Trade and Climate Change

Trade and climate change: theory and evidence

The 60 years prior to 2008 have been marked by an unprecedented expansion of international trade. In terms of volume, world trade is nearly 32 times greater now than it was in 1950, and the share of global GDP it represents rose from 5.5 per cent in 1950 to 21 per cent in 2007.

This enormous expansion in world trade has been made possible by technological changes which have dramatically reduced the cost of transportation and communications, and by the adoption of more open trade and investment policies. The number of countries participating in international trade has increased: developing countries, for instance, now account for 34 per cent of merchandise trade – about double their share in the early 1960s.

This expansion in trade raises questions such as: “Will trade opening lead to more greenhouse gas emissions?” and “How much does trade change greenhouse gas emissions?” Trade opening can affect the amount of emissions in three principal ways, which are typically referred to as the scale, composition and technique effects.

The scale effect refers to the expansion of economic activity arising from trade opening, and its effect on greenhouse gas emissions. This increased level of economic activity will require greater energy use and will therefore lead to higher levels of greenhouse gas emissions.

The composition effect describes the way that trade opening changes the structure of a country’s production in response to changes in relative prices, and the consequences of this on emission levels. Changes in the structure of a liberalizing country’s production will depend on where the country’s “comparative advantage” lies. The effect on a country’s greenhouse gas emissions will depend on whether a country has a comparative advantage in emission-intensive sectors and whether these sectors are expanding or contracting.

The composition of production in an economy that is opening its markets to trade may also be a response to differences in environmental regulations between countries (resulting in the “pollution haven hypothesis”, which suggests that high-emission industries may relocate to countries with less stringent emission regulation policies).

Finally, the technique effect refers to improvements in the methods by which goods and services are produced, so that the emission intensity of output is reduced. This is the principal way in which trade opening can help mitigate climate change. A decline in greenhouse gas emission intensity can come about in two ways. First, more open trade can increase the availability, and lower the cost of, climate-friendly goods and services.

This will help meet the demand in countries whose domestic industries do not produce these climate-friendly goods and services in sufficient quantities or at affordable prices. Such potential benefits of more open trade highlight the importance of the WTO’s current trade negotiations under the Doha Round, which aim to open markets for environmental goods and services.

Second, as income levels rise because of trade opening, populations may demand lower greenhouse gas emissions. For rising income to lead to environmental improvement, governments must supply the appropriate tax and regulatory measures to meet the public’s demand. Only if such measures are put in place will firms adopt cleaner production technologies, so that a given level of output can be produced with fewer greenhouse gas emissions.

It has been pointed out, however, that the positive link between per capita income and environmental quality may not necessarily apply to climate change. Since greenhouse gas emissions are released into the atmosphere, and since part of the cost is borne by
populations in other countries, there may not be a strong incentive for any given nation to take action to reduce such emissions, even if its citizens’ incomes are improving.

Since the scale and technique effects tend to work in opposite directions, and the composition effect depends on the comparative advantage of countries and on differences in regulations between countries, the overall impact of trade on greenhouse gas emissions cannot be determined a priori. The net impact of greenhouse gas emissions will depend on the magnitude or strength of each of the three effects, and ascertaining this requires detailed empirical analyses.

Three aspects of the empirical literature on trade opening and emission levels have been reviewed: econometric or statistical studies of the effects of trade opening on emissions; estimates of the “environmental Kuznets curve” for greenhouse gases (which describes the relationship between higher per capita incomes and lower greenhouse gas emissions); and assessments – carried out by the parties to various trade agreements – of the environmental impact of these agreements.

Most of the statistical studies reviewed indicate that more open trade will most likely lead to increased CO2 emissions, and suggest that the scale effect tends to offset the technique and composition effects. Some studies indicate, however, that there may be differences in outcomes between developed and developing countries, with environmental improvement being observed in OECD countries and environmental deterioration in developing countries.

The empirical literature on the environmental Kuznets curve for greenhouse gas emissions has produced inconsistent results, although the more recent studies tend to show that there is no relationship between higher income and lower CO2 emissions. Studies that differentiate between OECD and non-OECD countries tend to find evidence of an environmental Kuznets curve for the first group of countries but not for the second.

Although many developed countries now require environmental assessments of trade agreements that they enter into, these assessments tend to be focused on national rather than cross-border or global pollutants. A few of these assessments have raised concerns about the possible increase in greenhouse gas emissions from increased transport activity, although none have attempted a detailed quantitative analysis of these effects. Some assessments have alluded to the potential of mitigation measures to reduce the effects of increased emissions from transport.

Trade involves a process of exchange requiring that goods be transported from the place of production to the place of consumption. Consequently, international trade expansion is likely to lead to increased use of transportation services. Merchandise trade can be transported by air, road, rail and water. Maritime transport accounts for the bulk of international trade by volume and for a significant share by value. Recent studies indicate that, excluding trade within the European Union, seaborne cargo accounted for 89.6 per cent of world trade by volume and 70.1 per cent of global trade by value in 2006.

International trade can serve as a channel for spreading technologies that mitigate climate change. The spread of technological knowledge made possible by trade provides one mechanism by which developing countries can benefit from developed countries’ innovations in climate change technology. There are several ways in which this transmission of technology can occur. One is through the import of intermediate and capital goods which a country could not have produced on its own.

Second, trade may increase communication opportunities between countries, allowing developing countries to learn about production methods and design from developed countries. Third, international trade can increase the available opportunities for adapting foreign technologies to meet local conditions. Finally, the learning process made possible by international economic relations reduces the cost of future innovation and imitation.

Beyond offering opportunities for mitigation, trade can also play a valuable role in helping humankind adapt to a warmer future. Climate change threatens to alter geographical patterns of production, with food and agricultural products likely to be the most affected. Trade can provide a means to bridge differences in demand and supply, so that countries where climate change creates scarcity are able to meet their needs by importing from countries where these goods and services continue to be available.

A number of economic studies have simulated how trade can help reduce the cost of adapting to climate change in the agricultural or food sectors. However, some of these studies also suggest that the extent to which international trade can contribute to adaptation depends on how agricultural prices – which are the signals of economic scarcity or abundance – are transmitted across markets. Where these price signals are distorted by the use of certain trade measures (such as subsidies), the contribution that trade can make to adaptation to climate change may be significantly reduced.

Finally, climate change can affect the pattern and volume of international trade flows. It may alter the comparative advantage of countries and lead to shifts in the pattern of international trade. This effect will be stronger in those countries whose comparative advantage stems from climatic or geophysical sources. Moreover, climate change can also increase the vulnerability of the supply, transport and distribution chains upon which international trade depends. Any disruptions to these chains will raise the costs of engaging in international trade.

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