International Trade and Environment

International Trade and Environment

The Copenhagen Summit, in some sense, was the effort to create a renaissance in the field of environmental cooperation at the global level. The past few decades have been characterized by a number of international environmental agreements (IEA’s), including Helsinki and Oslo Protocols on reduction of sulphur in 1985 and 1994, respectively, the Montreal Protocol on chlorofluorocarbons (CFCs) that deplete the ozone layer in 1987 and Kyoto Protocol on greenhouse gas reductions in 1997. These signify, to a large extent, the recognition that environmental problems are not contained with the political borders of any country and is a global problem that requires global solutions.

Environmental laws and regulations can be classified into two major categories. The first represents the policies that are initiated at the national level and aimed at protection of the environment. These affect the export competitiveness and the importability of products – and hence, affect trade. The second class relates to environmental regulations and policies that arise out of the international agreements or arrangements. This post on Course Module 9 would be primarily dealing with interactions among countries – competitive and cooperative – in setting up environmental policy and hence, would focus on the second class.

Growth and Environment

One of the most interesting questions in the field of international environmental concerns is whether environmental protection rises or declines with the economic growth of a country. Income does influence demand for environmental protection and both seem to be positively correlated. Considering this is true in the case of emerging markets like China and India, the primary question that arises is whether developing countries would use lax environmental regulations as a means to attract capital away from the advanced countries.

One of the techniques used in estimating this relationship is the application of the Kuznets curve – popularly known as the Environmental Kuznets Curve. It determines what happens to the environmental quality as income rises in a specific country over time. However, most of the work has been done based on a cross-sectional data set including several countries in the world, and theoretically, it is constructed as indicated in the figure below. However, with the effects of population density and technology left unmodelled, the interpretation of the EKC needs to be undertaken with care. One of the quick policy implications is for governments to concentrate energy on increasing incomes and letting growth clean up the environment through market demand for environmental quality.


Pollution Havens is a related concept whereby polluting industries are shifted to poor countries with lax environmental regulations. A frequently cited example in this regard is that of the sweatshops in China that use cheap labour and lax standards to export cheap commodities to the rest of the world. Admitting that developing countries are emitting high levels of pollution, would it be in their advantage to attract polluting industries and specialize in pollution-intensive goods. When empirical investigations were conducted, we fail to find any evidence that argues for countries using lax environmental regulations to attract polluting industries.  However, we do find that lax regulations attract FDI for polluting industries. Hence, we could at least partially attribute the theory to understanding the movement of capital with regard to polluting industries.

Transboundary Pollution

The fundamental problem in the area of transboundary pollution is the lack of incentives for countries to engage in abatement efforts. There is a tendency for each country to try and free ride on the efforts of other countries. With abatement effort being considered a public good whose benefits are positive externalities on other countries, there is a trend of under-provision visible in the international arena. Particularly, when it comes to non-uniform damages and non-uniform mixing of pollutants that move across political borders, the country impacted the most would take initiatives on abatement and the rest would prefer to absorb the benefits without incurring the costs of abatement.

Transboundary Pollution in Ontario

How is this different from positive externalities associated with firms located in a country? Within the national limits, the government is able to internalize these externalities using taxes and subsidies. The lack of a supranational authority makes the situation harder to control. For example, even in the case of EU, which claims to have a supranational government, members are flexible about what tools they use to attain particular pollution directives. One of the main causes of the Kyoto failure is that it was not enforceable on countries by a governing authority. It relied on the aspirations of the national governments to integrate Kyoto provisions into their laws and policies.

International Environmental Agreements

The only solution to the pollution problem in the international arena is that of voluntary international environmental agreements. They need to be enforced in order to safeguard the global commons from free riders and over-exploitation. With victims having no “right” to compensation (thanks to Coase?), agreements need to recognize spillover effects and operate in a manner that befits Pareto optimality. Hence, the idea is not to check if side payments can be made (like in the case of Kaldor payments or Coast theorem), but to see what incentives would induce these side payments to be made in actuality – decisions regarding which countries should make what payments dominate the work done in these agreements.

For an environmental agreement to be self-inforcing, two criteria need to be satisfied: there should be no incentive to deviate from the agreed conditions, and the net benefits of every country’s emission reductions should be in favour of climate protection. Thus, the incentive scheme needs to be put in place so that no country has any incentive to move away from the agreement voluntarily – sanctions would be in order in the case of breaching. Theory suggests that such self-enforcement coalitions are likely to be small in size, as greater the number of agents involved, the harder it is to find an agreement that would make someone better off without making someone else worse off. Even with the use of side payments, there is no specific increase seen in the size of the coalition. But, the single most effective solution is the self-enforcement – a system of checks and balances among the agreed parties, for the agreement to work inspite of the lack of a policing organization.

Copenhagen Summit - Illustration of an IEA

How do we put in place such a system of checks and balances? Theory and policy circles suggest two ways: side payments and linkages. One way is to sanction country A if it acts in a way that breaches the net benefits of country B from the agreement. If some countries commit themselves to cooperate, while the remaining countries act independently and in pure self-interest, it appears to be possible to achieve a Pareto improvement if the non-signatory countries reduce their emissions, in exchange for transfers from the countries which sign an agreement.

Nevertheless, most theorists argue that a simpler technique would be to use the behaviour modelling embedded in non-cooperative game theory. Simply put, linking environmental issues with other games of trade and human rights would lead to possible outcomes that would add value by bringing in hesitant partners to join the coalition. Every agreement has a post-contractual risk, with countries failing to comply with the proviso(s) of the agreement. However, with repeated games involving more than the environmental issue, countries could use tit-for-tat strategies and adopt a cooperative equilibrium at the final stage. (Unrelated Punishing)

The primary constraints as to why these theoretical games aren’t translated perfectly into reality are the institutions governing the environmental concerns in each country as well the international institutions involved in the policy-making process. The multitude of organizations, with varied interests, makes it harder for a consensus to emerge on relevant issues.

Institutional Set-up at the International Level

Game Theoretic Approaches

The impact of a single country on the global pollution level is quite small, but the abatement costs are high. Hence, each agent unilaterally an incentive to defect from competition. The incentive structure is very similar to that of a Prisoner’s Dilemma and indicates that the dominant strategy for the country is to defect in terms of abatement efforts. With no supranational authority to monitor and enforce cooperative behaviour, games are the easiest way to induce cooperation.

Barrett proposed a game that has a two-period structure. At time t=0, countries decide whether or not to join a coalition on environmental cooperation. The coalition and the remaining countries choose emission levels non-cooperatively. The coalition would be stable if none of the parties have an incentive to leave the coalition and none of the countries outside want to enter into it. But this model indicates that the cooperation possible makes the size of the coalition very small.  Using fairness preferences for international negotiations can be motivated by political economy arguments, there are implications of equity preferences for international cooperation in reducing global pollutant. Relative payoffs, more than absolute, then enter the consideration matrix of the agents and induce cooperative behaviour if they have a preference to be on par with their peer countries. There is a possibility of even completing the grand coalition.

A political economy model at the national level

Using a Partial equilibrium model of a representative import-competing oligopolistic industry, Hillman and Ursprung (1988) argue that environmentalists (greens) tend to side with the protectionists in an economy. Providing the example of policy pronouncements of two competing candidates, introducing the environmental interests as the third group, they side with the protectionist group. A simple illustration of their logic is presented in the form of an algorithm below.

Algorithm for the Political Economy Model


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