Chapter

V Trade and the Environment

Author(s):
Peter Uimonen, Arvind Subramanian, Naheed Kirmani, Nur Calika, Michael Leidy, and Richard Harmsen
Published Date:
February 1995
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Concern about the environment has grown markedly in the recent past. At the Earth Summit in 1992, governments collectively espoused the concept of “sustainable development”—meeting present needs without compromising those of future generations—thereby signaling a common concern for the environment. The global nature of environmental problems has potentially increased the scope of the interface between trade and the environment.

The trade-environment debate came into prominence in 1991 when a GATT dispute settlement panel ruled that import restrictions taken by the United States against tuna imports from Mexico were inconsistent with GATT rules. The restrictions had been defended by the United States on the ground that the fishing methods employed by Mexico in catching tuna resulted in more dolphin killings than specified under U.S. law. This ruling sparked a wider debate on the extent to which trade and environmental objectives were compatible and on the consequent need to change existing international rules to take greater account of environmental concerns. An example of the latter was manifested in the North American Free Trade Agreement (NAFTA), which contains provisions in some areas—technical standards and sanitary and phytosanitary measures—that explicitly incorporate environmental concerns. In addition, a side agreement to NAFTA created a Commission for Environmental Cooperation responsible for overseeing the implementation of the agreement, promoting cooperation on the environment, and ensuring that member countries enforce their environmental laws (failing which they could be liable to sanctions by trading partners).2

The Uruguay Round also responded to certain environmental concerns. It modified some provisions of the Draft Final Act in the areas of technical standards, sanitary and phytosanitary measures, and subsidies and countervailing measures. It incorporated the objective of sustainable development in the preamble of the WTO. At the Marrakesh meeting in April 1994 concluding the Uruguay Round, agreement was reached to set up a Committee on Trade and the Environment under the future World Trade Organization (WTO) to address a wide range of issues relating to trade and the environment. This Committee will take over the work of an earlier body (the GATT Group on Environmental Measures and International Trade) and will examine a wide range of issues.3 It will report to the first biennial Ministerial Conference of the WTO after its entry into force. The Organization for Economic Cooperation and Development (OECD) is also undertaking extensive work in this area.

This paper covers selected aspects of the trade-environment nexus, particularly the environmental effects of trade liberalization and the consequences of differential environmental standards on international competitiveness. While not covered in this paper, transborder environmental problems are an important issue.4 Countries have made collective efforts to address some global environmental problems by negotiating international environmental agreements (IEAs). These generally provide for technical and financial assistance to induce countries to adopt first-best environmental policies. In a number of cases, such agreements also incorporate trade restrictions as a mechanism of last resort to enforce them.5

Environmental Impact of Trade Liberalization

Environmental problems originate in production and consumption distortions and, consistent with the literature on optimal intervention, require corresponding domestic policy interventions.6 From the perspective of economic efficiency, trade interventions are generally viewed as second-best instruments for addressing such problems. A corollary is that if trade liberalization is associated with environmental problems, it should be coupled with appropriate domestic environmental policies aimed at correcting the externality that has its root in either production or consumption activity rather than trade.7

In practice, it is difficult to predict ex ante the environmental consequences of economy-wide policies, such as trade liberalization, because of the variety of effects—often conflicting—that are induced. Grossman and Krueger (1991), however, identify three kinds of environmental effects. First, liberalization generally leads to an increase in the scale of activity, resulting in an increase in resource use (or pollution) for a given composition of output. Second, liberalization and its induced relative price changes lead to changes in the composition of output. If a country has a comparative advantage in less pollution- or resource-intensive activities, liberalization will increase the share of environment-friendly products—and, vice versa, a country that specializes in pollution- or resource-intensive products. Third, liberalization typically induces changes in the techniques of production. In a developing country, techniques are likely to become friendlier to the environment with trade liberalization8 to the extent that comparative advantage generally lies in labor-intensive (i.e., generally cleaner) production; foreign products transfer more modern environmentally efficient technologies; income levels rise, increasing the demand and ability to pay for a cleaner environment.9

A number of empirical studies suggest that in practice trade liberalization improves, instead of harms, the environment. Where the environmental effects are adverse, the primary cause is not trade liberalization but the failure of markets and governments to price environmental resources appropriately. Some evidence from studies dealing with agriculture and industry is presented below.

Agriculture

In a survey of the literature on environmental implications of agricultural trade policies, Runge (1993) concluded that many of the environmental problems associated with agriculture stem from the same policies that result in trade distortions. In industrial countries, selected agricultural commodities are granted price supports and trade protection, as well as subsidies for water, fertilizers, and pesticides. These policies result in reduced crop variety, chemical pollution, soil erosion and depletion, and pollution of water supplies. In developing countries, where agriculture is often taxed rather than subsidized, low prices induce poor farmers to cultivate marginal lands. The policy bias against agriculture is in some cases partly offset by generous subsidies for fertilizers and pesticides, resulting in soil erosion and intensive chemical use.10 To the extent that liberalization is accompanied by reduced input subsidies and results in reduced marginal cultivation by the rural poor as commercial agriculture expands, there would be environmental benefits.

Anderson (1992a) shows that protection shifts agricultural production from efficient producers in low-income countries to inefficient producers in high-income countries. In turn, this is likely to cause more environmental damage because of the greater use of chemical fertilizers and pesticides in the latter. Anderson also presents evidence suggesting that variations in agricultural output in developing countries in response to price changes (induced by trade liberalization or otherwise) are primarily via changes in capital and labor use rather than via changes in quantity of land used,11 so that the loss of forests due to trade liberalization may not be a serious problem.12 Although agricultural production expands, resources might be diverted from smokestack manufacturing or mining activities. Further, some of the rural poor and urban unemployed may be absorbed into commercial agriculture, reducing pressures on marginal lands and the urban environment.

Pearce and Warford (1993) noted that various agricultural crops have differing implications for soil stability. For example, in a country that has a comparative advantage in a less soil-erosive crop, liberalization can be beneficial. Further, numerous internationally traded crops that can be beneficial for soil stability have suffered from adverse terms of trade effects or the anti-export bias of government policies (e.g., coffee, cocoa, and tea). On the other hand, certain commodities benefiting from special trade arrangements can be environmentally damaging, such as cattle and other crops (maize, cassava, and groundnuts); under a preferential trade agreement with Botswana, the European Union (EU) imports a guaranteed quantity of lean, grass-fed beef at prices above world levels—the result has been a doubling of rangeland in the period 1964–84, over-grazing on marginal lands, and competition with indigenous wildlife.

Some studies have analyzed the adverse effects of trade liberalization. For Ghana, Lopez (1993) analyzed a model that included the quantity of biomass on village-owened fallow land as an input in an agricultural production function. A positive relationship between the amount of cultivated land and agricultural output prices was estimated, indicating a negative relationship between agricultural prices and the quantity of biomass factor services. This means there is a trade-off between the direct increase in output from extending the margin of cultivation and the decrease in agricultural productivity from the reduction in the use of the environmental (biomass) resource. Lopez also estimated that the productivity effects of a reduction in biomass more than offset the output gain from extending the margin of cultivation. He went on to estimate the effects of a decrease in agricultural export taxes and a decrease in industrial tariffs and concluded that real income declines in each case, because of a worsening of the environmental distortion associated with increased exploitation of the biomass.

In relation to forest depletion, Braga (1992) analyzed Indonesia’s log export ban aimed at curtailing deforestation. Its effects may have been partially offset, because the resulting fall in domestic log prices provided a subsidy to the downstream wood-processing industry (furniture and production of low-grade plywood from high-grade timber), thereby increasing the demand for logs. Given the low efficiency of this industry, the adverse environmental consequences of the subsidy implicit in the ban were significant. These could have been avoided had the export ban been replaced by the appropriate domestic policy instrument—an equivalent production tax—which would have avoided the subsidization of the local processing industry.13

Industry

In the industrial sector, too, a positive correlation has been observed between openness and environmental quality. Birdsall and Wheeler (1992) examined whether free trade in Latin America was harmful to the environment by regressing changes in pollution intensity on various “gravity” variables and an openness index. The evidence suggested a negative relation between openness and pollution-intensive growth. Lucas, Wheeler, and Hettige (1992), using pooled crosssectional time series data, observed that pollution and resource intensity increased more rapidly in closed economies than in open ones. The scope of the above studies was limited, however, to an examination of changes in pollution intensity due solely to changes in the composition of output, rather than changes in its scale or production techniques.

A number of studies have assigned an important role to the effects of openness in inducing the adoption and diffusion of clean technology. For example, Wheeler and Martin (1992) studied the wood pulp industry, and Birdsall and Wheeler (1992) examined the experience of Chile. Wheeler and Martin (1993) demonstrated that liberalization in Indonesia in the 1980s promoted a surge in cleaner, assembly-based industries and a move away from more pollution-intensive processing sectors. In addition, industry expanded rapidly away from densely populated areas, reducing the adverse health impact of industrial concentration.

Feenstra (1985) showed that voluntary export restraints (VERs) on Japanese automobiles in the 1980s resulted in “quality upgrading,” shifting the composition of Japanese exports to the United States to larger, less fuel-efficient cars. Thus, while protection restrained car purchases in the United States (relative to what would otherwise have been the case), the shift to imports of larger cars resulted in more carbon dioxide per car imported. The net effect of the VERs could well have been greater environmental damage.

Environment and Competitiveness

Implications of Differential Standards

Differences in domestic environmental standards have recently featured in the trade-environment debate. Some are concerned that lower environmental standards, particularly related to production processes and methods, in developing and transition economies confer “unfair” advantage in trade and induce shifts in investment (the “pollution-haven” hypothesis). Another aspect of this view is that the competitive advantage conferred by lower standards abroad puts pressure on all countries to lower their own standards in order to remain competitive. These concerns have generated political pressures in some industrial countries to offset the so-called “unfair” advantage by raising standards world-wide (through greater harmonization) or by trade restrictive action (countervailing duties against “eco-dumping”). A number of countries are concerned that strict or demanding standards may act as disguised barriers to trade and have sought to discipline their use in the Uruguay Round agreements on Technical Barriers to Trade and Sanitary and Phytosanitary Measures (Box 1).

On the other hand, developing countries have argued that despite a shared concern for the environment, there may be international variations in environmental standards, reflecting many factors—for example, different capacities to assimilate pollution, different costs and benefits associated with a given amount of pollution abatement and control activity,14 and different environmental priorities.15 As long as environmental problems are confined within national borders, differences in environmental standards may be economically efficient, in which case they should not be the basis for denial of the opportunity to trade.16

Box 1.GATT/WTO Rules and the Environment

Under the GATT’s national treatment rule, countries have the freedom to take any environmental measure—taxes, charges, standards, and so on—against imported products as long as equivalent measures are in place in respect of domestically produced products. In such cases, restrictions against imported products can be imposed as a means of enforcing a nondiscriminatory environmental measure. Thus, governments can employ many different measures to protect and improve the local environment. Sales taxes on products that can create pollution (those containing chlorofluorocarbons, for example), deposit refund schemes for recyclable waste (bottles, scrap cars), or favorable tax treatment of environmentally friendly products (lead-free gasoline, solar panels for home heating) and other nondiscriminatory measures would not normally be open to challenge. Similarly, export restrictions can be maintained provided there are equivalent restrictions on the domestic sale of the same goods.

The national treatment rule does not apply, however, to processes or production methods that have no effect on the product as such; in other words, this rule cannot be invoked to impose restrictions on imports of goods whose manufacture uses processes different from those used in the manufacture of similar domestically produced goods. Similarly, under the GATT’s border adjustment rule, any tax on domestic products (e.g., an excise tax), levied for environmental reasons, can also be levied on imports. But a domestic process tax (e.g., a tax on fuel use) cannot be levied on imports.

In certain cases, even a measure taken for environmental protection (which would otherwise contravene GATT’s nondiscrimination rule), may be permitted under Article XX of the GATT. The narrowly defined exceptions in Article XX permit a Contracting Party to discriminate or to take trade restrictive actions to achieve health, safety, or domestic-resource-conservation goals, but only when certain conditions are fulfilled. In general, these conditions ensure that a trade measure is necessary for the achievement of such goals—and that these goals are not used in order to reduce competition from imports.

While the above relates to whether trade measures taken for environmental reasons can discriminate against imports, the future WTO will also regulate technical regulations and other regulations taken for health, safety, or environmental reasons (in the agreements on Technical Barriers to Trade and on Sanitary and Phytosanitary Measures) that do not apparently discriminate against imports; the objective in such cases is to ensure that environmentally motivated measures do not become obstacles to trade. The guiding principle is that regulations adopted in conformity with international standards would be deemed to be consistent with WTO rules. Any deviation in the form of higher or tighter standards are also allowed provided these can be scientifically justified and are necessary to achieve legitimate objectives.

The Uruguay Round also specifies that subsidies provided for the adaptation of existing facilities to new environmental requirements cannot be countervailed by a partner country; the proviso is that such subsidies should be of a nonrecurring nature, limited to 20 percent of the cost of adaptation, not cover replacement and operating costs of investment, and be available to all firms that can adopt the new process or equipment. The Uruguay Round agreement on subsidies and countervailing measures does not sanction countervailing duties against products from countries with environmental standards lower than those in importing countries, but this issue is likely to be raised in the post-Uruguay Round work program. The Uruguay Round agreement on agriculture exempts payments made to farmers under government environmental or conservation programs from the general requirements to reduce subsidies.

Developing countries have further argued that attempts to offset these differences through trade restrictions (1) lead to protection of domestic industries and reduce market access for them, depriving them of the benefits of trade; (2) risk going down a “slippery slope” on which any difference between countries (on labor standards, human rights) would be legitimate grounds for taking unilateral trade restrictive action; and (3) divert attention from the search for more appropriate solutions.17

Empirical Evidence

In addition to clarifying the conceptual and policy issues surrounding the competitive effects of differential environmental standards, it is important to consider the likely empirical magnitudes of some of these effects.18 The available empirical evidence indicates that differences in standards are not substantial in their cost implications and hence do not have a significant impact in motivating trade or investment flows.

Trade Effects

Grossman and Krueger (1991) examined the effects of NAFTA on Mexico’s environment; they concluded that traditional determinants of trade and investment patterns (unskilled labor in the case of Mexico) explained Mexican specialization, and the alleged comparative advantage created by tax pollution controls there played no substantial role. Tobey (1990) found that strict environmental regulations imposed in the 1960s and 1970s by industrial countries did not measurably affect trade patterns in the most-polluting industries (defined as those for which direct and indirect abatement costs account for greater than 1.85 percent of total costs). The most-polluting industry—chemicals—faced abatement costs that were less than 3 percent.

Low (1992c) examined costs for firms to comply with U.S. domestic environmental standards. Available data suggested that pollution abatement and control costs to U.S. firms are small. The weighted average ratio of such costs to output was only about ½ of 1 percent in 1988. The highest ratio for a single industry was just over 3 percent. Based on a legislative proposal before the U.S. Senate in 1992. Low estimated the trade effect of a “pollution abatement and control equalization” tax on imports entering the United States. Even under the unrealistic assumption that Mexican industry incurred no abatement and control costs at all, and that Mexican exports were therefore liable for the full equalization tax, the trade effects of such a measure were estimated to be small.

Sorsa (1994) found little evidence of a relationship between environmental expenditures and trade in environmentally sensitive goods—defined as the sectors with the highest pollution abatement costs in the United States in 1988 (e.g., pulp and paper, petroleum products, chemicals). Industrial countries have maintained competitiveness in these goods, according to indices of revealed comparative advantage. Though environmental expenditures in Austria and Finland have increased, so have their world shares of exports of environmentally sensitive goods. While Germany, Sweden, and the United States were successful in maintaining competitiveness in these goods despite increased expenditures. Japan has shifted out of these industries, most likely because of increased energy prices.

Richardson (1993) examined the effects of environmental costs on U.S. sectoral export performance across states. Export data were regressed on various factor endowments and measures of export disincentives, including state pollution abatement costs. States with higher pollution abatement controls were not found to suffer lower export performance. Robison (1988) estimated the effects of a 1 percent increase in environmental control costs on the U.S. trade balance (without taking account of the variety of general equilibrium effects resulting from the relative price changes). The estimated net reduction in the trade balance for 1977 was less than 1 percent of total U.S. trade.

Investment Effects

Support for the pollution-haven hypothesis could be found if firms that locate in low-income countries are “dirtier” than they would be if they located in industrial countries. As discussed in Birdsall and Wheeler (1992) and Wheeler and Martin (1992) (based on evidence from Latin America), there are reasons why firms might wish to eschew this strategy even if it appeared that differential environmental regulation offered a competitive advantage. These factors include fear of liability in the event of an environmental accident, the risk to a firm’s reputation from an environmental scandal, the costs of unbundling technology, the demands of consumers (“green consumerism”) in export markets, anticipation of more stringent local environmental standards in the future, and the relatively high costs of retrofitting aging capital equipment instead of starting out with “top-of-the-line” technology. All these considerations would act as disincentives if firms were tempted to differentiate production processes and techniques according to location.

Leonard (1988) examined the “pollution-haven” hypothesis in foreign direct investment decisions in Ireland, Spain, Mexico, and Romania, and found that pollution control costs were not substantial enough to alter the investment decisions of multilateral enterprises. Grossman and Krueger (1991) obtained similar results for U.S. investment in Mexico.

A recent paper by Harrison and Eskeland (1994), based on detailed plant-level studies of four countries (Côte d’Ivoire, Mexico, Morocco, and Venezuela) found no evidence that foreign investors invest in more polluting sectors. Further, they found that foreign investors were more efficient in their energy use than their local competitors. Both these findings, although not arguing directly against the pollution haven hypothesis, suggest that environmental standards are not crucial determinants of investment decisions.

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The principal authors.

During the NAFTA negotiations, provision was also made for instituting and funding a body for the clean up of the U.S.-Mexico border region.

These include (1) the relationship between GATT/WTO provisions and (a) trade measures for environmental purposes, (b) environmental policies and measures with trade effects, and (c) environmental charges and taxes, labelling, packaging, and recycling requirements: (2) transparency of trade measures used for environmental purposes and of environmental measures and requirements with trade effects; (3) relationship between dispute settlement mechanisms in the GATT/WTO and those in international environmental agreements (IEAs); (4) effect of environmental measures on market access, especially for developing countries: and (5) exports of goods whose use is domestically prohibited.

For a comprehensive review of the issues, see Uimonen and Whalley (1994).

See GATT (1992). The appropriateness of such restrictions and the safeguards that need to be incorporated (in case of their use) are likely to be discussed in the WTO by the Committee on Trade and Environment. In general, it has been noted that trade sanctions will rarely be used if countries are willing signatories to IEAs and hence unlikely to renege from their international environmental commitments (World Bank (1992)). Further, the wider the participation in IEAs, the less will be the need for trade sanctions against nonsignatories. Hence, if IEAs are efficient and equitable, trade sanctions will seldom need to be used (Blackhurst and Subramanian (1992)).

See World Bank (1992). However, some environmental problems are observed to get worse as incomes rise, but this negative link can be broken through appropriate national and international policies.

Evidence of pesticide subsidies in developing countries is documented in Repetto (1985).

See below for counterexamples.

According to Anderson (1992b), studies for Brazil and Argentina show that the elasticity of land use with respect to changes in prices of agricultural products, even in the long run, is small and much smaller than the relevant elasticity for labor, capital, and input use. For Argentina, the relevant elasticity for land was 0.12 and 0.23 after five and ten years, respectively.

Braga reported that it” the local processing industry were operating under realistic price signals instead of being subsidized by the export ban, annual timber harvests would be 10 percent less.

For example, even if all countries adopted the polluter-pays principle—that is, that the polluter should hear the cost of measures to reduce pollution—the determination of the cost would still entail some valuation of the pollution, which could vary across countries.

See GATT (1992). While the weight given to attaining environmental and other objectives (such as poverty reduction) could vary with the level of income, so too could the weight accorded to different environmental problems, for example, sanitation, clean water, and air pollution.

See Bhagwati (1993) and (1994), and World Bank (1992). In the context of environmental policy, an important distinction arises between product standards and standards relating to production processes and methods. With regard to the former (which generally address environmental externalities in consumption), and consistent with GAIT rules, countries can impose the same standards on imported products as those on domestic products (Box 1). However, in relation to production processes and methods that are not related to the product as such (which generally address production externalities), multilateral rules do not permit a country to stipulate what production processes and methods should be followed in another country, nor to impose trade restrictions against imports produced using production processes and methods different from those used domestically. Whether differences across countries in production processes and methods should be allowed to prevail or be harmonized is likely to be a key issue in the post-Uruguay Round agenda. There are also increasing pressures in industrial countries to use trade restrictions against processes that do not create environmental externalities in production, but which are considered objectionable on ethical or moral grounds (the tuna-dolphin case was an illustration of this view).

See Subramanian (1992). For example, if a society finds another society’s methods of preparing food ethically offensive, it may be more appropriate to organize a private consumer boycott of the latter’s products or to encourage the use of labeling requirements rather than imposing trade bans (Bhagwati (1993)).

An important caveat to note is that most studies that make within-industry, cross-country comparisons of pollution abatement costs deal with absolute rather than comparative advantage; such comparisons should therefore be treated with caution in explaining trade flows (Bhagwati (1994)).

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