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Environmental Policy and International Competitiveness

Environmental Economics Seminar Series
Department of the Environment, Sport and Territories, 1996
ISBN 0 642 24879 6

Background paper

Mick Common
Centre for Resource and Environmental Studies
Australian National University


The standard economics position is that environmental considerations do not undermine the case for free trade:

trade per se is not a direct cause of environmental problems. Some distortion must be present - most obviously, the absence of inappropriate environmental policy - in order for there to be a possibility that international trade will create or worsen environmental problems (Anderson and Blackhurst 1992 p20).

There is, that is, no environmental case for policies to restrict trade, provided that policies to address environmental problems directly are in place. This condition severely limits the relevance of the conclusion. Appropriate environmental policies are not generally in place. Concerns about impacts on competitiveness are very often raised when it proposed that environmental policies be put in place.

The 1993 Fenner Conference in Canberra (Buckley and Wild 1994) ranged widely over trade and the environment issues. This background paper is more narrowly focussed. It does not, for example, consider whether free trade and sustainability are mutually reinforcing. It has been argued, in Daly and Cobb (1989) for example, that they are not: see also Ekins et al (1994) and other papers in the same issue of the journal Ecological Economics. This paper follows the standard economics approach, concentrating on allocative efficiency/consumer sovereignty criteria. The next section distinguishes free trade and the environment problem settings. Section three looks at the competitiveness implications of domestic environmental policy in a simple context. Section four briefly reviews some evidence from models and actual experience. The final section offers some concluding remarks.

Trade and the environment issues

The economics literature distinguishes three different types of situation in regard to trade and the environment. In all three, produced goods and services cross national frontiers. The typology is in terms of the crossing of national frontiers by environmental impacts. Differences in this respect give rise to different types of policy issues arising. The environmental impacts may arise from production or consumption activity. In Type I situations environmental impact does not cross national frontiers. In Type II situations, unidirectional externalities or spillovers, the impact flow is one way - an activity taking place in A gives rise to damage in B but not in A. In Type III situations, reciprocal externalities or spillovers, the impact now is two way - activity in A causes damage in A and B, and activity in B causes damage in A and B.

In Type I situations the basic question is whether domestic environmental policy should be adopted to deal with the domestic environmental problem. The question has a trade dimension in so far as unilateral action is held to imply adverse effects on the country's trade situation. A related question arising is whether trade policy should be used to shield the domestic economy from the trade effects consequent upon domestic environmental policy. Type I situations are where the environmental policy/competitiveness issue is clearest, and will be discussed in the next section.

In Type II situations the basic questions are about the appropriate way for the nation suffering the damage to seek to protect its environment, given that it cannot use domestic environmental policy. Where some activity in A is causing damage in B, but not in A, the situation between the nations is analogous to that of the two firms considered in standard expositions of the Coase Theorem (see, for example, Common 1988, chapter five). If a supranational Environmental Protection Agency existed, it could assign a property right to either A or B, who could then bargain an improvement over the situation of no property rights. On one assignment A would offer B compensation, on the other B would offer A inducements to curtail the level of its damaging activity. In the former case the polluter pays principle would be operative. In the latter case, the 'victim pays principle' applies. This is the operative principle in the absence of any supranational agency with property rights granting powers. Given no damage arising in A, A otherwise has no incentive to introduce policies to curtail the damage occurring in B. The prospect of conditional payment from B would create such a incentive.

Suppose A exports to B the commodity X, the production of which gives rise to the damage experienced in B. Then prohibition by B of imports of X from A is sometimes argued as the way to deal with the unidirectional spillover arising. For example, environmentalists in a number of industrial countries have called for bans on the importation of tropical timber in order to reduce the rate of forest clearance in tropical countries, with a view to halting biodiversity losses there. The effectiveness of such an approach is generally questionable. First, import bans would be a second best policy in that they would involve foregoing some of the gains from trade. Bribery, on the other hand, could in principle be tailored so as to retain the gains from trade while limiting the damage. Thus, in the logging case, B's payment to A could be conditional on the observance of logging practices that minimise environmental damage. Second, it will not generally be the case that B is the only destination to which A exports X. If there are many nations importing X from A, an import ban by B alone will be ineffective, and securing general agreement to ban imports may be difficult.

Where, as in the case of acid rain, the damage arising in B is not due to a single unidentifiable production activity in A, the possibility of this kind of import ban does not exist. A problem which arises with bribery is that of monitoring compliance. In the case of payment for following less damaging logging practices, for example, B would need to prescribe the nature of those practices and to be assured that the prescriptions were being followed. It could be argued in favour of import bans that, where feasible and effective, they avoid monitoring problems in that, for example, there is a direct reduction in the quantity of timber felled.

The prime example of a Type III situation is the role of carbon dioxide emissions in the so-called greenhouse effect. All countries burn fossil fuels releasing carbon dioxide into the atmosphere, where all emissions mix globally. The climate relevant parameter is the global atmospheric concentration of carbon dioxide in the upper atmosphere. The origin of any particular molecule of carbon dioxide is irrelevant to its role in the world climate system. Driven by increasing rates of fossil fuel combustion, global carbon dioxide concentrations are increasing. According to the basic physics of the world climate system, increasing carbon dioxide concentrations imply, other things equal, a warmer world. All nations are involved in driving up atmospheric carbon dioxide concentrations: all nations would experience climate change and its consequences.

In Type III situations the essential issue is seen as the incentive structure facing nations in regard to action to reduce environmental damage. It can be sketched using illustrative numbers for the two country case, as in the following table which relates to carbon dioxide emissions.

image: SQ stand for EPA

SQ stands for 'status quo', and EPA for environmental protection agency. Each country can be in one of two states, following recognition of the existence of the problem. It can do nothing, making no attempt to do anything about the control of its domestic emissions. It can set up an EPA mandated to control domestic emissions to some arbitrary standard. It is assumed that the arbitrary standard would be the same in each country, that the two economies are of the same size, and have the same costs of emissions abatement. These assumptions are not essential to the argument, but do simplify it.

Given two states for each nation, there are four possible outcomes, each represented by a cell in the table. In each cell, the number to the left of / refers to country A, that to the right to country B. The numbers are for the welfare of the representative individual in each nation. They can be thought of as being per capita income adjusted for pollution damage. The numbers are normalised so that when both countries do nothing to control emissions, welfare in each is unity. This serves to emphasise that these are purely imaginary numbers. The numbers in the other cells arise as follows.

In the top right cell, A does nothing while B sets up an EPA. As compared with the full status quo, A gains while B losses. B incurs the domestic costs involved in emissions abatement, and suffers a loss of competitiveness in international trade, while gaining some benefit from the reduced pollution due to its own emissions, but not those of A, being reduced. A gains exactly the same pollution reduction benefit, benefits from B's loss of competitiveness, and incurs no abatement costs. The bottom left cell shows the numbers reversed, as it refers to the reciprocal situation. Comparing the cell for the full' status quo with these two cells, it is clear that for neither country is there an incentive to act alone. So to do would confer gains on the other country; and involve domestic losses.

The bottom right cell is for a situation where both countries set up EPAs. In this situation, the reduction in the level of emissions is twice that occurring when either acts unilaterally. Both incur domestic abatement costs, but neither suffers from any loss of competitiveness. Both countries are better off than in the full status quo. But neither is as well off as it would be if it did not act and the other did. Each country has an incentive to free ride on the emissions abatement of the other, if it can. Given that each has this incentive not to act on domestic emissions, in the absence of some kind of agreement between the nation states, there will be no emissions abatement anywhere. However, if each could be assured that the other would act if it did, there would be incentives to act as both would be better off than in the full status quo. This is the nub of the matter in reciprocal externality situations. All parties are better off as participants in an effective international agreement that each acts to reduce emissions, but none has an incentive to act unilaterally. Indeed, each has an incentive to try to free ride on the efforts of the other. The operative problem is the negotiation of international agreements on emissions abatement.

The actual problem in the enhanced greenhouse effect case is, of course, much more complex than this Table suggests, for a number of reasons. First, negotiation of credible agreements is more difficult where there are many countries involved. An agreement is credible only if potential participants believe that its terms will be adhered to by all. This raises questions of compliance monitoring and enforcement. Second, given that countries actually differ in size, income level, abatement costs etc, all would not gain equally from participation. Nations, and individuals, often feel strongly about equity, and may be prepared to forego available gains on the basis that others would make larger gains. Third, in the enhanced greenhouse context there is massive uncertainty about the potential global costs and benefits associated with any particular proposed global target for emissions reduction, and about the gains to particular nations that would ensue.

Competitiveness effects of domestic environmental policy

Competitiveness considerations are most clearly isolated in Type I situations. Consider the production of widgets, which are a final demand commodity only, in country A, which gives rise to pollution in A but not elsewhere. Suppose that in the international whanged market A is a 'small' country, so that its actions have no effect on the world price of widgets. Suppose also that in A the whanged industry is small in the sense that partial equilibrium analysis is appropriate. If A unilaterally introduces policy to control emissions in whanged production the effect is to shift the supply function from So to Sl in Figure 1. The output of the domestic whanged industry falls from Qo to Q1, with a loss of producers surplus equal to Oef. Given that the price of widgets on the domestic market does not change, consumers surplus in whanged consumption, abc, is constant in the face of the policy change. The question of whether the policy change is justified turns on the relative sizes of the consumers surplus effect of reduced pollution and the loss of Oef producers surplus in whanged production. If the level of pollution control is optimal, in the sense the minimal costs and benefits of abatement are equal, then this condition is necessarily satisfied since abatement benefits exceed abatement costs.(see note1 below)


image: figure 1

If the pollution reduction welfare gain is greater than Oef the policy change is justified on economic efficiency criteria. The fact that other countries do not act is not then a justification for not acting domestically. There is a loss of competitiveness in whanged production, but it goes with a welfare gain. The widget industry suffers, but the economy as a whole gains. There can be no general presumption about the relative sizes of the pollution reduction welfare gain and the producers surplus loss. The question is empirical and to be judged on a case by case basis. The point being made here is that there is no general presumption that a loss of competitiveness for a particular industry means a welfare loss for society in general. Of course, in many cases the environmental benefits are likely to be widely dispersed throughout the population and small in magnitude per individual, whereas the losses bear heavily upon a relatively small number of individuals. In such cases, one would expect to hear more about the losses than the gains.

It is interesting to note that in this case unilateral action may be superior to all whanged producing nations acting on their domestic pollution problems. If they do, the world price of widgets rises from P U to PE, and there is a loss of consumers surplus bb 1c1c. The increase in producers surplus bb1e1e is necessarily larger. However, the increase in domestic output from Q1 to Q2 will entail increased pollution and a welfare loss which could exceed cc 1e1e.

1 See Anderson in Anderson and Blackhurst (1992) for a fuller exposition of this kind of analysis of trade and environment issues.

If Oef exceeds the environmental welfare gain from unilateral action, there is no case for such action on efficiency grounds. A variant of the argument of the previous paragraph would appear to indicate that in this case there is no general presumption that similar action by all widget producers would necessarily imply an overall domestic welfare gain. As compared with the unilateral action case, widget producers gain, more than the loss of consumers surplus, but there is an increase in domestic environmental damage. The argument that a domestic environmental policy that does not pass the efficiency test if adopted unilaterally would do so if all other countries adopted similar policies and standards is not necessarily valid in all cases.

At the level of principle, given these assumptions and using only efficiency criteria, the problem is relatively simple. In the unilateral action case, if we know the parameters of the domestic supply and demand functions, the relationship between environmental damage and widget production, and the valuation of that damage, we can, in any particular case decide whether the environmental policy should be adopted. In fact, matters are far from simple and often give rise to controversy because:

  1. the assumptions are not applicable;
  2. the information required is not generally available; and
  3. not all participants in the debate adhere solely, or at all, to efficiency criteria.

However, this simplistic analysis does serve to make a couple of points which would apply generally. The first is that the numbers matter. There are no general results and each case must be judged on its merits. This is often difficult, by virtue of (ii), and opens up opportunities for special pleading, often involving (iii). The second point follows from this. It is that there is no question but that environmental policy will, in the short run and given standard economic assumptions, impose costs on the widget industry. It is not necessary to introduce the trade dimension to see this. The question, trade or no trade, is whether those costs are worth incurring to secure some environmental improvement.

The standard analysis assumes that technology is unchanging. Porter (1990), among others, has argued that domestic environmental policy may enhance an industry's competitive position if it spurs technological innovation. The argument is that properly constructed environmental policy will cause firms to innovate in ways which cut costs, and/or improve product quality, as well as reduce pollution emissions. This assumes both that emissions and cost cutting technological innovation is feasible, and that management will respond to policy by innovating. Neither of these assumptions is likely to be generally valid. Opportunities for technical innovation will vary across productive activities, and management cultures across industries and societies.

Modelling and evidence

At the previous seminar in this series, on Taxation and the Environment, there was some consideration of carbon taxation as a means to meet the obligations in respect of greenhouse gas emissions that Australia entered into at the Rio Conference in 1992. Much of what is expressed as argument against carbon taxation is in fact argument against the objective of reducing gross carbon dioxide emissions. Unless one believes that Australia is currently using fuels in, technically and/or allocatively, inefficient ways, the use of any policy instrument in pursuit of a carbon dioxide emissions abatement objective will involve costs. One element of the arguments against such an objective is that the costs would include large competitiveness effects. Given that fossil fuels are used, directly and/or indirectly, as inputs in all of the production activities in the economy, the argument is that domestic production costs would rise everywhere, but especially in sectors where Australia is currently supposed to have comparative advantage, such as minerals processing. A number of modelling studies of the impact of the unilateral introduction of carbon taxation in Australia have been undertaken. Given differing models and differing abatement targets, generalising about the results arising is impossible. However, all show widely differing impacts across sectors. In some results there are sectors which expand output. The pattern of comparative advantage shifts.

Pearce (1992) reviews several modelling studies of the economic impact of environmental policy, and concludes that in regard to competitiveness: 'the available economic studies do not bear out the worst fears about the employment, price and income effects of environmental policy'. Related to fears that domestic environmental policy adversely affects competitiveness for existing activities are concerns that it drives existing and potential future activities offshore to 'pollution havens' where environmental standards are lower. According to Pearce (1992): 'there is very little evidence to suggest that firms move in response to variable environmental policies'.

Esty (1994) notes that

Politically, no trade and environment issue commands more attention than the potential loss of jobs to overseas producers that can achieve lower production costs because of the low environmental which they operate (p 155).

This is a source both of opposition to the introduction of domestic policy to protect the environment and of calls for trade measures to offset low overseas standards. The latter is the main point at which trade and environment issues interact with the GATT: see Buckley and Wild (1994), Esty (1994) and Young (1994). According to Esty most economists 'see the competitiveness argument as a nonissue and potent a protectionist contrivance' and consequently 'argue against trade measures aimed at addressing environmentally derived competitiveness concerns'. The basis for treating competitiveness arguments as nonissues is that: 'study after study has concluded that differences in environmental compliance costs are rarely a serious competitiveness factor' (p 159). Esty also notes a paucity of evidence for the pollution havens hypothesis. The basic reason adduced as to why environmental compliance costs have little effect on competitiveness is that they are generally low. Esty cites estates of 2.1 per cent of GNP for the USA in 1990 and 2.4 per cent of total sales for major corporations worldwide in 1991. He notes the expectation that environmental compliance costs will rise as a proportion of total costs, and comments that: 'the traditional conclusion about the minimal competitiveness effect of environmental costs may not be true in the future' (p 162).

An article The Guardian Weekly for March 20-24 reported that two recent reports in the USA have found against the hypotheses that environmental policy has adversely affected competitiveness and driven industry offshore. It quotes from a study by the World Resources Institute, authored by Repetto, as follows: 'Contrary to widespread perceptions, the industries heavily affected by environmental regulations did relatively well in international trade'. The article reports that:

Over the years many companies have threatened to move production to developing countries in response to tough environmental regulations, but Repetto found scant evidence that they ever followed through.

The other study was sponsored by the National Bureau of Economic Research and Resources for the Future. According to the article, based on a review of more than one hundred studies, it concluded that there was little evidence that environmental compliance costs have 'adversely affected the competitiveness of US manufacturing firms'. The article also notes contrary claims from, for example, the oil refining industry in the US. An oil industry study is reported according to which US environmental costs give Venezuelan refineries a seven cents per gallon cost advantage, which will rise to 15 cents over the next decade.

Public debate over these issues frequently reflects special interest pleading. The issues are complex and subtle, and important distinctions often appear to escape journalists and commentators. A recent article in The Australian, by environment writer Natasha Bita, appeared under the headline: 'Stricter environmental laws might weaken trade position'. The article was a report of a paper given by Kym Anderson at an Australian Centre for Environmental Law conference. Anderson's warning, as reported in the first paragraph of the article was that: 'Stringent environmental laws could weaken Australia's trade position in resource based industries' (emphasis added). Anderson is also reported as saying that:

We'll disadvantage the most polluting industries by having higher standards. But other industries in the economy will be beneficiaries in that Australia's comparative advantage just shifts.

It might be noted that higher standards will presumably also have as beneficiaries those Australians who derive utility from the domestic environmental effects.

Concluding remarks

There is no doubt that domestic environmental policies can have adverse effects on the competitiveness of affected industries. However, the evidence seems to indicate that as yet few industries have been significantly affected. Even where significant impact on an industry can be established, it does not follow that the responsible environmental policy should not be adopted. The environmental benefit should be taken into account, though in practice this is difficult. However, supposing that some domestic environmental policy can be shown to be good for society as a whole on efficiency criteria notwithstanding its adverse effects on some industry, those adverse effects remain. There are, that is, issues of equity, as well as efficiency, to be considered. The next seminar in the series is concerned with equity and the environment.


Anderson, K. and Blackhurst, R. (eds). 1992. The greening of world trade issues. Harvester Wheatsheaf, Hemel Hempstead.

Buckley, R. and Wild, C. (eds). 1994. International trade investment and the environment: proceedings of the Fenner Conference on the environment. Griffith University, Gold Coast.

Common, M. 1988. Environmental and resource economics: an introduction. Longman, Harlow.

Daly, H. E. and Cobb, J. B. 1989. For the common good: redirecting the economy toward community, the environment and a sustainable future. Beacon, Boston.

Ekins, P., Folke, C. and Costanza, R. 1994. 'Trade environment and development: the issues in perspective', Ecological Economics, 9:1-12.

Esty, D. C. 1994. Greening the GATT: trade environment and future. Institute for International Economics, Washington DC.

Pearce; D. 1992 .Levelling the playing field: environmental policy and competitiveness. CSERGE Working Paper PA 92-01.

Porter, M. 1990. The comparative advantage of nations. Free Press, New York.

Young M. D. 1994. 'Ecologically-accelerated trade liberalisation: a set of disciplines for environment and trade agreements', Ecological Economics, 9:43-52.

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