Unilateral action on climate change can have unintended consequences

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The writer is a former central banker and a professor of finance at the University of Chicago’s Booth School of Business

There is nowhere to hide. Whether you are being baked in Athens, Rome, Phoenix, or Tehran, or drenched in Beijing or Delhi, climate volatility is not far from you. With global talks on climate change going nowhere, countries and regions are feeling the pressure to do something on their own, rather than waiting for global agreement. Action is usually good, but some of it has serious adverse spillovers on other countries, especially poor ones. Uncoordinated action can be profoundly unfair.

Europe is probably most advanced among regions in taking action against climate change, with its cap and trade scheme for emissions (EU ETS). Fearing that EU companies that pay the implicit carbon tax will be at a disadvantage to foreign firms, and even choose to shift production abroad, the EU has settled on a carbon border adjustment mechanism (CBAM), which will levy a border tariff on imported goods, proportional to the untaxed emissions on the imports. Both the direct emissions from a company’s production and the emissions that were generated in the power it uses will be tariffed.

The US has its own approach. Rather than taxing emissions, it will subsidise clean energy use and generation with nearly $400bn of tax incentives, grants, and loan guarantees under the Inflation Reduction Act. Since some of these schemes are open-ended, the actual funding may be substantially more. To ensure its producers do not decamp to the US, the EU is trying to match some of these subsidies with its €2tn post-Covid recovery fund.

Finally, for many developing countries damaged by Covid and food inflation, budgets are tight. For now, there is little prospect of climate action funding coming from industrial countries despite past promises. Given that developing countries in the global south will bear much of the effects of climate change, and given that environmental disruptions will probably get much worse before they get better, developing countries are better off spending their own funds on adaptation — moving people to higher ground, shifting farmers to hardier crops, or reviving traditional water storage techniques — than on reducing emissions.

Each of these actions makes sense taken alone; together they have unintended effects. So, CBAM passes muster under World Trade Organization rules (which prohibit giving domestic companies an unfair advantage) because the EU will levy a similar carbon tax on its own producers. But if the EU subsidises clean energy production to match the US, any EU manufacturer will have lower effective emissions since more of the power they use will be clean. For an Egyptian producer, whose government is strapped for funds and has modest possibilities for increasing green power, the playing field will become unfairly tilted. 

If that Egyptian producer cannot compete, exports fall, lay-offs increase, tax collections fall and the country becomes even less able to afford climate action of any kind. And even if Egypt does improve its fiscal situation, would it not make more sense for the government to spend more on helping its farmers adapt at this juncture than spending scarce budgetary resources on replacing existing energy sources with green energy?

In sum, the CBAM alone is a sensible policy, though the global playing field would really be level only if other countries had an equal opportunity cost of funding green investment. For developing countries, though, not only are the direct costs of financing much higher, adaptation is becoming much more critical, and so the opportunity cost of devoting scarce funds to green energy is increasing. And everything is made yet more unequal for developing countries by the subsidies the US is pouring into green energy, which Europe is striving to match.

Ideally, a global agreement would take all of these concerns into account. For instance, I have proposed a scheme whereby countries emitting carbon per capita above the global average should pay into a fund, and those below the global average should receive. High emitters (largely rich countries) would pay, giving poor countries transfers they could then leverage so that they have enough resources to fund mitigation and adaptation.

Are we letting the perfect be the enemy of the good in pushing for a just global agreement? Not if the unintended consequences of unilateral action tend to pile up in countries and among people least able to bear them. The industrialised world can do better.