Transatlantic Climate and Trade Relations: Conflict or Cooperation?

By Matt Porterfield
November 10, 2022

The passage of the Inflation Reduction Act (IRA) in August, with its $369 billion commitment to addressing climate change, has been described as the most significant climate legislation in U.S. history. European officials, however, have expressed concern over a number of IRA’s subsidy programs intended to promote decarbonization.

One provision in particular has drawn criticism: a $7500 subsidy for purchasers of electric vehicles (EVs) with batteries made in North America from minerals recycled in North America, mined in the United States, or mined in any country with which the U.S. has a free trade agreement. German Chancellor Olaf Scholz and French President Emmanuel Macron have suggested that the European Union would respond with similar “Buy European” programs, and EU Trade Commissioner Valdis Dombrovskis has indicated that the subsidies violate the United States’ obligations under the World Trade Organization (WTO). Other U.S. trade partners have also questioned the legality of the subsidies, with South Korea explicitly threatening to challenge them in the WTO.

The relationship between international trade and climate policy has become a growing focus of discussions between the U.S. and the European Union, presenting the potential for either conflict or cooperation. Last year, the Biden administration initially responded with skepticism to the EU’s proposal to extend its internal carbon pricing system to certain imports through a “carbon border adjustment mechanism” (CBAM). Subsequently, however, the administration indicated that it was considering developing its own system of carbon border adjustments, even without a domestic price on carbon. Senators Coons and Whitehouse have also introduced legislation embracing alternative approaches to border adjustments. And in October of 2021, the U.S. and the EU announced their intent to negotiate a “Global Arrangement on Sustainable Steel and Aluminum,” which the Biden administration described as “the world’s first carbon-based sectoral arrangement on steel and aluminum trade.

The controversy over EV subsidies threatens to undermine U.S.-EU coordination on climate and trade policy. But the U.S. is far from alone in trying to ensure that its climate policies benefit domestic industries and create jobs. Canada lost a WTO dispute in 2013 over local content provisions in Ontario’s renewable energy program. In 2016, India’s domestic content requirements for solar power generation were similarly found to violate the WTO’s nondiscrimination standards. And just last March, the EU initiated a WTO dispute over the United Kingdom’s subsidies for low carbon electricity generation.

The EU has its own vulnerabilities on climate subsidies. Earlier this month, the U.S. Court of International Trade confirmed the Department of Commerce’s determination that certain free allowances under the EU’s Emissions Trading System constitute countervailable subsidies. Industries in the EU also receive support for low carbon technologies both from the EU’s Innovation Fund, which will provide €38 billion between 2020 and 2030, and from individual Member States.

Fortunately, efforts are underway to prevent climate subsidies from fueling tensions or sparking a trade war. The U.S. and the EU have created a “Task Force on the Inflation Reduction Act” to address the EU’s concerns over the IRA’s subsidy provisions. Although these discussions are in their infancy, there are some obvious steps that the U.S. and EU can take to the lower the temperature on the debate over climate-related subsidies.

A good start would be to agree to a “peace clause” under which the U.S. and the EU would agree not to institute WTO challenges for a specified period against subsidies programs and other policies intended to promote domestic decarbonization. A peace clause would provide time and space to negotiate standards for permissible climate-related trade measures, potentially modelled on the expired “green light” provision of the WTO’s subsidies agreement.

The U.S.-EU discussions, in turn, could provide a basis for broader collaboration on climate and trade, potentially through existing initiatives like the proposed “climate club” in the G7.  Participants in a climate club not only could develop standards for subsidies, they could also coordinate on implementing shared domestic mitigation policies and border measures aimed at rewarding lower-carbon manufacturers. One such path is “the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary”: an economy-wide carbon price with border adjustments. This approach would allow the United States to reduce the carbon intensity of our supply chains while expanding the market share of our energy-intensive industries, due to the relative carbon-efficiency of U.S. manufacturers compared with our key competitors.

The controversy over the subsidy provisions of the IRA could degenerate into an escalating trade war that delays the implementation of necessary climate policies. As countries implement more aggressive climate policies aimed at reducing the carbon intensity of internationally traded products, tensions between trade partners are inevitable. The U.S. and the EU should seize the opportunity to create a path forward for managing these tensions and ensure closer international cooperation on climate and trade policy.

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