Climate Change 2001:
Working Group III: Mitigation
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5.3.4 Trade and Environment

The barriers discussed in this section pertain to the whole economy of a country, and constitute a type of market failure. They inhibit the implementation of mitigation options indirectly by maintaining conditions in which investments in energy efficiency and fuel switching are ignored, undervalued, or considered too risky by economic actors.

High tariffs on imported goods or policies that constrain entry of imported products into the market can prevent new and GHG-efficient technology from entering the country. Since countries often rely on imports for high-efficiency equipment, duties can raise the price of imported equipment considerably. When both types of equipment are imported, the duty raises the price differential between the two.

An example of the limitations created by government regulation was a high import duty imposed on CFLs in Pakistan. When this duty was reduced from 125% to 25% in 1990, the price of CFLs dropped by almost half, and sales started to rise, leading to improved energy efficiency (US AID, 1996).

Government regulations that prohibit foreign firms from bidding on the construction of new industrial factories or power plants limit a country’s access to new foreign technology. Conditions that constrain the entry of imported products, while beneficial in establishing a new industry or in achieving rapid expansion of an existing one, can also lead to the use of obsolete technology. The history of government intervention to address a severe paper shortage in India during the early 1970s illustrates this barrier. To address the shortage, the Indian government promoted the establishment of small paper mills that could be quickly set up (Datt and Sundharam, 1998). This led to the import of inexpensive energy-intensive and highly-polluting second-hand paper mills that were set up in many regions of the country. The inefficient mills grew to account for 50% of the country’s paper production. Then, in 1988, the government removed the protection it had accorded the paper industry, which led to the shutdown of many of these small, inefficient plants. The elimination of government protection will in the long run increase GHG efficiency and economic productivity.

The transfer of modern technology takes place mainly through licensing of designs for local production, joint ventures, and export and/or import. Practices of transnational corporations, and policies of countries can inhibit these modes of technology transfer. Also, large fluctuations in exchange rates and inflation can inhibit capital flows. The fuel economy of motor vehicles across developing countries varies with the type of technology that is imported. Countries either import new (high fuel economy) or used (mostly lower fuel economy) motor vehicles, manufacture vehicles with outmoded low fuel-economy technology (Ambassadors in India or the VW Bug in Mexico and Brazil, the VW Jetta in China), and/or manufacture modern vehicles with some domestic components (Nissan in the Philippines, Maruti/Suzuki in India) (Sathaye and Walsh, 1992). Lack of suitable local firms to supply components and services, limited access to capital, and restrictions on repatriation of foreign exchange are some of the conditions that slow the introduction of modern efficient vehicles (Davidson, 2000, Section 8, Transportation).

There is not much empirical evidence for a relationship between trade and environmental regulation (Cropper and Oates, 1992; Rauscher, 1999) though there is a little more in the direction of the impact of trade on the environment (van Beers et al., 1997). This lack of empirical relationship is caused by two reasons. First, it is most cost effective to use the same technology everywhere and, therefore, to operate everywhere according to the most stringent environmental regulations (Levinson, 1994). Second, the industry cost of environmental regulation is too small relative to other costs, such as labour, to weigh heavily in location decisions (Dean, 1992; Jaffe et al. 1995; Markusen, 1999; Steininger, 1999). In particular, there is little empirical evidence that developing countries tend to become pollution havens. This is because their production is primarily for the domestic market, their comparative advantage lies in less-polluting labor-intensive sectors, and weak environmental standards often go hand in hand with other factors that deter investment such as social capital weaknesses (Frederikson, 1999; Markusen, 1999). There is no empirical evidence of systematic FDI in polluting industries (Leonard, 1988). The environmental effects of trade liberalization seem to be highly country- and policy-specific (Frederikson, 1999).

There is also little evidence, both on theoretical and empirical grounds, of a “race to the bottom” when other countries use environmental standards to retaliate against trade measures. A globally optimal solution remains a combination of free-trade and co-operative environmental policies. This does not mean that, as environmental resources become scarcer, free trade may not generate negative environmental impacts under some circumstances as suggested by theoretical models (Copeland and Taylor, 1994; 1995). Little is known both theoretically and empirically about the links among trade, environment, and innovation (Carraro, 1994, Steininger, 1999). There is also little evidence, both theoretical and empirical, in favour of the Porter Hypothesis that stronger environmental regulation creates a long-term technological advantage (Jaffe, 1995; Ulph, 1997). Regulatory capture through which interest groups striving for protection against foreign competition lobby against environmental standards and for environmental tariffs is a possible barrier to diffusion of technology. Capture is less likely under a market-based instrument approach to environmental policy, which regulates polluting substances than under a command-and-control one, which regulates polluters. This is because the former raises the cost of lobbying and decreases the agency problem as the regulated group is larger and more heterogeneous under the former regime than under the latter and has no incentive to hide information from the regulator (Rauscher, 1999). Many international environmental agreements allow for trade sanctions. Though, in a less than efficient world, trade sanctions for environmental violations can be justified, the latter are discriminatory and may jeopardize diffusion of required technologies (Rauscher, 1999).

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