Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal

The potential impacts of proposed U.S. climate policies on the competitiveness of U.S. industries is a major political issue, and it was one of the key issues in the Energy and Commerce Committee of the House of Representatives in the design of Henry Waxman and Edward Markey’s H.R. 2454 (the American Clean Energy and Security Act of 2009). In the floor debate that will soon take place as the full House considers the bill, it will be an important issue. It promises to be an equally important topic when the Senate takes up its own climate legislation, although the debate in that body on this issue will likely be quite different.

The ultimate answer to the question of how best to address concerns about international competitiveness is to bring all countries – both the industrialized nations and the developing world’s large, rapidly-growing economies (China, India, Brazil, Korea, Mexico, South Africa, and Indonesia) – into a meaningful (post-Kyoto) international climate change agreement (a topic on which I’ve spent much time over the past several years).  But – for the most part — that long-term objective is outside of the reach of the domestic policy of any single nation, even the United States.

Can Domestic Climate Policy Address Competitiveness Concerns?

A range of approaches has been considered for implementing sound, domestic climate policy while seeking to “level the economic playing field” with other countries. While no approach is without its flaws (as I describe below), the approach taken in the Waxman-Markey legislation is sensible and pragmatic:  in the short term, output-based updating allocations of allowances are employed for a few energy-intensive, trade-sensitive sectors; and in the long term, the President is given the option to put in place (under specific, stringent conditions) import-allowance-requirements in selected cases.

In order to explain my reasoning for coming to this conclusion, let’s back up for a moment and reflect on the reasons for the high level of political attention and receptiveness in the United States toward employing a cap-and-trade system nationally to address emissions of greenhouse gases.

It is because of the significant economic and political advantages of cap-and-trade systems to address carbon dioxide and other greenhouse gas emissions that most (but not all) attention by policy makers has been focused on this policy approach. First, it provides a cost-effective means of achieving meaningful reductions in emissions over relevant time horizons. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by virtually any climate policy. Third, it is less likely than alternative approaches (such as a carbon tax) to be degraded – in terms of environmental performance and cost-effectiveness – by political forces. Fourth, it has a history of successful adoption and implementation over two decades. And fifth, it provides a straightforward means to link and harmonize with other countries’ climate policies.

The Waxman-Markey bill, H.R. 2454, would establish such a U.S. cap-and-trade system to reduce emissions that contribute to global climate change. The bill would put a declining cap on emissions and create a corresponding number of emission permits. Regulated firms could trade these permits at a price determined by the market – creating powerful incentives to reduce emissions cost-effectively.

But imposing a price (cost) on carbon in the United States at a time when some other countries (in the developing world) are not taking comparable actions raises concerns about negative impacts on the competitiveness of U.S. industry, particularly in energy-intensive, trade-sensitive sectors. This heightens worries about possible job losses, a particularly troubling concern when the United States find itself in the worst global recession in a generation.

The environmental side of the same coin is “carbon leakage.” Again, imposing a cost on the production of carbon-intensive goods and services shifts comparative advantage in the production of those same goods and services in the direction of countries not taking on such costs.  Also, reduced demand in the United States for carbon-intensive fuels such as coal can be expected to reduce worldwide demand enough that the world price of coal would fall, thereby making it more attractive for use in countries that are not participating in a meaningful international climate agreement (or otherwise taking significant domestic climate actions).

Both routes can result in a shift of carbon-intensive production to countries without climate controls, and therefore an increase in their CO2 emissions. This is carbon leakage, which reduces the environmental benefits of mitigating emissions and reduces cost-effectiveness of any actions (properly measured in terms of net changes in CO2 atmospheric concentrations).  Given that the United States, the European Union, and Japan are net importers of embodied CO2, while China and India are net exporters, the environmental – as well as the economic – impacts of carbon leakage are a natural concern of lawmakers.

Despite the high levels of attention that international competitiveness therefore receives in debates about domestic climate policies, economic research has consistently found that the actual competitiveness impacts of proposed domestic climate policies would not — in quantitative terms — constitute a major economy-wide economic issue for the United States, partly because differences in other costs of production (including labor and energy costs, without accounting for carbon constraints) across countries swamp differences in costs due to environmental policies, including prospective climate policies.

On the other hand, this is a real issue for some specific sectors, in particular, energy-intensive industries subject to international competition, such as aluminum, cement, fossil fuels, glass, iron and steel, and paper. More importantly, it is in any event a major (economy-wide) political issue.  So, it needs to be addressed in any domestic climate policy which is to be both meaningful and politically pragmatic.

How About Free Allowance Allocations?

The approach frequently proposed by policy makers and the approach utilized in the European Union for its Emission Trading Scheme, and discussed in a number of other countries for their planned cap-and-trade programs is generous and free allocation of allowances to specific sectors and companies.  This makes the receiving companies happy, but has no effect on their international competitiveness. This is because such a free grant of allowances is no different than cash, that is, a fixed subsidy. The allowances can be sold by the receiving companies, are as good as cash, and represent a lump-sum transfer from the government, not tied to carbon abatement efforts or production (and hence, in the language of economics, are infra-marginal subsidies rather than marginal incentives).

Since the subsidy has no effect on the company’s marginal cost of production (its supply function), it has no effect on international competitiveness. The company will continue to find it as challenging as it did without the subsidy to produce cement, steel, or whatever at a price that can compete with companies located in countries without climate policies (apart from liquidity effects, which are minor in most cases). And the domestic company will have the same incentives as previously to locate its next production facility in a country without a climate policy.

A Potentially Effective Approach:  Output-Based Updating Allocations

With proper design, allowance allocations can be used effectively to address leakage and competitiveness.  If the free allocation of allowances is tied to the company’s production level, then it does affect marginal production costs, and therefore does affect competitiveness. Such a “home rebate” can thereby reduce leakage. This is, in fact, the approach taken in the Waxman-Markey legislation, and it is a potentially effective means to address concerns about international competitiveness for a select set of energy-intensive trade-sensitive sectors.

There are, however, some legitimate concerns about this approach of linking annual allowance allocations with production levels, as I wrote in my previous post, “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey.” Such output-based updating allocations can provide perverse incentives and thereby drive up the costs of achieving a cap. This is because an output-based updating allocation is essentially a production subsidy. This distorts firms’ pricing and production decisions in ways that can increase the cost of meeting an emissions target.

Think of it this way. On the one hand, the cap-and-trade system is (sensibly) increasing the cost of using carbon-intensive fuels and emitting CO2 into the atmosphere. An aluminum producer, for example, is therefore paying more for the (fossil-fuel generated) electricity it uses, driving up its cost of production. At the same time, the government hands a subsidy to the company for each unit of aluminum it produces, working at cross-purposes with the energy-pricing incentive, and thereby driving up the aggregate social costs of achieving the cap. In addition, these home rebates do not distinguish between competition from countries with and without domestic climate policies.

The Key Question

So, there are problems with output-based updating allocations, but the key question in the real world of legislative design is whether better approaches are available?  The answer – in my view – is that there are several other available approaches, but they are not any better; and indeed, they appear to be significantly worse.

An Alternative Approach:  Import Allowance Requirements

One alternative approach is an import allowance requirement, whereby imports of highly carbon-intensive goods (in terms of their manufacture) must hold allowances for the U.S. cap-and-trade system, mirroring requirements on U.S. sources, if those imports come from countries which have not taken comparable climate policy actions. Note that this approach – which is referred to as a border adjustment, and is an implicit border tax – differentiates according to the country of origin.  In principle, this approach can maintain a level playing-field between imports and domestic production, reduce leakage, and possibly help induce key developing countries to take domestic action to avoid the implicit border tax on their products.

The import allowance requirement approach has its own problems, however. First, it focuses exclusively on imports into the United States, and has no effect on the competitiveness of U.S. exports. Second, it may not be compliant with World Trade Organization (WTO) rules, because it would discriminate among trading nations (I’ll leave that issue for trade economists and trade lawyers to analyze and debate).

Third, it is questionable whether it would be effective as an inducement for developing countries to join an international agreement to reduce emissions. Why is that? Think about China, for example. China is the largest producer of cement in the world, accounting for almost 50% of world output. It is also the world’s largest exporter of cement. This may sound as though the threat of import allowance requirements in the U.S. and European cap-and-trade systems would be a powerful incentive for China to undertake emission reductions at home in order to avoid the border tax on its cement exports.  But China consumes 97% of its cement domestically, exporting only 3%, and much of that to developing countries. So, would a country such as China be willing to increase the costs of producing 97% of its output in order to protect a market for 1% or 2% of its production?(To be fair, for small developing countries for which their exports of a given product are a large share of their total output, the message could potentially be quite different.)

Despite these three problems with the import-allowance-requirement approach, note that it was a key part of the Lieberman-Warner Climate Security Act in the U.S. Senate in 2008, and may re-appear when serious debate commences in the Senate on climate legislation later this year. Also, it should be noted that this approach of import-allowance-requirements is included as a long-term backstop in Waxman-Markey if the President determines by 2022 that the output-based allocation mechanism is insufficient for some of the energy-intensive trade-sensitive sectors (and if a number of stringent conditions are met; see the “International Reserve Allowance Program” in the bill).

Other Possible Approaches

Another potential approach is a border rebate for exports to level the playing field abroad, whereby the government rebates the value of emissions embodied in exports. Imports, however, would retain their competitive advantage at home, and there are problems with WTO compliance. Finally, there is full boarder adjustment, meaning a border (import) tax plus a border (export) subsidy. Here there are questions not only about consistency with international trade law, but also concerns about feasibility. In some cases, there are tremendous challenges of calculating the embodied emissions of foreign products, and more generally, there are difficulties of defining and enforcing reliable rules of origin.

The Good, the Bad, and the Ugly

Thus, none of these approaches are ideal, not home rebates as in Waxman-Markey, nor implicit border taxes on exports as in Lieberman-Warner, nor border rebates, nor full border adjustments.  As I said at the outset, the only real solution to the international competitiveness issue in the long term is to bring non-participating countries within an international climate regime in meaningful ways. (On this, please see the work of the Harvard Project on International Climate Agreements.) But that solution is fundamentally outside of the scope of the domestic policy action of any individual nation, including the United States.

So, among the feasible set of options to address international competitiveness concerns – if only imperfectly and at some cost – which is best? The two live political options appear to be the output-based updating allocation mechanism in the Waxman-Markey legislation and the import allowance requirement, typically associated with the former Lieberman-Warner bill. At this time, meaning in the short term, I would be more worried about the potential damage to the international trade regime that import allowance requirements could foster than about the incremental social costs that an output-based updating allocation mechanism will create.

This is a political problem without a perfect solution (other than bringing all key countries into a meaningful international climate agreement).  For now, the domestic political process has done a credible job of patching together a set of interim solutions. Among the range of possible approaches of trying to level the international economic playing field, none is without its flaws, but the approach taken in the Waxman-Markey legislation appears best.  Subject to possible improvements on the House floor or in the Senate, the Waxman-Markey approach of combining output-based updating allocations in the short term for select sectors with the option in the long term of a Presidential determination (under stringent conditions) for import allowance requirements for specific countries and sectors seems both sensible and pragmatic.

A Broader Question:  Should the U.S. Enact a Domestic Climate Policy without a New, Sound International Climate Agreement in Place?

Stepping back from the specific policy design question, the broader argument has been made (indeed until a few years ago I was among those making it) that there should be no serious movement on a U.S. domestic climate policy until a meaningful and sensible (post-Kyoto) international agreement has been negotiated and ratified.  It is natural for questions to be raised about the very notion of the U.S. adopting a policy to help address a global problem. The environmental benefits of any single nation’s reductions in greenhouse gas emissions are spread worldwide, unlike the costs. This creates the possibility that some countries will want to “free ride” on the efforts of others. It’s for this very reason that international cooperation is required.

That is the why the U.S. is now vigorously engaged in international negotiations, and the credibility of the U.S. as a participant, let alone as a leader, in shaping the international regime is dependent upon our demonstrated willingness to take actions at home. Europe has already put its climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. If the United States is to play a leadership role in international negotiations for a sensible post-Kyoto international climate regime, the country must begin to move towards an effective domestic policy – with legislation that is timed and structured to coordinate with the emerging post-Kyoto climate regime.

Without evidence of serious action by the U.S., there will be no meaningful international agreement, and certainly not one that includes the key, rapidly-growing developing countries.  U.S. policy developments can and should move in parallel with international negotiations.

The Bottom Line

So, like any legislation, the Waxman-Markey bill has its share of flaws. But it represents a solid foundation for a domestic climate policy that can help place the United States where it ought to be – in a position of international leadership to develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world.

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16 Responses to Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal

  1. Pingback: Daily Digest for June 19 » New Deal 2.0

  2. A second argument for free allowance allocations is to prevent large electricity rate increases. Does Waxman-Markey require that these subsidies be passed through to rate payers, or does it punt that issue to PUCs? Is there a third argument in favor of these subsidies–or is it just the way votes are being bought?

  3. Kevin Leahy says:

    Thanks Rob. Like your previous posting, this is a very helpful contribution to the discussion. I admit to having had concerns regarding this instance of updating in the bill, but had overlooked the fact that this resolved an important problem, namely that without updating the allocation would not have done anything to prevent emissions (or jobs) leakage.

    Hopefully, your post will be noticed by those concerned about the impact of this bill on trade exposed industries.

    Kevin Leahy
    Duke Energy

  4. Kevin, thanks for your comment.

    You’ve got it right. As I noted in my previous post, “The Wonderful Politics…,” there are economic problems with an output-based updating allocation mechanism, i.e., it drives up the cost — nationally — of achieving any given abatement target. But as I emphasize in this post, “Worried About …,” this mechanism — as it is structured in Waxman-Markey — is probably the best (least problematic) of the available mechanisms to address concerns about international competitiveness. Thanks again for your comment.


  5. Roger, whether or not free allowance allocations will prevent electricity price increases depends upon a complex set of factors. Please see my previous post on “The Wonderful..” for some discussion of this. The way the allocation to electricity local distribution companies (LDCs) is handled in Waxman-Markey is indeed intended to pass on the benefits of the allocation to consumers. It should be noted, however, that although this is politically important and may also be distributionally sensible (in the case of low-income consumers), it poses problems — not unlike the output-based allocation — because by keeping electricity prices down, energy conservation by consumers is discouraged, thereby driving up the aggregate social costs of achieving any given national abatement target. The key question is whether that financial signal (from the allowance benefit) to consumers can be separated effectively from their electricity rates. On this, you might want to take a look at the comments from Dallas Burtraw on my previous post, or more generally at Dr. Burtraw’s work (Resources for the Future). It’s an interesting and potentially important issue.
    Thanks for your comment,

  6. Walt French says:

    Sometime around the US rejection of Kyoto, we lost any leverage over the huge, and growing emissions from China.

    China is quite happy to accept part of the status quo of carbon, that developed nations are trying to reduce emissions in part by taxes and tax-like controls that shift production to nations without those efforts. To the extent that China causes MORE CO2 due to low-grade coal, inefficiencies, etc., we in the US and Europe have worsened both our domestic economies AND the global carbon situation. China is happy to exploit this perverse incentive scheme, but it requires them to refuse to pay the going rate for carbon.

    A start that could easily accompany Waxman-Markey, which would make good political sense in the US: an import duty on products based on the producing country’s carbon tax rate, perhaps double the difference in carbon taxes to account for multiplier effects of production resulting in additional high carbon emissions.

    With this little rider, Waxman-Market IMPROVES US competitiveness in addition to having stronger carbon controls. Win-win.

  7. Mr. French,
    Thanks for your comment. What you recommend — a border tax on the embodied carbon content (through production) of imports from China (and, I would assume, other large, rapidly growing economies which are outside of Annex I of the Kyoto Protocol) is economically equivalent to the import-allowance-requirement, on which I comment in my post, and which was a key feature of the Lieberman-Warner legislation in the Senate last year, and is the backup, long-term feature I describe in this post as a Presidential option in Waxman-Markey. My judgment, with which you may not agree, is that the output-based updating allocation mechanism is superior (or less bad, if you will) than import-allowance requirements (border taxes), because of the risky international trade implications of the latter. Some economists — including some for whom I have great respect (among them, Joseph Stiglitz of Columbia and Jeffrey Frankel of Harvard) may not, I believe, agree with me on this judgment.
    You can read more about this topic in an excellent paper on “Global Environmental Policy and Global Trade Policy” by Jeff Frankel at the following web address: http://belfercenter.ksg.harvard.edu/publication/18647/global_environmental_policy_and_global_trade_policy.html

    Thanks again for your comment,


  8. Michael Wara says:


    I agree with the main thrust of your argument that none of the approaches, other than international agreement, are perfect and that its not clear that the one taken by W-M is any worse than the other options.

    However, I’m not at all sure that output based free allocation will not run afoul of WTO law. This approach to compensating firms subject to international competition has the potential, if it does not precisely offset the change in competitiveness, to count as a violation of national treatment. The key here – and I confess I have not delved into this part of the bill – is that the trade-impacted industries not be overcompensated for the costs of climate change policy. What is your take on the level of compensation in the current bill relative to the likely costs for these industries? Given the political economy and the need to garner votes, especially later this summer in the Senate, my suspicion would be that there are likely to be too many allowances given away, which will set the stage for future WTO challenges.

    All the best,

  9. Michael,
    Thanks for your comment. I’ve discussed this with some trade economists (which I’m not) and they seem to feel that this section of the legislation would be WTO-compliant, particularly if the US is party to an international agreement, and the domestic legislation is the US implementation mechanism under the international agreement. Further, my understanding is that there is not over-compensation (but there is the inefficiency that I describe in the post associated with any output-based updating allocation mechanism). Also, as I said in the post, I will leave the issue you raised to trade economists and trade lawyers.

  10. Tennant Reed says:

    As I understand it, the output-based updating allocation mechanism in ACES will both provide incentives for emissions efficiency, and guarantee that some firms will be (in one sense at least) overcompensated. The allocation to individual firms is based on that firm’s production multiplied by direct and indirect carbon factors which derive from whole-of-industry averages. Thus relatively less intensive firms may receive more allowances than they are liable for, and more intensive firms will receive less. Both have an incentive to reduce emissions by any means except production cuts.

    The result is still not as environmentally and economically efficient as pure auctioning under a global constraint, since the shrinkage of some industries may ultimately be necessary for lowest-cost global abatement. But it’s not a bad interim way of addressing the leakage problem.

    A more difficult question is how much free allocation is necessary. In Australia, we’re grappling with this at the moment as our own cap-and-trade legislation faces a difficult time in our Senate. Our government’s proposed legislation uses a similar output-based updating allocation using industry averages, but with two key differences. One is that assistance to each emissions intensive trade exposed firm is limited to less than 100% of their production times average intensity (the most intensive industries get 90% of this figure; somewhat less intensive industries get 60%; the rest get nothing). Another is that there is no limit on the total proportion of our cap that can go to EITE industries; while assistance levels are currently set to decay, total assistance can grow with production.

    There is considerable interest in Australia in whether our proposed arrangements are more or less generous than those in ACES. This is not a simple question, but do you have a view on how wide a set of industries will be covered by the US definition of energy intensive adn trade exposed? And how well will their emissions fit within the set 15%-and-shrinking of allowances available for free allocation to them?

    I’ve very much enjoyed reading your posts on this – I look forward to many more as the debate moves on!


  11. Pingback: How to Set Greenhouse Gas Emissions Targets for All Countries | Jeff Frankels Weblog | Views on the Economy and the World

  12. Tennant,
    Thank you for your comment. The best way for me to answer your question is to provide you (and others) with the following web address, where you will find a complete description of the criteria through which “energy-intensive trade-exposed” sectors are to be identified by the EPA Administrator, as well as the formula for allocation of allowances to such sectors: http://thomas.loc.gov/cgi-bin/query/F?c111:2:./temp/~c111rzUNmD:e1134972:
    I hope you find this helpful.
    Thanks again for your comment.

  13. Michael Bishop says:


    Should we be worried about international competitiveness? The issue may overblown, since I believe that most of the current analysis rests on the faulty assumption that there is no carbon pricing in developing countries. Based on this analysis, it is said that the US (or any developed country that has ratified Kyoto) wlll suffer from carbon leakage – to a greater or lesser extent – and that, from a political point of view, the [insert name of developed country here] needs to do something about it, such as implementing a domestic policy measure to plug the gap (output-based allocations, import taxes, etc.) and twisting the arms of developing countries in full public view.

    The no-carbon price assumption is based on the notion that if a developing country does not have a commitment to reduce emissions, there cannot be any carbon price signal in their internal emissions market. However, this assumption does not reflect the current reality that the carbon price is internationalized through the Kyoto Protocol international market mechanisms. Developing countries that have ratified the Kyoto Protocol are eligible to host Clean Development Mechanism (CDM) projects, which in turn allows emissions reductions to be realized (as Certifed Emission Reductions – CERs). Since these CERs can be traded freely and used for compliance by the developed countries within Kyoto, just like any other Kyoto compliance unit (AAUs, ERUs), they introduce the price signal into these developing countries (albeit in the form of a subsidy). The CDM helps to ensure that the marginal cost of emission reductions is equalized not only across developed countries that have ratified the Kyoto Protocol, but also within the developing countries themselves. In fact, the US is one of the few countries in the world without a carbon price signal.

    Nonetheless, even if there were no comparative advantage afforded to developing countries as a result of the internationalization of the carbon price , there is still the political optics of the distributional impacts of the CDM. Even though there is a signicant level of emission reductions occurring in developing countries as a result of the CDM price signal (total of 317 megatonnes of CO2e issued as CERs), can it be considered a ‘comparable effort’ when the projects are fully subsidized and significant economic rents can be captured due to low-cost emission reductions opportunities in developing countries (even though a great portion of the rents are captured by the international finance and other companies involved rather than the developing countries)? However, objections raised over the distributional impacts of the CDM can also be applied to potential recipents under a US scheme for domestic carbon offset projects.

    I would appreciate seeing results of analysis that reflected the international pricing of carbon in developing countries, as propogated through the CDM. It could offer very different recommendations with regards to US domestic policy design and positions in international negotiations, ones that will help us move beyond the current stalemate.

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  16. jane says:

    Thanks for your comment. What you recommend — a border tax on the embodied carbon content (through production) of imports from China (and, I would assume, other large, rapidly growing economies which are outside of Annex I of the Kyoto Protocol) is economically equivalent to the import-allowance-requirement, on which I comment in my post, and which was a key feature of the Lieberman-Warner legislation in the Senate last year, and is the backup, long-term feature I describe in this post as a Presidential option in Waxman-Markey. My judgment, with which you may not agree, is that the output-based updating allocation mechanism is superior (or less bad, if you will) than import-allowance requirements (border taxes), because of the risky international trade implications of the latter. Some economists — including some for whom I have great respect (among them, Joseph Stiglitz of Columbia and Jeffrey Frankel of Harvard) may not, I believe, agree with me on this judgment.

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