Can Trade Policy Help Combat Climate Change?

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The Issue:

Greenhouse gas emissions from developing economies have risen markedly and account for an increasing share of global emissions. Although many developing economies have signed international climate agreements few have instituted emission trading systems or imposed carbon taxes to limit greenhouse gas emissions. There is a “free riding” problem: Countries have strong incentives to benefit from other countries’ costly emission reductions while not reducing their own emissions. To tackle free riding, experts have proposed that governments committed to addressing climate change use trade penalties to encourage other countries to engage in greater levels of greenhouse gas abatement. How effective could this be in curbing global emissions?

Trade policy could help reduce carbon emissions significantly. But simply adding carbon border taxes to the existing tariff system is not very effective.

The Facts:

• Developing economies are critical to reducing greenhouse gas emissions and mitigating the impacts of climate change. Although developed countries are responsible for the bulk of historical carbon emissions, cutting current emissions from developing countries has become increasingly important for limiting the impacts from climate change. In 2022, developing nations accounted for 67% of worldwide CO2 emissions, a notable increase from 45% in 1990. During this period, while CO2 emissions from OECD countries experienced a slight decline, emissions from non-OECD countries, often referred to as developing economies, surged by 141%, equivalent to an annualized growth rate of 2.8% (authors’ calculation based on data from the Global Carbon Project, 2023). Current projections indicate that this trend is likely to persist in the coming years. 
• Developing countries also face disproportionately higher costs from climate change compared to developed nations. All countries can expect to experience some degree of climate change damage from carbon emissions. However, the extent of the damage varies greatly from country to country, with some countries likely to experience proportionally much higher costs than others. When considering the country-specific costs of carbon emissions per unit of GDP, developing countries, on average, bear costs that are 10 times greater than those faced by developed countries, according to our calculations based on estimates from a study published in Nature Climate Change. This disparity highlights the increased vulnerability of developing nations to the consequences of carbon emissions. 
• Raising carbon prices in developing economies is crucial for combating climate change, as these countries often lack carbon pricing initiatives. Setting a price on carbon emissions — through a carbon tax, emission trading system, or other policy tools — incorporates the cost of pollution in production decisions and can play a key role in reducing emissions (see here). The World Bank's 2022 report on carbon pricing finds that only 23% of global greenhouse gas emissions were subject to carbon pricing initiatives, and that these were primarily implemented in developed countries. As a result, implementing higher carbon prices in developing economies is essential for achieving meaningful reductions in carbon emissions worldwide.
• Climate-conscious governments could use trade policy as a tool to address free riding. Border tax measures can be used in two ways to curb carbon emissions. The first involves “carbon border taxes,” which are tariffs levied on imported goods based on the greenhouse gas emissions from production in their country of origin. The second approach uses border taxes as a punitive and contingent mechanism within a “climate club” framework. Here, countries that adopt appropriate carbon prices are rewarded with lower or no border taxes, while non-cooperative (free riding) countries face border tax penalties. In practice, climate policies incorporating border tax measures often blend elements of both approaches. The European Union’s Carbon Border Adjustment Mechanism (CBAM) launched in October 2023, is a prime example. The CBAM taxes the carbon content of imports at the EU borders, like the first approach. However, it also includes a contingent element akin to the second approach, exempting exporting countries that implement adequate carbon reduction measures.
• The extent to which carbon border taxes imposed by individual countries can reduce global emissions is fairly limited. Carbon taxes imposed on goods that are traded cannot be as effective as within-country carbon pricing. Most global carbon emissions are due to non-traded goods, which cannot be subjected to border taxes. Services — including Construction, Wholesale and Retail, and Transportation —  which are less traded, account for 47% of global CO2 emissions from production, according to our estimates. Meanwhile, the Electronics & Machinery, Textile, and Motor Vehicle industries that have high trade-to-GDP ratios, collectively account for only 6% of the global CO2 emissions from production, according to our estimates (see Table 1, page 28). 
• Non-contingent carbon border taxes implemented using standard tariff lines are incapable of singling out specific firms with high emissions. Most tariff lines are populated by numerous exporting firms from each country. For instance, the median 6-digit Harmonized System (HS) product code is served by more than 18 exporting firms per country, after adjusting for exports volumes, according to the World Bank's Exporter Dynamics Database. Furthermore, the top 25% of 6-digit tariff lines are served by over 50 exporting firms per country. This lack of targeting granularity means that individual firms have little incentive to reduce emissions when faced with carbon border taxes. Our projections suggest that non-contingent carbon border taxes can achieve at most a 1.2% reduction in global emissions, which is only 3.2% of the 37.6% reduction required to effectively address the free-riding problem (see chart).
• The “climate club” model in which a group of countries with ample market power work together to use border penalties as an instrument to reduce global emissions could be highly effective according to our projections. In the climate club model, proposed by William Nordhaus, a group of founding members establish the climate club and leverage their collective, contingent trade penalties to encourage participation of reluctant governments. To join the club, countries must commit to meeting a specific domestic carbon price target (which would cover both tradeable and non-tradeable sectors). Our analysis reveals that such a hypothetical climate club initiated by a coalition of the EU, US and China could achieve 69% of the emissions reduction achievable under globally optimal carbon pricing, while ensuring global participation and upholding free trade. However, the club's effectiveness would decrease to 45% if China were not part of the founding coalition and to 33% if the EU were the only founding member (see chart). The success of the climate club, therefore, depends on an alliance of founding members with ample market power and selecting an appropriate carbon price target — one that is large enough to bring about emission reductions but not so large that it discourages membership.
• The success of the GATT/WTO in regulating free trade in the second half of the 20th century can serve as a model for implementing a more holistic approach that links free trade to climate action. The General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO) successfully promoted free trade through a multi-decade process, with the WTO's dispute settlement mechanism allowing retaliation as a means to deter non-cooperation and enforce the provision of free trade as a global public good. The climate club model bears similarities with the WTO's structure and can follow a similar path, unfolding as a gradual process in which countries seek membership and then take climate action as members. The key difference compared to the GATT/WTO is the emphasis on linking trade policy to climate policy, making the benefits of free trade contingent not only on reciprocity but also on adequate climate action (see here for a discussion of remaking the global trading system to focus on sustainability).