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CHAPTER 2

TRADE AND ENVIRONMENT: LINKAGES AND POLICY ISSUES

1. Introduction

The multilateral trading system (MTS) created after the Second World War, afterseveral rounds of trade negotiations culminating in the Uruguay Round, led to the

establishment of the World Trade Organization (WTO) on January 1, 1995. The

main objective of the WTO is promotion of world trade by gradually reducing tariffs

and eliminating non-tariff barriers. The WTO envisages an open equitable and non-

discriminating multilateral trading system. As on February 28, 2005 the WTO had

148 member nations that accounted for 97 percent of the global trade.

Even though there is a provision in the General Agreement on Tariffs and Trade

(GATT) 1947 Article XX which allows countries to sidestep the normal trading rules

to protect human, animal or plant life or health, or to conserve exhaustible

resources, interest in environmental issues was awakened only at the time of the

UN Conference on Human Development held in Stockholm in 1972. The UN

Conference on Environment and Development (UNCED) held at Rio de Janeiro in

1992, particularly the Rio Declaration on Environment and Development, stressed

the need for understanding the linkages between trade and environment and

translating the Rio principles in terms of trade and environmental policies atnational and global levels. The Marrakesh Decision on April 14,1994 identified ten

items for discussion on trade and environment. The General Council of the WTO

established the Committee on Trade and Environment (CTE) to consider the ten

items and report to the WTO Council.

Even though the CTE holds the view that there should not be nor needed to be any

policy contradiction between upholding and safeguarding an open equitable and

non-discriminatory MTS on the one hand and acting for the protection of the

environment on the other, there are many contentious issues on the trade and

environment debate. Some interesting questions in the debate are: (a) whether

trade liberalization is harmful to the environment particularly to the environment in

developing countries? (b) What are the implications of cross-country diversity in

environmental standards for trade policy? (c) What kind of policy regimes are

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needed to handle pollution, which is domestic, and pollution, which involves cross-

border transfers or/and global in nature? (d) Is use of trade measures tariff and

non-tariffs legitimate in achieving a countrys environmental goals, targets in

multilateral environmental agreements? (e) To what extent the MTS is successful in

implementing the Rio principle of common but differentiated responsibilities and

special provisions in the WTO agreements giving developing and least-developed

countries special and differentiated treatment? (f) Does the environmental

requirements of some developed countries act as non-tariff barriers for developing

countries exports to developed countries? (g) Are the use of environmental

measures legitimate in achieving trade policy goals? This chapter considers these

questions from the perspective of developing countries, utilizing information

available in the literature on trade and environment covering theory, empirical work

and policy regimes. The specific issues relating to leather exports, particularly the

impacts of environmental requirements abroad on market access and market entry

will be considered in Chapter 3.

The plan of this chapter is as follows. Section 2 deals with the evolution of the MTS

since 1947 focusing on the linkage between trade and environment and the WTOs

position on the linkage. Section 3 summarizes theoretical results of the impact of

trade liberalization on social welfare, with and without sound environmental

policies, when the pollution is domestic. Section 4 is devoted to a critical review of

the theoretical, empirical and policy literature dealing with the impact of cross-

country differences in environmental standards on trade patterns, production

patterns and environmental quality. It addresses the concerns of both developed

countries and developing countries and discusses the problems in cross-country

harmonization of the standards. Section 5 considers policy options available for

dealing with cross-border environmental externalities. The last section looks at the

MTS through the lens of the emerging global public goods literature.

2. Environment in GATT and WTO Trading Regimes1

Evolution till 1992

The main objective of the international trading regime established after the Second

World War was trade liberalization. There was no reference to environment in the

1 See Nordstrom and Vaughan (1999) and WTO (2004) for details.

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general proceedings of the contracting parties. Only the GATT 1947 Article XX

allows countries to sidestep the normal trading rules, if necessary, to protect

human, animal or plant life or health, or to conserve exhaustible natural resources,

provided that such measures do not discriminate between sources of imports or

constitute disguised protection on international trade.

The UN Conference on Human Development held in Stockholm in 1972 awakened

interest in environmental issues. The GATT Council established a Group on

Environmental Measures and International Trade (EMIT) with a mandate to

examine upon request any specific matters relevant to the trade policy aspects of

measures to control pollution and protect the human environment, especially with

reference to applications of the provisions of the GATT, taking into account the

particular problems of developing countries. However, no request was made to

convene the EMIT until the beginning of the 1990s.

During the Tokyo Round of trade negotiations (1973-79), the question of the degree

to which environmental measures (technical regulations and standards) could form

obstacles to trade was taken up. An Agreement on Technical Barriers to Trade,

known as the standards code, was negotiated. It called for nondiscrimination in the

preparation, adoption and application of technical regulations and for their

transparency. The issue of exports of domestically prohibited goods (banned onhealth or environmental grounds) to developing countries was on the GATTs work

programme at the 1982 Ministerial meeting. In July 1982, the Council established

a Working Group on the Export of Domestically Prohibited Goods and other

Hazardous Substances. As no agreement could be reached till July 1991, it was

agreed in the Marrakesh Ministerial Decision on Trade and Environment to

incorporate this issue into the work programme of the WTO Committee on Trade

and Environment. During the Uruguay Round of negotiations (1986-1993),

modifications were made in the standards code and some environmental issueswere addressed in the General Agreement on Trade in Services, the Agreement on

Agriculture, Sanitary and Phyto-sanitory Measures, Subsidies and Countervailing

Measures, and Trade Related Intellectual Property Rights.

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In the nineties a series of contentious environmentally related disputes arose. See

WTO (2004). The UNCED held at Rio de Janeiro in 1992 was an opportunity to

activate the EMIT Group. The European Free Trade Association (EFTA) urged the

need for studying the linkages between trade policy and environmental policy. It

noted that the approach to environmental policy making varied considerably from

country to country due to differing geographical settings, economic conditions,

stages of development and environmental problems. Accordingly, governments

priorities on these problems differed as well. The important point here was that the

resulting differences in actual policies could set stage for trade disputes. The GATT

Council requested its Chairman to conduct informal consultations to promote a

structured debate. The EMIT Group met from November 1991 to January 1994.

The Group agreed that there was no policy contradiction between upholding the

values of the MTS on the one hand, and acting individually or collectively for the

protection of the environment and the acceleration of sustainable development on

the other. The UNCED at Rio de Janeiro from June 3 to 14, 1992 was a milestone

in working towards international agreements that respect the interests of all and

protects the integrity of the global environmental and development system.

The Rio Declaration

The Rio Declaration on Environment and Development proclaims the followings

principles that are relevant for environment policy and trade policy of developing

countries:

Principle 2: States have, in accordance with the Charter of the United Nations and

the principles of international law, the sovereign right to exploit their own resources

pursuant to their own environmental and development policies, and the

responsibility to ensure that activities within their jurisdiction or control do not

cause damage to the environment of other states or of areas beyond the limits of

national jurisdiction.

Principle 4: In order to achieve sustainable development, environmental protection

shall constitute an integral part of the development process and cannot be

considered in isolation from it.

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Principle 6: The special situation and needs of developing countries, particularly the

least developed and those most environmentally vulnerable, shall be given special

priority. International actions in the field of environment and development should

also address the interests and needs of all countries.

Principle 7: States shall cooperate in a spirit of global partnership to conserve,

protect and restore the health and integrity of the Earths ecosystem. In view of the

different contributions to global environmental degradation, States have common

but differentiated responsibilities. The developed countries acknowledge the

responsibility that they bear in the international pursuit of sustainable development

in view of the pressures their societies place on the global environment and of the

technologies and financial resources they command.

Principle 11: States shall enact environmental legislation. Environmental

standards, management objectives and priorities should reflect the environmental

and developmental context to which they apply. Standards applied by some

countries may be inappropriate and of unwarranted economic and social cost to

other countries, in particular developing countries.

Principle 12: States should cooperate to promote a supportive and open

international economic system that would lead to economic growth and sustainable

development in all countries, to better address the problems of environmental

degradation. Trade policy measures for environmental purposes should not

constitute a means of arbitrary or unjustifiable discrimination or a disguised

protection on international trade. Unilateral actions to deal with environmental

challenges outside the jurisdiction of the importing country should be avoided.

Environmental measures addressing transboundary or global environmental

problems should, as far as possible, be based on international consensus.

The Marrakesh Decision

At the July 1992 Council meeting, the Director-General noted that Agenda 21

contained a number of recommendations directly relevant to the work of the GATT

in the field of trade, environment and sustainable development. The Marrakesh

Ministerial Conference decided to adopt a work programme on trade and

environment. This led to the adoption, on April 14, 1994, of the Decision on Trade

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and Environment (Marrakesh Decision). The trade Ministers noted that (a) it should

not be contradictory to safeguard the MTS on the one hand, and act for the

protection of the environment and the promotion of sustainable development on the

other hand, and (b) policies in the field of trade and environment be coordinated,

but without exceeding the competence of the MTS, which is limited to trade policies

and those trade-related aspects of environment policies which may result in

significant trade effects.

The Marrakesh Decision lists the following ten items:

1. The relationship between the provisions of the MTS and trade measures for

environmental purposes, including those pursuant to multilateral

environmental agreements (MEAs),

2. The relationship between environmental policies relevant to trade and

environmental measures with significant trade effects and the provisions of

the MTS,

3. The relationship between the provisions of the MTS and

(a) Charges and taxes for environmental purposes

(b) Requirements for environmental purposes relating to products,

including standards and technical regulations, packaging, labelling

and recycling,

4. The provision of the MTS with respect to the transparency of trade measures

used for environmental purposes and environmental measurements and

requirements which have significant trade effects,

5. The relationship between the dispute settlement mechanisms in the MTS and

those found in MEAs,

6. The effect of environmental measures on market access, especially in relation

to developing countries, in particular to the least developed among them, and

environmental benefits of removing trade restrictions and distortions,

7. The issue of exports of domestically prohibited goods,

8. Trade-related intellectual property rights (TRIPs),

9. Services, and

10. Appropriate arrangements for relations with non-governmental organizations

referred to Article V of the WTO and transparency of documentation.

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Committee on Trade and Environment

The General Council of the WTO established the Committee on Trade and

Environment (CTE) at its first meeting, held on 31 January 1995. The CTE is

composed of all the WTO members and a number of observers from inter-

governmental organizations. It reports to the WTOs General Council.

The CTE in its report to the Singapore Ministerial Conference in December 1996,

noted that there should not be nor needed to be any policy contradiction between

upholding and safeguarding an open, equitable and non-discriminatory MTS on the

one hand and acting for the protection of the environment on the other. It said that

the WTO members were committed not to introduce WTO-inconsistent or

protectionist trade restrictions or countervailing measures in an attempt to offset

any real or perceived adverse domestic economic or competitiveness effects of

applying environmental policies. Governments had the right to establish their

national environmental and developmental conditions, needs and priorities. It also

noted that it would be inappropriate for them to relax their existing national

environmental standards or their enforcement in order to promote their trade. On

the issue of the relationship between trade measures in MEAs and the MTS, the

Report endorsed and supported multilateral solutions as the best and most effective

way for governments to address global and transboundary problems. The Report

also summarizes the deliberations of the Committee on the ten items.

Multilateral Trade Rules Governing Environmental and Health Requirements

WTO Agreement on Technical Barriers to Trade (TBT)

The TBT Agreement governs the preparation, adoption and application of product

technical requirements, and of procedures used for the assessment of compliance

with them. It defines technical regulation a document that lays down product

characteristics or their related processes and production methods (PPMs) with

which compliance is mandatory. It defines standard a document approved by a

recognized body, that provides for common and repeated use, rules, guidelines or

characteristics for products or related PPMs, with which compliance is not

mandatory.

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The main principles of the TBT Agreement are: (a) non-discrimination, (b) avoidance

of unnecessary obstacles to trade, (c) harmonization, (d) equivalence, (e) mutual

recognition, and (f) transparency.

The non-discrimination principle requires satisfying Most-favoured Nation (MFN)and National Treatment (NT) principles. The WTO members shall ensure that

products imported from other member countries shall be accorded treatment no

less favourable that accorded to like products of national origin and to like products

originating in any other country. Likeness is determined on a case by case using

four criteria namely, physical characteristics, tariff classification, consumers tastes

and habits, and product end uses.

Governments must ensure that technical regulations and standards do not create

unnecessary obstacles to trade. The mandatory technical regulations must not be

more trade-restrictive than necessary to fulfill legitimate objectives such as national

security requirements, protection of human health or safety, protection of animal or

plant life or health, protection of the environment and prevention of deceptive

practices.

The Agreement encourages countries to use international standards developed by

International Standardizing Bodies except when inappropriate because of climatic

or geographical factors or fundamental technological problems. The equivalence

principle recognizes acceptance of other regulations as equivalent even when they

differ provided that they fulfill the objectives of their own regulation. Conclusions of

mutual recognition arrangements are also encouraged. It provides for transparency

via notification of draft technical regulations, conformity assessment procedures

and standards, establishment of national enquiry points providing the information

and establishment of a panel of technical experts to examine disputes between

members.

The Agreement contains provisions for developing countries. Article 12 of the

Agreement states that all members shall take into account the special needs of

developing countries and avoid creating unnecessary obstacles to exports of special

interest to developing countries. Developing member countries shall only use

international norms appropriate to their needs and they can be granted specified,

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The Cancun Ministerial Conference of the WTO held in September 2003 ended in a

stalemate. Many developing countries opposed Singapore issues relating to

investment, procurement and competition, and demanded time bound elimination

of all forms of export subsidies to agricultural products in developed countries. The

WTO Framework Agreement, adopted on August 1, 2004 by members of the WTO,

has ensured that the negotiations are back on track.

As per the Framework Agreement, developing countries are eligible to designate an

appropriate number of products as special products based on food and livelihood

security or rural development needs as regards tariff reduction formula, the number

and treatment of sensitive products, expansion of the tariff quotas and the

implementation period. Regarding industrial products under non-agricultural

market negotiations, developing countries concerns about reduction of peak tariffs

and tariff escalations in products of export to these countries will be addressed.

A note prepared by the WTO Secretariat (2004) reports the different perceptions of

developed and developing countries as follows: Whilst developed countries were

subjected to increased pressure from environmental interest groups to reconcile

what they perceived as incompatibles between trade and environment policies,

developing countries feared that environmental concerns would be addressed at the

expense of international trade. In particular, they feared that a new greenconditionality would be attached to market access opportunities. The Note

mentions that the following parameters have guided trade and environment

discussions at the WTO:

(i) The WTO is not an Environmental Protection Agency,

(ii) GATT/WTO rules provide significant scope for environmental protection,

(iii) Increased market access for developing countries,

(iv) Trade and environment coordination should be enhanced.

3. Trade Liberalization and Welfare Gains

For a small country, it is well known that, in the absence of pollution, trade

liberalization will result in an increase in social welfare. It can also be shown that

trade liberalization in the absence of a sound environmental policy will result in

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decrease in social welfare. Trade liberalization with sound environmental policy will

increase welfare. We present the above results using simple models.

a. No pollution

We use a two-commodity model to illustrate that by opening up the country forforeign trade the country can attain higher welfare. The country is small in the

sense that its trade volumes have no effect on the world prices. In Figure 1, the

product transformation curve is denoted as TT and a social indifference curve is

denoted as S0. In a closed economy, that is, before trade, the production optimum

and the consumption optimum are at the point e0 where the marginal rate of

transformation in production equals the marginal rate substitution in consumption.

The common slope of the TT curve and the S0 curve at e0 indicates the domestic

relative price.

The slope of the pp line gives the external (world) relative price. A comparison of the

slope of the pp line with the common slope at e0 shows that, at e0 the domestic price

of y (in terms of x) is cheaper than the external price of y (in terms of x). On the

other hand, the domestic price of x (in terms of y) is higher than the external price

of x (in terms of y). Hence, the country has a comparative advantage in the

production of y. The country can achieve the production optimum, by moving along

the TT curve to the point e1 where the slope of TT curve (the marginal rate oftransformation between x and y) equals the external price ratio. Then it can

achieve the consumption optimum at the point e2 on the social indifference curve,

s1, where the slope of the social indifference curve (the marginal rate of substitution

between x and y) equals the external price ratio. The social welfare at e2 is higher

than at e0. The country exports y1 y2 of good y and imports x2 x1 of good x.

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Figure 1

Trade Liberalization and Welfare Gain: No Pollution

y

p

T

e1y1

y0 e0y2 e2

s1

s0

p

x1 x0 T x2 x

b. With PollutionSuppose production of y generates negative externality in the form of local

environmental pollution. With trade liberalization, production of y will increase and

hence the volume of pollution. What would be the effect on welfare in the absence

of any environment policy. It is possible to carry out the analysis using a general

equilibrium model. See for example Bhagwati and Srinivasan (2002). However, we

prefer the Marshallian partial equilibrium framework with the welfare criterion of

consumers surplus and producers surplus, because it is a convenient apparatus

for measuring the external costs and the economic welfare. First, we consider theautarchy case, without and with sound environmental policy. Second, we study the

situation after trade liberalization, without and with sound environmental policy.

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Autarchy: without and with environmental policy

We consider the case where the production of a commodity causes local pollution.

In Figure 2 MCs and MCp represent social and private marginal costs of producing

the output. Domestic market demand is given by the curve D. In the absence of

environmental policy, the private competitive market outcome corresponds to the

point c with output q3 and price p1. The marginal social cost of q3 at e is higher

than the market price. The social welfare is, abc minus bce, which also equals abd-

dce. The negative externality can be internalized by levy of a Pigouvian tax (social

marginal cost minus private marginal cost). When a tax equals (d-k) is levied and

collected, the new equilibrium will be at the point d, with output q2 and price p2.

The social welfare corresponding to d is abd, which is greater than the social

welfare corresponding to c, by the area of the triangle dce.

Trade Liberalization: without and with environmental policy

If the world price for the good is pw, there is an export opportunity. The exporting

country is assumed to be small in the sense that its volume of export does not affect

the world price. In the absence of an environmental policy, the private market

equilibrium will be at the point f with output q5. The country will be exporting (f-j)

output. The social welfare is given by abfj minus bfh where bfh is the negative

externality; or abgj-gfh. With an imposition of a Pigouvian tax equal to (g-l) the

social optimum is at the point g corresponding to output q4. Production and export

values corresponding to the social optimum are lower than the ones corresponding

to the private optimum, but the social welfare corresponding to the social optimum

is higher by the area of the triangle gfh. Hence, in the presence of negative

externality in the production of an exportable or /and absence of sustainable

management policy for natural resource, trade liberalization will result in

deterioration in environmental quality and degradation of natural resources.

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Figure 2

Trade Liberalization, Environmental Policy and Welfare

MCHa

MCs h

j i g MCppw

d e f

p2 c lp1

k

D

b

0 q1q2 q3q4 q5 Output

In the above analysis, MCs may be interpreted as the marginal social cost of

complying with domestic environmental standards. The choice of standards and

their levels are based on an assessment of the domestic trade-offs between

environment and development. Both the UNCED and the WTO allow each country

to choose its own environmental standards based on their trade-offs between

development and environment. Suppose the importing countries prescribe

environmental standards that are higher than the ones in the country, then the

cost of compliance with the higher standards will be higher. Let the dashed MCH

line represent the marginal compliance cost corresponding to the higher standards.

The imposition of higher standards results in reductions in the export and the

production. It may be observed that the resulting output (q1) is even below the

social optimum output under autarchy (q2). The domestic consumer would face a

higher price pw and the volume of export will be only i-j. Hence, the country may

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prefer no trade (point d) to a trading regime when importing countries prescribe

higher environmental standards. The results corresponding to the different policy

regimes are summarized in Table 1.

Table 1: TRADE LIBERALIZATION AND ENVIRONMENTAL POLICY:

EQUILIBRIUM OUTPUT, PRICE AND SOCIAL WELFARE UNDER ALTERNATIVE

POLICY REGIMES

Autarchy Trade Liberalization

Noenvironmental

policy

Withenvironmental

policy

Noenvironmental

policy

Domesticenvironmental

policy

Higherstandards

fromimporters

Equilibrium c d f g i

Output q3 q2 q5 q4 q1

Price p1 p2 pw pw pw

Social

welfare

abd-dce abd abgj-gfh abgj abij

MCp: private marginal cost

MCs: social marginal cost corresponding to domestic standards

MCH: marginal cost of meeting higher standards of importers

Trade liberalization and stringent environmental standards also provide an

opportunity for developing countries to undertake structural reforms, technological

upgradation and joint ventures and creation of a policy environment to lower the

marginal social costs (rightward shifts of the MCS and MCH curves) and thereby

increase production and exports without an increase in pollution. See Porter and

Van der Linde (1995).

Trade liberalization may result in over exploitation of natural resources in

developing countries. Chichilnisky (1994) notes that the south has an apparent

comparative advantage in natural resource extraction because natural resources

are often managed as common properties with open (free) access regime.

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4. Diversity in Environmental Standards

The Rio Principle 11 recognizes diversity in environmental standards across

countries and notes that any attempt toward harmonization of the standards may

be inappropriate and of unwarranted economic and social cost to other countries,

in particular developing countries. The WTO also recognizes diversity in

environmental standards and the WTO agreements contain provisions giving

developing and least-developing countries special and differential treatment.

Diversity in environmental standards across countries can be justified on

theoretical grounds. First, the social welfare function that reflects the trade-off

between income and environmental quality depends on the stage of economic,

social and political development. The Environmental Kuznets Curve postulates that

as income goes up environmental quality worsens up to a point after which

environmental quality improves. Trade liberalization that results in an increase in

income can generate more resources for improving environmental quality. But,

apart from an increase in income, institutional and democratic reforms are

necessary to articulate peoples preferences for environmental quality and influence

the political decision making process. Second, there are large variations in baseline

emissions across countries. The factors responsible for these variations include

composition of and levels of outputs of various activities, technologies used, types

and intensity of energy used, levels of pollution abatement etc. Third, the pollution

absorption capacities of regions differ depending on topological conditions,

meteorological factors and existing pollution loads.

Despite the theoretical case for cross-country diversity in environmental standards

and its acceptance by the global community, there is a debate on the outcomes

when high standard and low standard countries engage in free trade. Developed

countries are concerned about industry flight, a tendency towards a race-to-the-

bottom in environmental standards, unfair trade and export competitiveness.The developed countries responses to these perceived or real threats are demands

for harmonization of the standards, import ban on products coming from countries

with low environmental standards, levy of countervailing duty on imports from low

standards countries because the trade is unfair and use of non-tariff barriers such

as ecolabelling, tighter environmental requirements on products, processes and

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methods, life cycle assessment and so on. The developing (low standard) countries

view these responses as a new form of protection. They consider the contemplated

measures as WTO-inconsistent and contrary to the special provisions for developing

countries agreed upon in the UNCED and the WTO.

Trade Patterns and Pollution Havens

Grossman and Kruger (1991) study on North American Free Trade Agreements

(NAFTAs) environmental effects uses a general equilibrium framework and

decomposes the environmental impact of trade into three interacting elements a

composition effect, a scale effect, and a technique effect. The composition effect

arises from trade-induced specialization. The net effect on the local environment

will be positive if the expanding sectors are less polluting on average than the

contracting importcompeting sectors, and negative if the opposite holds. For a

given composition of production and given pollution coefficients, enhanced

economic activity will increase pollution (the scale effect). They name the income-

induced reduction in pollution per unit of output as the technique effect. This effect

assumes that the willingness to pay for goods produced with higher environmental

standards increases with income. They conclude that the combined net effect is

uncertain.

Copeland and Taylor (1994) consider the effect of trade liberalization onenvironmental quality in the North (developed countries) and in the South

(developing countries). They find that (a) the composition effect mitigates pollution

in the North and magnifies in the South, (b) the scale effect is bad for environment

in the North and in the South, and (c) the technique effect reduces pollution in the

North and increases pollution in the South. Therefore, trade liberalization will

mitigate local environmental problems in the North but magnify the problems in the

South.

Sorsa (1994) finds that the industrialized countries share of manufacturing exports

in world trade declined from 91 percent in 1970 to 81 percent in 1990, but most of

the decline was recorded in labour-intensive sectors such as textiles, apparel,

footwear and other light manufacturing, in which comparative advantages have

drifted to developing countries with lower labour costs. In contrast, developed

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countries share of world trade in environmentally sensitive sectors, which are

capital-intensive remains unchanged.

Using world trade data for the years 1965 and 1988, Low and Yeats (1992) find that

developing countries had increased their share of world trade in polluting industriesfrom 22 to 26 percent. But the World Bank (1998) data on net exports of pollution

intensive industries for 1986 and 1995 give a different result. The export-import

ratio in pollution-intensive goods is small (around 0.3) for low-income countries, a

little higher but less than 1 for middle -income countries but above 1 for high

income countries. The results show that the developing countries, with a few

exceptions, do not specialize in highly polluting industries; rather they import more

pollution-intensive goods than they export.

Based on a survey of international and domestic evidence on environmental

regulations and industry location, Levinson (1996) concludes that environmental

regulations have not affected inter-jurisdictional trade or the location decisions of

manufacturers. Using the dataset of annual trade flows of environmentally sensitive

goods disaggregated at the four-digit level of the Standard International Trade

Classification (SITC) from 1965 to 1995 for 34 reporter countries, Xu (2000) finds

no systematic changes in trade patterns of environmentally sensitive goods between

1965 to 1995, despite the introduction of more stringent environmental regulations

in most of the developed countries in the 1970s and 1980s.

It must be noted that most of the empirical studies suffer from one or more of the

following limitations namely, assumptions of constant returns to scale and same

pollution intensities across countries in each industry in input-output based

models, use of pollution intensities based on the US data and high level of

aggregation. By concentrating on pollution intensities, some of these studies do not

recognize differences in pollution abatement levels among countries. It is possible

that an industry may be highly polluting but if it undertakes abatement upto the

level of prescribed standard, there is no harm to the environment. What matters is

the share of environmental compliance cost in the total cost and whether or not the

compliance cost erodes the comparative advantage. Most of the studies are carried

out at 2 digit or 3 digit industrial classifications. In many industries environmental

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pollution occurs only in certain stages of processing. Also these studies ignore

trade policy intervention by States.

Studies on foreign direct investment flows also do not provide support to the

hypothesis that stricter environmental standards encourage migration of pollutingindustries from countries with high environmental standards to those with low

standards. Nordstrom and Vaughan (1999) identify the restraining factors that

prevent the migration of polluting industries. These factors are: (a) pressure from

local communities in developing countries to clean up their act, (b) effort by foreign

firms to safeguard their reputation, to avoid consumer boycotts in environmentally

conscious markets, and to reduce the risk of legal liabilities, (c) multinationals base

their technology decisions not only on the current regulatory framework, but on

what they expect in the future, and (d) rapid adoption of voluntary environmentalmanagements promulgated by the International Standardization Organization (ISO)

e.g., ISO 14,000. Neumayer (2000) mentions a few other factors that make

migration difficult. Some dirty industries cannot migrate when they are dependent

on being close to their product markets. Migration itself is costly because of

dismantling, transportation, and new establishment costs. Factors other than

differences in environmental costs are likely to be much more important in

determining investment location decisions, e.g. poor infrastructure, trained labour

force, proximity to natural resources, and tax incentives.

Race-to-the-bottom and regulatory chill

Critics of stringent environmental regulations argue that different jurisdictions

compete to attract international business by lowering their standards below socially

efficient levels. A race-to-the-bottom may occur if the industrial lobby has the

upper hand over the green lobby. On the other hand, a race-to-the-top is likely to

bid up standards in a race to prevent the pollution from locating in their territory

the not-in-my-backyard (NIMBY) phenomenon.

Presenting a synthesis of the theoretical findings, Nordstrom and Vaughan (1999)

note that race-to-the-bottom is likely when capital is mobile and (a) there is access

only to distortionary policy instruments and high unemployment or polluting

industries more profitable than clean industries, (b) there is transboundary/global

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pollution and, (c) there is industrial capture of the political process. Race-to-the-

top is likely when capital is mobile and (a) polluting and clean industries are equally

profitable, and (b) greens capture the political access.

The empirical evidence for regulatory chill is of anecdotal nature. In politicaldebates over new environmental regulations or tightening enforcement of existing

regulations, competitive concerns are raised both in developed and developing

countries. The reluctance of the United States to sign the Kyoto Protocol is due to

the likely adverse impact of an increase in energy price on the countrys growth

prospects.

Competitiveness Concerns

The basic argument underlying the pollution haven, race-to-the-bottom and

regulatory chill hypotheses is that stricter environmental regulation will increase

the environmental compliance costs of the firms and thereby erode their competitive

advantages. As pointed out by Nordstrom and Vaughan, comparison of compliance

costs with different national environmental regulations is seriously hampered by

lack of data. Even for the US, the data are at the two digit level and more than ten

years old. Pollution abatement operating costs as percent value of shipment for

different industries in 1993 varied from 0.12 to 1.93. They cite a study prepared by

the Organization for Economic Cooperation and Development in 1997, which gives

pollution abatement costs between 1to5 percent of production costs. The

overwhelming share of production costs is determined by other factors, such as

wages, payroll taxes, capital costs, import tariffs on intermediate inputs, corporate

taxes and so on.

The US data on pollution intensities and abatement cost as percent of production

cost cannot be transplanted for application in developing countries. The reasons

are differences in technologies, scale of operations, and more importantly

differences in environmental standards. The pollution abatement costs given above

are average values at the industry level. For compliance or non-compliance what is

relevant is the marginal abatement cost of achieving the specified standard. For a

discussion on the measurement and estimation problems, see Sankar (2001b),

Chapter 14.

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Porter and Van der Linde (1995) argue that the environmentcompetitiveness

debate has been framed incorrectly. The notion of an inevitable struggle between

ecology and the economy grows out of a static view of environmental regulation, in

which technology, products, processes and customer needs are all fixed, (p.97).According to them, competitive advantage rests on the capacity for innovation and

improvement that shift the constraint (p.98).

Environmental Diversity and Free Trade

Bhagwati and Srinivasan (2002) discuss the issue Does environmental diversity

detract from the case for free trade?. They consider the following four objections to

diversity of standards. First, diversity of standards is tantamount to lack of level

playing fields and therefore amounts to unfair trade. Their response to this

objection is: the fact that others abroad do not carry the same burden is symmetric

with the fact these countries have different wages, capital costs, skills,

infrastructure, weather, and what have you: all of which lead to differential

advantages of production and trade competitiveness. Diversity of environmental tax

burdens is thus no ground for complaints of unfairness (p.75). They argue that

attributing competitive disadvantage to differential pollution tax burdens in the

fashion of cross country inter-industry comparisons for individual industries

confuse absolute with comparative advantage.

The second objection is that if free trade occurs with countries having lower

environmental standards, the effect will be to lower their own standards. This

argument is related to a race-to-the-bottom argument. They note that independent

governments (or jurisdictions), setting public policy for environmental protection

(via taxes and abatement) and competing for investment by reducing environmental

standards in a world of mobile and scarce capital, will set these standards at levels

that are too low, that is, that are inefficient for the world economy . We have

non-Pareto optimal CournotNash equilibriacharacterized by lower environmental

standards than in the cooperative equilibrium (p.76). They find weak empirical

evidence in favour of interjurisdictional mobility in response to cross-country inter-

industry differences in environmental standards.

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The third objection is about the compatibility of ethical preferences and free trade

among trading nations who do not share the same ethical preferences. Bhagwati

and Srinivasan argue that the values sought to be imposed are lesser values and

culture-bound. They note that there are alternative ways in which ones values can

be propagated than via unilateral suspense of trade access.

The fourth objection is that the GATT procedures that enable low standards act as a

threat to the high standards. The GATT rules place no constraints on a countrys

right to protect its own environment against damage from either domestic

production or the consumption of domestically produced or imported products.

Bhagwati and Srinivasan throw lights on three issues: the intention issue, the

scientific test issue and the circumventing-democracy issue.

Neumayer (2000) observes that the dispute settlement system of the WTO favours

trade interests over environmental protection. In all four decisions (Canadas export

prohibition of unprocessed salmon and herring, Thailands levy of higher taxes on

imported as opposed to domestically produced cigarettes, US measures on

automobiles and US regulation of fuels and fuel additives), the dispute panel of the

WTO has stressed that it did not decide against the protection of the domestic

environment but merely against the intended or unintended effects of domestic

regulation on imports from trading partners. In all cases, the panel has suggestedways to protect the domestic environment without interfering with the trading

rights of foreign countries.

Developed Countries Proposals When Harmonization Does Not Occur

The proposals currently in vogue to deal with the problem of imports coming from

countries with lower environmental standards are (i) ban on the imports, (ii) eco-

dumping duties on the imports, and (iii) imposition of mandatory and non-

mandatory environmental requirements for market access to the imports. Import

ban is allowed in certain multilateral environmental agreements to achieve specified

environmental goals.

Regarding eco-dumping and levy of countervailing duties, Bhagawati and

Srinivasan argue that antidumping actions are selective: they can target down to

the level of the firm, not just a specific foreign country! Besides, compared to tariffs,

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they are also elastic: the duties will be set at rates that are decided during litigation

and therefore are a function of litigation expenditure, impartiality of the procedures

governing the litigation, and the bilateral game played between the complainants

and their targets. Further, in playing the game, the rules are set in favour of

litigants, relative to what the rules would be if the objective of antidumping actions

were truly to avoid economically defined predation. In particular, the usual game of

reconstructing the true costs, against which prices charged are compared to

determine dumping margins, has been played to the hilt to get these margins to be

as high as possible in litigation The eco-dumping margins would have to be

necessarily estimated on the basis of reconstructed costs of meeting the pollution

standards of the complainant country (p.80).

Environmental requirements have the potential of being turned into non-tariff

barriers. The environmental requirements with potential effects on market access

include regulations, standards, labelling requirements, packaging requirements,

and certain SPS measures. Regulations and standards refer to product content,

recycled content, energy efficiency, degradability and product characteristics. Many

of them require proof of compliance through conformity assessment, including

certification. Some countries emphasize integrated product policies and producer

responsibility, based on instruments such as take-back obligations, non-regulatory

measures (including information-based requirements and self-regulation) and life-

cycle analysis. See UNCTAD Note (2004). The private sector and NGOs are also

using voluntary standards, codes and benchmarks often as part of corporate social

responsibility or risk management initiatives.

The UNCTAD Note points out that the ability to enter a market is a function of both

the competitiveness of the export (determined by the relative cost and quality of the

product) and the characteristics of the supply chain and the structure of the

markets. The exporting countries can do by themselves to improve thecompetitiveness of the exports, but market exigencies (including voluntary

environmental requirements and codes) and the characteristics of supply chain are

to a large extent exogenous to the developing country exports.

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Eco-labels inform consumers that a labelled product is environment-friendly. It is

preferred to non-tariff barriers, if it is voluntary, participatory, market-based and

transparent. However, eco-labelling could be misused for the protection of domestic

markets. Some common complaints about the eco-labels in developed countries are

that (a) the labelling criteria tend to focus on the resource endowments and

technologies available in developed countries, and their environmental concerns,

and (b) poor participation by developing countries at the design stage and also

insufficient time to adjust their production plans to meet the labelling

requirements. See WTO (2004), and Nohani and Ghosh (2000).

A thorny issue in the eco-labelling debate is about the use of criteria linked to

PPMs, see WTO (2004). The WTOs position is that countries have the right to set

criteria for the way products are produced, if a production method leaves a trace in

the final product (e.g., fruit grown using a chemical pesticides, with there being

pesticide residue in the fruit itself). However, measures based on unincorporated

PPMs or non-product related PPMs i.e., PPMs which have no trace in the final

product e.g. fruits grown using a chemical pesticide with there being no trace of the

pesticide in the fruit are considered WTO-inconsistent.

Developing Countries Concerns

Many developing countries find that the environmental requirements with potential

market access effects are proliferating and becoming more stringent and complex.

They are also concerned that some of the standards fixed by some European

countries are higher than the international standards. These countries face

capacity constraints and structural problems. See UNCTAD Note (2004). The

capacity constraints include difficulties in identifying the relevant requirements,

implementing the necessary technical, institutional and procedural changes, and

demonstrating compliance in a creditable way. The structural problems identified

are lack of awareness and management of information, poor institutional capacity,

weak infrastructure, dominance of small and medium industries (SMEs) in the

export sector, lack of finance, and insufficient access to technology.

The UNCTAD Note suggests the following approaches to overcome the problems

faced by developing countries: (a) active participation in pre-regulation and pre-

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standard setting consultations, (b) harmonization and equivalence, (c) proactive

adjustment policies in developing countries, and (d) technical assistance to and

capacity-building in developing countries. It proposes a Consultative Task Force on

Environmental Requirements and Market Access for Developing Countries.

We consider the market access and market entry problems, the capacity constraints

and structural problems, the technical support and financial assistance available

from developed countries, and the adjustment policies in responses to the external

factors with respect to the exports of leather and leather products from developing

countries to the developed countries, in later chapters, 3, 5 and 7.

5. Environmental Problems with Transborder Externalities

We consider two cases. The first case is one where economic activity in one country

creates negative externality in another country. The popular example is thermal

power generation in the northern states of the United States causing acid rain in

the southern states of Canada. In case of merchandise trade, the export of a good

by one country may cause environmental problem in another country in the form of

pesticide content or traces of certain banned items or non-biodegradability or non-

recyclability of used product or/and packaging materials. The GATT Article XX and

the TBT Agreement in the WTO permit countries to use regulations and standards

to solve environmental problems, provided the methods used do not violate the

WTOs basic principles of MFN and NT. At the same time the developed countries

have to take into consideration the special problems of developing and least

developing countries. An alternative to trade measure is technical support and

financial assistance to developing countries to enable them to attain the prescribed

environmental standards of the developed countries.

When an environmental problem is truly global e.g., emission of green houses,

depletion of ozone layer, loss of biodiversity, collective action at the global level isneeded to reach a cooperative binding solution. Agenda 21 stresses that

environmental measures addressing global environmental problems should, as far

as possible, be based on international consensus. At the end of 2004, there were

238 multilateral environmental agreements (MEAs) in force. About 30 MEAs

contain trade measures to achieve goals of the MEAs. The main trade measures

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within the MEAs are trade ban, export/import license, and negotiation, packaging

and labelling requirements.

A possible conflict between the trade measures contained in a MEA and WTO rules

could be the violation by a MEA of the WTOs non-discrimination principle. Such aviolation could take place when a MEA allows trade between its parties in a specific

item, but bans trade in the very same item with the non-parties. This policy is in

violation of the WTOs MFN clause, which requires countries to grant equivalent

treatment to like imported products. When one of the trading partners has not

signed a MEA, it can bring the matter to the WTO Dispute Settlement Agency. Even

though no dispute has come to the WTO regarding the trade provisions contained in

MEAs, the WTO must be prepared for it when such a dispute is referred to it in the

future.

The Doha Ministerial Declaration [31(i)] asks the CTE to clarify the relationship

between the WTO rules and MEAs, with respect to those MEAs, which contain

specific trade obligations. However, the outcome of those negotiations must be

limited to the applicability of WTO rules to conflicts between WTO members who are

partners to an MEA.

While recognizing the problems of non-compliance by members of a MEA and free-

riding by the non-members and the need for the trade sanctions to secure and

enforce automatic compliance, Bhagwati and Srinivasan argue that such an

agreement itself has to be legitimate in the eyes of those accused of free riding or

non-compliance (p.98). The Rio Principle of common but differentiated

responsibility recognizes the greater responsibilities of developed countries

compared with the developing countries, because of their large contribution to

current environmental problems, their access to environmentally sustainable

technologies and ability to bear the financial burden.

6. Concluding Remarks

Creation of the WTO on January 1, 1995 was a milestone in the evolution of the

MTS for trade liberalization and promotion of world trade. The WTO is a democratic,

transparent and rule-based organization with special provisions for developing and

least developed countries.

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Inclusion of environment in world trade agenda has created some tensions. The

WTOs position is that the WTO is primarily a multilateral agency for promotion of

world trade and it is not an environmental protection agency. But some developed

countries who prefer high environmental standards, particularly green activists, feelthat harmonization of environmental standards across countries is necessary to

maintain their environmental standards, and if harmonization is not feasible, they

must have the freedom to use trade measures to achieve their goals. Trade

theorists argue that the WTO should not be burdened with environmental issues

and trade measures are not the first best instruments to solve environmental

problems.

Developing countries view any attempt at harmonization of environmental

standards and use of regulations and standards when harmonization does not

occur as neo-protectionism. They complain that some of the promises made by

developed countries at the UNCED and in the WTO Agreements have not been

fulfilled. Compared with the expectation of 0.97 percent of GDP of developed

countries in the form of Official Development Assistance, the actual level is now

only 0.40 percent. Even with regard to the bound rates, compared with the average

bound rates for all products of 3.9 percent in the USA and 4.1 percent in the

European Union, the actual bound rates in sectors such as textiles and leather,which are of interest to developing countries, are much higher.

As mentioned earlier, many developing countries face capacity constraints both at

the participation stage when the regulations and standards are designed in

developed countries and in coping up with the regulations and standards in the

form of testing/certification. The problems are serious in sectors of export interest

like textiles and clothing, leather and leather products, agricultural products and

meat. Most production units in these sectors are small and some of them are in the

unorganized sector. They face infrastructural problems and high transactions costs

in complying with the importing countries requirements. What is needed is

assistance from the developed countries in the form of transfer of environment-

friendly technologies at concessional rates and financial support towards capacity

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building efforts to enable developing countries to participate more effectively in the

MTS.

MTS can be made a global public good if equity considerations, Rio principles and

the commitments for developing countries incorporated in the WTO Agreements aretranslated into reality. The WTO can become a global public good only when it

meets three conditions - publicness in consumption, publicness in decision making

and publicness in distribution of net benefit. See Mendoza (2003). Rodrik (2004)

presents a case for making the trade regime work for development. He says that

the WTO rules must recognize that poor countries need the space within which they

can pursue development policies. This policy space would accept institutional

diversity and the right of countries to erect and protect their own institutional

arrangements so long as they do not seek to impose on others. He favours the

introduction of a development box in the MTS so that in trade negotiations more

emphasis could be given to developmental concerns than simply maximizing trade.

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ACRONYMS

CTE Committee on Trade and Environment

CTESS CTE Special Session

EFTA European Free Trade Association

EMIT Group on Environmental Measures and International Trade

GATT General Agreement on Tariffs and Trade

ISO International Standards Organization

MEA Multilateral Environmental Agreement

MTS

NAFTA

Multilateral Trading System

North American Free Trade Agreement

NIMBY Not-in-my-backyard

PPM Processes and Production Methods

SPS Sanitary and Phyto-sanitary

TBT Technical Barriers to Trade

TRIPS Trade Related Aspects of Intellectual Property Rights

UNCED

UNCTAD

USA

United Nations Conference on Environment and

Development

United Nations Conference on Trade and Development

United States of America

WTO World Trade Organization

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Chichilnisky, G. (1994), North-South Trade and the Global Environment, AmericanEconomic Review, September, 851-74.

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United Nations Conference on Environment and Development (UNCED) (1992), RioDeclaration and Agenda 21, Rio de Janeiro

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