What do green subsidies mean for the future of climate and trade?

Faced with the urgent challenge of climate change, the United States and the European Union (EU) are implementing their own subsidy schemes to boost private sector renewable investment. The US Inflation Reduction Act (IRA) has committed $400bn in investment and subsidies to cut the country’s greenhouse gas emissions and accelerate the adoption of renewable technologies. By cutting costs for consumers and companies, the IRA has the potential to significantly cut down on US greenhouse emissions and enhance renewable energy investment.

However, certain provisions of the bill, especially local production requirements for batteries and electric cars, have been criticized as trade restrictive practices in violation of agreements that underpin the multilateral free-trade system. US trading partners, including the European Union and Japan, have argued that the IRA’s $7500 tax credit for consumer purchases of electric vehicles and manufacturing subsidies for battery and wind turbine producers violate World Trade Organization (WTO) rules by providing domestic companies with unfair advantages.

“This this act incentivizes the (re) location of industry to the US, thereby potentially putting the EU industrial base for clean technologies at a disadvantage,” wrote Valdis Dombrovskis, European Commissioner for Trade, Frans Timmermans, Vice-President of the European Commission and Margrethe Vestager, European Commissioner for Competition, in an op-ed in the Financial Times. In response, the European Union has proposed its own €250 billion green subsidy package – the Green Deal Investment Plan – which will introduce new tax breaks and loosen the bloc’s state aid rules to further boost private sector renewable investment.

While both subsidy schemes are powerful steps toward reducing greenhouse gases and accelerating climate action, they could escalate trade tensions and leave developing and emerging economies on the sidelines. Wider global cooperation on trade and climate will be necessary to achieve sustainable and inclusive growth for all.

As the world’s second-largest emitter of greenhouse gases, the IRA represents an unprecedented level of financial support from the US federal government for clean energy and climate mitigation. Early reports suggest that 100,000 green jobs have been created since the bill was announced last year.

"The more affordable it is to pursue innovation, the more you're spurring innovation," said Jonathan Fried, former Canadian Ambassador to the WTO and Senior Associate, Economics Program, Center for Strategic and International Studies (CSIS). "You're going to get an acceleration in various technologies, clean technologies in the recipient countries or regions of those subsidies," he said. It’s also estimated that the IRA will close two-thirds of current greenhouse gas emissions gap between current policy and the US 2030 target.

Despite domestic protections for US manufactured products, many leaders consider it as a net positive for the planet. “I think the world can only be happy that the United States has moved over to the right side of the table – and we (Europe) have been waiting for that,” said Belgian Prime Minister Alexandre De Croo at the World Economic Forum’s Annual Meeting in Davos. “Finally, the number one economic powerhouse says that decarbonising is part of (its) trade agenda.”

Other European leaders view the IRA as a catalyst for competition between countries by simplifying climate laws and accelerating decarbonization efforts. “To keep European industry attractive, there is a need to be competitive with the offers and incentives that are currently available outside the EU,” said Ursula von der Leyen during her special address to the World Economic Forum’s Annual Meeting. "This is why we will propose to temporarily adapt our state aid rules to speed up and simplify. Easier calculations, simpler procedures, accelerated approvals,” she said.

The EU already provides renewable energy financing and subsidies that focus on the early-stage development of new forms of technologies. Unlike the IRA, existing EU subsidy policies, such as Germany's renewable energy scheme, do not include local production requirements.

However, as the green subsidy race between the US and EU heats up, some fear that other countries will be left behind, especially developing and emerging economies. “With all of these subsidies you have to have money,” explained Kamala Dawar, Reader in Commercial Law at the University of Sussex. “Do you think even a country, (like) Romania will be able to subsidize their green energy to the extent that Germany and France can? What about a country like Burkina Faso or Paraguay?” she said.

Developing economies account for more than two-thirds of global greenhouse gas emissions and are particularly vulnerable to the effects of climate change, according to the International Monetary Fund. Faced with rising interest rates and growing debt burdens in the wake of the COVID-19 pandemic, developing economies have been forced to tighten their budgets for supporting renewable energy roll-out, for example. Even before the pandemic, international financial flows to developing countries for renewables declined from $24.7 billion in 2017 to $10.9 billion in 2019, according to the United Nations Sustainable Development Goals Report.

This funding gap and mounting debt pressures have led to calls for alternative financing mechanisms from developing economies. Most notably, Barbados has proposed a massive overhaul of the international development finance system, known as the Bridgetown Initiative, to equip developing economies with the tools and resources to cope and adapt to climate change.

US and EU green subsidies run the risk of widening this gap between developing and developed economies by shielding their own domestic industries and consumers. “(Developing economies) are always going to be behind in a green energy race and they don’t have the intellectual property rights to implement a lot of this,” said Dawar. “All of this is going to exacerbate the North-South divide when it comes to climate change,” she said.

While it's clear that emerging economies do not have the same capacity to fund green subsidies, they could benefit from a "knowledge spill-over" or increased production demand from the United States and European Union due to these programmes. "They're takers, not makers of the innovations that result," explained Fried. "You still may begin to see the diffusion - in the medium term - of productive capacity (in developing economies) because there are other factors of production, (like) cost of labour and well-educated talent to draw on at a cheaper cost," he said.

The IRA and Green Deal Investment Plan could also challenge the rules underpinning the World Trade Organization (WTO) and multilateral free trade. Most notably, WTO rules prohibit subsidies and other distortive trade measures that favour domestic producers over foreign competitors. The WTO has urged the US, EU and other member states to come together to settle trade-related disputes related to green subsidies.

“It’s a question about where these subsidies will go and (how) can we encourage everyone to be a part of it,” said WTO Director-General Ngozi Okonjo-Iweala at the World Economic Forum’s Annual Meeting. “If it’s a race, then emerging markets and developing economies will be unable to compete in a subsidy race. I’m hoping that we see a balanced and nuanced subsidy approach and not something else,” she said.

Under Article I of the General Agreement on Tariffs and Trade (GATT), WTO members are committed to treating trade partners in a non-discriminate manner to promote fair and free competition. The IRA represents the first time that the US has local-content requirements (LCRs) in violation of WTO rules, though not the first time that LCRs have been in the WTO spotlight. In theory, any WTO member could challenge the IRA in the WTO Appellate Body – the organization’s dispute resolution system. However, the WTO Appellate Body has been paralyzed since 2019 as the United States continues to block any new appointments to the body.

“There is a clear role that the WTO can play. Whether it will – and whether it will politically be able to achieve anything – is a separate question entirely,” said Emily Benson, Scholl Chair in International Business at the Center for Strategic and International Studies. “We are slowly moving away from a multilateral, rules-based approach to one that is more focused on bilateral and plurilateral sectoral arrangements,” she said.