This project focuses on two aspects of the alleged tension between international economic integration agreements, and national environmental (and other regulatory) policies.


(A) BORDER CARBON TAXES VS TARIFF RENEGOTIATIONS
It is commonly suggested that more climate-ambitious countries should impose “border carbon measures” (BCMs), such as import tariffs, on imports from countries with less ambitious policies. Proponents claim that BCMs can help preserve the competitiveness of import-competing firms that are burdened with the costs of domestic climate policy, reduce carbon leakage, and leverage exporting countries to adopt more stringent climate policies. But proposals for BCMs are also severely criticized, since they represent unilaterally imposed trade barriers. It is held that BCMs will have repercussions for the whole system of negotiated trade barriers in the WTO, and they will be used for protectionist purposes. The literature hardly contains any analysis of the interaction between BCMs, trade negotiations, and national climate policies, however.

The purpose of this project is to identify the pros and cons from a global and national perspective with two alternative approaches to trade and climate policy. To represent BCMs, it is assumed in one scenario that tariffs are bound to be zero due to a trade agreement that has been negotiated without consideration of its climate impact (this is the metaphor for the current WTO Agreement). In this scenario, countries unilaterally decide on emissions taxes, and apply these to both domestic and foreign production. In the second scenario, the tariffs are negotiated with awareness of their climate impact. Once negotiated, each country unilaterally imposes emissions taxes, but on domestic production only--there are hence no BCMs in this case. The aim is to identify the pros and cons from a global and national perspective with the two alternative approaches.

The project, partly undertaken with Mark Sanctuary, is still under way. But some findings stand out from our work thus far. First, the exact design of the BCM matters crucially. We distinguish between two basic forms of carbon tariffs: one type imposes the same tax on imports as on domestically produced goods, the other imposes a tax that reflects the difference in the domestic and the foreign tax. It is highly unclear whether actual proposals aim for the former or the latter type. But our results thus far suggest that the latter design is superior from a global perspective, since it stimulates the less climate-ambitious country to increase its own taxation of emissions. Second, when importing countries set their carbon tariffs they tend to set these too high from a global welfare perspective, for commercial (protectionist) reasons. Third, when the (marginal) climate damage from production is large, renegotiations are preferable to BCMs.


(B) ECONOMICS AND POLITICS OF INTERNATIONAL INVESTMENT AGREEMENTS
At the time of the start of this project, the policy debate concerning the constraints imposed by international economic integration agreements on unilateral environmental policies, had shifted from the impact of trade agreements on unilateral climate policies, to the role of state-to-state investment agreements for unilateral environmental (and health) regulations. In Europe, the debate in particular concerned the investment protection in the Canada-EU Comprehensive Economic and Trade Agreement (CETA), and the EU-US Transatlantic Trade and Investment Partnership (TTIP). This debate was partly fueled by environment-related disputes under investment agreements: for instance, a large number of litigations against the Czech Republic, Italy and Spain for withdrawal of renewable energy support schemes; the litigation by the energy company Vattenfall against Germany regarding the German decision to accelerate the phase-out of nuclear power in the wake of the Fukushima disaster; and the threat by TransCanada Corporation to litigate against the US under NAFTA regarding US$ 15 billion in damages for the Obama administration's decision to disallow the construction of the Keystone XL pipe line for environmental reasons. Due to the complete lack of economic analyses of these issues, the focus in this part of the project was shifted to the optimal design of investment agreements, and their implications for unilateral regulation of e.g. the environment. Most effort in this project has been devoted to this issue. The work has been done jointly with Thomas Tangerås.

International investment agreements aim to promote foreign investment by protecting foreign investors against host country policy measures. The agreements typically require host countries to compensate investors in case of expropriation or measures with similar effects, and they contain a range of other provisions, including non-discrimination of foreign investment. The agreements normally include investor-state dispute settlement (ISDS) mechanisms that enable foreign investors to litigate against host countries outside their domestic legal systems.

The project focuses on rules concerning regulatory (or indirect) expropriations in IIAs. These rules govern compensation payments in cases where host country regulatory measures deprive investors of the return on their investment, but where host countries do not formally seize ownership of the assets. Compensation for regulatory expropriation is (together with provisions concerning minimum standard of treatment) the main source of contention regarding the substantive undertakings in IIAs.

At the outset of the interaction in our assumed setting, a foreign firm makes an irreversible direct investment in a production facility in a host country (a monopoly setting is used only for expositional convenience, most main results are derived for more general settings). Production creates benefits such as employment, higher incomes or technology transfers. But the investment also causes adverse effects, such as environmental damage or health hazards, that can render production undesirable from a domestic and even a joint welfare perspective. The severity of the adverse effects becomes known only after the investment has been sunk. Having observed the threatening damage, the host country decides whether to allow production or to shut down the facility (regulate). When taking this decision, the host country disregards any loss of operating profits suffered by the foreign investor from a decision to regulate, which tends to cause overregulation from a global point of view. Investors’ awareness of the incentives facing the national regulator in turn reduces their willingness to invest. The stage is thus set for an investment agreement to correct the distortions to investment and regulation.

Our analysis generates a number of findings that we believe offer valuable new insights regarding the validity of arguments in the policy debate. In what follows, we will point to a three results.

First, Pareto optimal investment agreements never yield underregulation (“regulator chill”) from a joint welfare perspective. Such agreements instead induce either ex post efficient regulation or inefficient overregulation. Our argument here applies much more broadly than the particular setting we use.

Second, "North-North" agreements such as CETA or TTIP are likely to increase foreign investor profits, but reduce domestic welfare in both countries. These findings are consistent with the considerable popular resistance to agreements such as CETA and TTIP.

Third, compensation payments and disputes under IIAs are often seen to indicate flaws in the investment regime, resulting from investors' opportunistic exploitation of excessive investment protection. Others instead see the disputes as caused by bad faith regulations by host countries, and thus as proof of the need for investment protection. But in the present setting, equilibrium compensation payments (and possibly also litigations to trigger those payments) are necessary to achieve full efficiency. The payments then serve as implicit subsidies to investment, the benefit of which materializes for other realizations of the regulatory shock than those for which the compensation payments are made.

The project identifies a number of issues that require further research. For instance: How do we understand the notion of "legitimate expectations" that arbitration panels often use? What is the difference between Investor-State and State-State Dispute Settlement? Why is investment protection often packaged with trade liberalization in agreements?

(C) DISSEMINATION OF RESULTS/THE INTERNATIONAL DIMENSION OF THE PROJECT
For the project, Henrik Horn participated in the meeting ”Charting A Vision of Progress for Trade and Environment in 2030: Key Impact Areas for UNEP and Partners”, organized in Geneva by the United Nations Environmental Program (UNEP) and the International Institute for Sustainable Development (IISD); in the conferences “The WTO Case Law of 2014”and ”The WTO @ 20: Taking Stock and Looking Forward”, both organized by the European University Institute, Florence; and in the World Trade Forum 2015 in Bern, a meeting that brought together a large number of economists, lawyers, and political scientists specializing in the areas of trade agreements and investment agreements. The main study has been presented at the conference "Globalization and New Technology: Effects on Firms and Workers" at Waxholm, at the “1st Applecross Workshop in Economics”, Scotland, and at the conference “Creative Perspectives on International Trade and Foreign Direct Investment”, University of Colorado, Boulder.