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Sustainable trade

Sustainable trade balancing act grows more difficult

Published 24 October 2023

Despite its noble intentions and its anticipated environmental upsides, the EU’s Carbon Border Adjustment Mechanism will further stress an already over-stressed trade system in much the same way tariffs do. As we launch the 2023 Hinrich-IMD Sustainable Trade Index, Senior Research Fellow Stephen Olson highlights the importance of managing the trade-offs between greater progress in addressing social and environmental issues and the imperative to keep trade as open as possible.

While trade has been an important driver of global economic growth and development for decades, the need to engage in trade on a more sustainable basis has never been greater – or more challenging – than it is today.  Rising protectionism, growing public dissatisfaction with the social outcomes associated with trade, along with the imperative to address climate change, means that our efforts to balance the economic, societal, and environmental aspects of trade are growing more complex.

The Hinrich-IMD Sustainable Trade Index (STI) provides useful insights into the challenges that economies face as they strive for that balance.  The STI evaluates 30 economies across the economic, societal, and environmental pillars of trade sustainability. Under the economic pillar, the top-ranked economies reduce trade and investment barriers, invest in solid technological and physical infrastructure, and diversify their trade relationships. Under the societal pillar, top-performing economies provide political stability, minimize economic inequality, and ensure their citizens are well-educated. Under the environmental pillar, top scorers typically maintain low transfer emissions, undertake efforts to combat air and water pollution, and adhere to high environmental standards in trade.

In the 2023 edition of the STI, New Zealand has the best overall score, followed by the United Kingdom and Singapore. While there is much that these three economies got right, this year’s index is set against a global backdrop that is growing more complicated for trade in general and sustainable trade in particular.

The need to address increasingly urgent societal and environmental challenges is presenting policymakers with difficult trade-offs to weigh.  Policies that will produce welcome progress on these fronts are also in many instances posing challenges to the maintenance of an open and cooperative trade system capable of delivering economic growth and development. Trade impacts will be felt across sectors and countries.

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Balancing societal and environmental concerns with trade outcomes

The EU’s Corporate Sustainability Due Diligence Directive (CSDD) will require companies to conduct extensive due diligence throughout their global value chains to ensure that suppliers are not operating in ways that violate human rights or are environmentally unsustainable. From a societal and environmental point of view, the directive and policies like it should be warmly welcomed and will ideally contribute to better outcomes across both these pillars of sustainability.

From a trade perspective, however, the picture is considerably more nuanced. Many suppliers in less developed countries, especially SMEs, will lack the staffing and resources to adequately demonstrate compliance with the stringent and sometimes vague requirements (what exactly is “spatial freedom”?) and their opportunities to trade could suffer. EU importers could be inclined to bypass their products for fear of running afoul of the directive. Companies and countries that are most in need of the opportunity to access the transformative power of trade would find that access circumscribed.

Under ambitious and well-intentioned deforestation policies, coffee producers in more than 70 countries, many of them small operations, will need to demonstrate that their beans were not harvested from newly deforested land in order to enjoy unimpeded market access to the EU.

Ultimately, however, the most consequential example of a beneficial environmental policy which complicates the trade picture could turn out to be the EU’s Carbon Border Adjustment Mechanism or CBAM.

On the surface at least, CBAM is an entirely logical measure aimed at preventing carbon leakage. The EU is one of the first jurisdictions to attempt to impose a cost on the greenhouse gas emissions (GHG) emissions embedded in a number of industries such as cement, iron, steel, aluminum, fertilizer, and electricity.

This creates an obvious problem, however. If the EU imposes a cost on carbon-intensive manufacturing within its borders while other jurisdictions do not, EU producers will be incentivized to relocate production to a no-cost jurisdiction and then simply export back into the EU. Hence the need for a “border adjustment” – in essence, a tariff – to level the playing field. The “border adjustment” would be intended to replicate the additional cost the product would have faced if it had been manufactured in the EU, thereby removing the economic rationale for relocating manufacturing to a no-cost location.

The “border adjustment” also provides a positive incentive for other countries to follow the EU lead and price carbon emissions embedded in manufacturing. Doing so would facilitate the ability of their domestic producers to access the lucrative EU market. Indeed, the CBAM has already prodded a number of countries around the world to more seriously consider carbon pricing – a move that could have game-changing implications for global efforts to address climate change.

While CBAM will be a positive environmental milestone that will almost certainly reduce GHG emissions, it also provides a case in point of the challenges inherent in seeking greater trade sustainability across the economic, societal, and environmental pillars.  In terms of the quest for greater trade sustainability, CBAM will be a knife that cuts in both directions.

Trade barriers undermine sustainable trade

Perhaps the most fundamental cornerstone of sustainable trade is the need to keep trade open. Reducing and eliminating trade restrictions – and avoiding the imposition of new restrictions - is therefore imperative. The maintenance and strengthening of our rules-based global trade system are likewise central to sustainable trade, both to facilitate a further reduction in trade barriers and to resolve trade disputes before they flare into trade wars.

Unfortunately, that’s not where we are today. We face a distressing increase in tariff and non-tariff barriers and a proliferation of hard-to-resolve trade disputes that further fray the trading system and run contrary to the principles of sustainable trade.

CBAM – despite its noble intentions and its anticipated environmental upsides – will further stress an already over-stressed trade system.  Although the “border adjustment” will be applied for readily understandable reasons, it will function as a trade restriction in much the same way tariffs do and will produce the same trade-dampening effects. Worse yet, the countries most likely to be adversely affected are the countries that need trade most – developing countries attempting to use trade as a locomotive to a more sustainable future. Developing countries are less well equipped to develop, implement, and administer the remarkably complex carbon pricing systems that would be required in order to avoid higher trade barriers on shipments into the EU.

Trade battles on the horizon?

From the perspective of trade governance – and the overall health of the rules-based system - CBAM could prove to be even more challenging. Although there is a lively debate underway among trade experts as to whether CBAM will violate World Trade Organization (WTO) rules, it’s safe to say that its legality will be vigorously contested. Some of the countries most likely to object to CBAM include Russia, China, India, Turkey, the US, Egypt, United Arab Emirates, and Ukraine. Indications thus far are that one or more of these countries will formally challenge CBAM in the WTO. Ultimately, the case could prove to be one of the furthest reaching in WTO history, both in terms of what it will tell us about the WTO’s ability to resolve disputes, as well as the viability of climate change policies which spill over into the trade realm.

Don’t believe anyone who tells you they can predict the outcome of the anticipated WTO challenge. The only thing we can be sure of is that it will be messy and will almost certainly leave the system further weakened – especially if the complainants resort to unilateral retaliation outside of WTO channels. Bruising trade battles – the very antithesis of sustainable trade – could be on the horizon.

What’s the path forward?

Sustainable trade is all about the need to weigh trade-offs and strike the best available balances.  The question is not whether the societal or environmental concerns that CBAM or other similar measures seek to address are legitimate. It is plainly evident that they are. Rather, the issue is: how should we manage the trade-offs between greater progress in addressing these issues and the potentially deleterious impact these measures might have on the sustainability of a rules-based system and our shared imperative to keep trade as open as possible? That is the challenge of the day.

There are no easy or clear-cut answers. The Hinrich-IMD Sustainable Trade Index does, however, provide us with important insights into how 30 economies are currently navigating that delicate balance act across the economic, societal, and environmental pillars of sustainability.

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Stephen Olson

From 2014 to January 2024, Mr. Olson was a Senior Research Fellow of the Hinrich Foundation. Mr. Olson began his career in Washington DC as an international trade negotiator and served on the US negotiating team for the NAFTA negotiations.

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