under FDI both firms produce in the South for the Southern market where no pollution tax exists, the optimal quantity produced by both firms resembles that in a typical Cournot case. Finally, if the Northern firm completely closes down production in the North and establishes a plant in the South to serve both markets, pollution taxes become irrelevant and tariffs reduce the exports of both firms to the North.

Location

In the first stage of the game, the Northern multinational must choose where to locate to serve each market. By substituting the optimal output back into the Northern firm’s profit function and comparing the profits for each case, we can find the locational outcome that yields the most profits. Northern profits for each scenario are simply

Looking first at profits of keeping all production in the North against establishing an extra plant in the South, we can see that in the absence of relocation costs Γ, a firm would always be better off by serving each market through a local subsidiary.

When fixed costs are below this level, costs of relocation are sufficiently low making FDI the preferable scenario. Otherwise, relocation is too costly and the Northern firm keeps all production at home anyway leaving no concern about the supplementary influence of environmental policies on firm location. This scenario reflects a situation where there is no threat of relocation due to very high plant-specific fixed costs, or inflexible foreign investment laws and political instability in the host country. As we are interested in a case where relocation is at least partly an option, this paper focuses on a situation with sufficiently low fixed costs of relocation. The export scenario where the Northern firm keeps all production in the North is therefore ruled out under asymmetric standards.10

We can now concentrate on the comparison between profits under FDI and delocation to distinguish between the standard form of capital movement and relocation due to pollution-related reasons. The threshold tariff rate, below which the Northern firm completely delocates, is the t that makes profits under the two options equal

Figure 2 shows the locational choice of the Northern firm in the space of ? and t for an emission level of e0=1. It is easy to see that a higher pollution tax in the North makes delocation to the South more attractive. The shaded area shows the region where tariffs halt trade. dt¯ / dτ > 0  implies that tougher standards require a higher tariff on dirty goods from the South to impede delocation. We can also see that in the case of free trade, profits of completely delocating to the South are always higher than having local facilities in each country. This reinforces the complementary nature of economic integration and environmental standards by showing that without a trade policy, the smallest amount of pollution tax could result in complete delocation of multinationals to countries with lax environmental regulations. As tariffs rise, delocation becomes less attractive for a larger range of Northern pollution tax. As a result, our location model shows another scenario, where green trade liberalization is called for to avoid the movement of multinationals to regions where global nvironmental regulations are not recognized.

Conflicts Between MEAs and the WTO

Global enforcement of environmental standards through the WTO is moving closer to realization with the latter devoting greater attention to environmental negotiations in recent rounds. A significant part of the Doha declaration in 2001 for instance dealt with trade and environment. In fact, there are about 200 MEAs in place today, of which only 20 contain trade provisions. Examples are the Montreal Protocol on substances that deplete the ozone layer, the Convention on Biological Diversity, the Convention on International Trade in Endangered Species, the Basel Convention on the international movement of toxic waste, and the United Nations Framework Convention on Climate Change and its Kyoto Protocol aimed at curbing emissions of greenhouse gas.  Loopholes currently allow non-signatories to use their WTO rights to protest trade restrictions put against them by an MEA. This has lead to suggestions to eliminate such free riding opportunities by only allowing WTO members that are also parties to a MEA to practice their WTO rights. As a first step, ministers have agreed in the new Article 31 (i) of the Doha text to launch negotiations on the relationship between existing WTO rules and specific trade obligations set out in MEAs.11 The WTO in this case could give a signatory country the choice to accept greater economic integration with another country only if the latter agrees to ratify and adopt stronger environmental standards. In other words, it allows rivals of a nonsignatory country to impose punishing tariffs on its imports for having laxer environmental regulations in the case of non-compliance.12

The so called green tariffs in this case simply reflect a possibility for signatories of MEAs to successfully enforce the measures set out in the agreement. As it can be seen in Figure 3, the trade rights of a WTO member allow it to protest any trade sanctions put against it on the basis of production and process methods. This clearly weakens any environmental agreement between two WTO members by allowing a non-signatory to ignore the trade obligations of an agreement or put a countervailing tariff against the imposing country. The eligibility of green tariffs in this case again proves important for a successful implementation of globally recognized environmental agreements. An alternative proposal to resolve such conflicts is to oblige WTO members to also be signatories of a treaty accepted by a majority of its members. This once again hints at a process of “green trade liberalization”, where members of a multilateral trade agreement must also take the environmental into consideration while lowering their trade barriers.

Conclusion

This paper studies the importance of tariffs for a sustainable process of globalization. It particularly attempts to analyze the issue from a trade perspective, to see when and why a move towards a more green procedure of trade liberalization is called for.

  1. Hinting at a general equilibrium model of environment, trade, and competitive advantage,
  2. building a partial equilibrium to study the location decision of firms based on tariffs and environmental policy, and
  3. revealing a clear conflict between WTO rules and trade obligations set by MEA,

we argue that tariffs may not necessarily be taboo as often thought of by trade economists.  The paper shows that tariffs could be green by blocking specialization of dirty production in regions with no environmental standards, by deterring the movement of firms to pollution havens, and by facilitating the implementation of globally recognized environmental treaties.

We found that unlike conventional environmental policy recommendations, a successful policy to control pollution could only be optimal when it is a mix of complementary measures. Since a pollution tax alone may not be an effective policy tool, its role must be reassessed and trade obligations must be considered when reaching out for environmental targets.

The arguments in the paper are only a cornerstone to highlight the basic roles of tariffs and the potential need for them to achieve a green round of globalization. It is also important to look into more direct measures of improving the environment such as abatement R&D subsidies to avoid creating a distortion. It must however be taken into account that such subsidies must be financed from costly taxation.

As the value of the environment continues to be recognized by a higher proportion of the world population, the demand for such distortions, even at a global level, is expected to rise. Globalization is indeed a one-way street, yet it remains to be studied how to make it sustainable and minimize its potential externalities. An important step could be to initiate the involvement of international institutions with credible enforcement power, such as the WTO.

                                         

WORLD POLLUTION: HIGHER (dirty firms in South with no standards)

Notes & References

  1. Copeland, Brian R. and M. Scott Taylor. “North-South Trade and the Global Environment.” Quarterly Journal of Economics 109 (1994): 755-87.
  2. Markusen, James R., Edward R. Morey and Nancy Olewiler. “Environmental Policy when Market Structure and Plant Location are Endogenous.” Journal of Environmental Economics and Management 24 (1993): 69-86.
  3. Motta, Massimo and Jacques-Francois Thisse. “Does Environmental Dumping Leadto Delocation?” European Journal of Economics 38 (1994): 563-76.
  4. Hoel, Michael. “Environmental Policy with Endogenous Plant Locations.” Scandinavian Journal of Economics 99 (1997): 241-59.
  5. Ulph, Alistair and Laura Valentini. “Is Environmental Dumping Greater When Plants are Footloose?” Scandinavian Journal of Economics 103 (2001): 673-88.
  6. This decision remains exogenous to simplify the model and focus on the locationchoice of the multinational.
  7. Note that the model only considers goods that are directly related to the environmentalproblem.
  8. Tariffs and pollution taxes have been normalized to the market size to allow for the elimination of (a-c) from all upcoming equations.
  9. It will be seen that this constraint is never binding as it coincides with the scenario of complete delocation, where the Northern firm does not produce at home and no longer pays an emission tax.
  10. The dividing line between the export and the FDI case has been studied in Motta andThisse (1994). It plays a more important role in their analysis, as they also look at differences in the market size between regions and changes in fixed costs of establishing a plant.
  11. WTO ministerial conference in Doha originally set Jan. 1, 2005 as the deadline fornegotiations on clarifying the relationship between WTO rules and the trade obligations established by the MEAs. No consensus has since been reached to produce a new mandate or reaffirm the existing timeframe.
  12. See http://www.wto.org/english/thewto_e/minist_e/ min01_e/mindecl_e.htm.
Dr. Alireza Naghavi is Adjunct Professor of International Economics and Assistant Professor of Economics at the University of Modena and Reggio Emilia. He is visiting Assistant Professor at the University of Bologna. He received his Ph.D. in economics from the University College Dublin (Ireland), his M.A. in economics from the University of Konstanz (Germany) and his B.S. in business administration from Louisiana State University (U.S.).