“Depending on what comes out of Washington, the reality is the Americans may have the whip hand on this stuff,” [Doug Thomson, an environmental lawyer with McCarthy Tétrault LLP] said. “And if they do, it’s not going to be a matter of keeping all sides happy but reflecting the reality of the situation. … We may have no choice.”
(from “West rejects Ottawa’s emission plan,” SHAWN MCCARTHY AND DAWN WALTON , April 10, 2009, Globe & Mail)

My Response:

With all due respect to Mr. Thomson, I cannot agree that the US has the “whip hand”, though I do agree that US negotiators have worked and will continue to work hard to convince Canadian expert advisors that this is the case. I do agree that Canadian negotiators could still make critical errors that might hand the US the whip hand. But I have not yet seen evidence to suggest that such a Canadian negotiating failure is imminent, let alone inevitable.

At this time I think it is very important for all Canadian lawyers who are considering the trade implications of or advising the Canadian participants in the North American climate change negotiations to reread the 1997 WTO ruling in respect of the US’s 1993 “Reformulated Gasoline Standard”, and, in particular, how the WTO ruled regarding the US’s definition of “comparable measures”.

I addressed this issue, as well as my recommendations for Canadian negotiating strategy, in a message I originally wrote for other reasons, below.

What US document I would compel Canadian negotiators to read if I could only give them one.
The most important existing source our negotiators should consider is the attached September 18 2008 decision of the California’s Air Resources Board and Public Utilities Commission. The strategy and decisions that play out in this document will also play out for the US as a whole, not just to the state. This decision reports, in a nutshell:

• Four intensity-based mandatory product/performance standards–the California Renewable Portfolio/Energy Standard, a GHG intensity limit (roughy 0.55 kg/kWh) for new Power Purchase Agreements, the 2005 California Greenhouse Gas Tailpipe Emission Standard for New Vehicles and the 2008-proposed full fuel cycle Low Carbon Fuel Standard (LCFS) for gasoline and diesel fuels sold in the state–will ensure the state’s compliance with its 2020 goal of reducing GHGs, absolutely, by 15% from 2005 actual levels.
• The economy-wide increases in power, fuel and auto prices that will result from regulating these mandates should be under US$50/T of avoided GHG emissions. I actually percieve that this cost estimate is exaggerated, as I explain below.
• Adding a GHG quota allocation and “cap and trade” rule on top of the already-approved mandatory measures WILL NOT ADD ANY INCREMENTAL GHG REDUCTIONS BY 2020 UNLESS THE MARKET PRICE FOR GHG ALLOWANCES REACHES US$130/TCO2E. In the publshed decision, the regulators specifically say “If we were to use a market-based approach [cap and trade] approach alone, we may not be able to keep program costs low or support market transformation of desired technologies” (page 100).
• And “…modeling results reveal specific areas of concern where careful monitoring and verification will be needed to ensure that the cap-and-trade system functions as anticipated. In particular, these include monitoring to ensure that the cap-and-trade program does in fact achieve real reductions in emissions at reasonable cost and that significant revenue shifts unrelated to emission reductions between customers of different retail providers, or from retail providers to generators, are avoided” (page 108).

On its face, the CPUC/CARB decision to subject the CA electricty sector to cap and trade is irrational. The regulators endorsed their prior decisions to demand that the power sector bear GHG reduction obligations that are disproprotionate (high) compared to the sector’s contribution to the state GHG inventory, even as they acknowledge “It is challenging at this point to determine the cost-effective level of electricity and natural gas sector emission reductions because we have very little sense of the abatement opportunity and costs in other sectors” (page 112).

Also, after repeatedly asserting that the quota allocation and cap and trade rule will not add incremental GHG reductions at CO2 allowance prices under $130/TCO2e, and that there is material risk that the cap and trade market will not function as desired, the regulators decide that the state should impose a cap and trade regime on top of the existing mandatory measures and says “If electricity is included in the cap-and-trade program contemplated in the Draft Scoping Plan, and were to achieve the additional emissions reductions that ARB expects from the cap-and-trade program, the electricity sector could, in total, deliver as much as 55% of the required emission reductions in the State” (page 119).

Readers will not find an answer to the question “why”, in this document. The answer to that question is in the US “cap and trade” history, which is one that sacrifices efficiency for trade protectionism. But, hopefully, once our negotiators read the attached they will be motivated to investigate other sources.

(In this section of my message I am restricting myself to use the CARB and CPUC compliance cost estimates. It is pretty easy, however, to demonstrate that the CARB and CPUC mandatory measure compliance cost estimates are exaggerated. Go to **** below for an explanation of this statement.)

Given:

• The regulators’ reported findings that electricity sector will deliver 40% of the state’s required 2008 through 2020 reductions without the cap and trade regime at rate increases that are implied (by the plethora of other analyses available at the CARB and CPUC websites) to be less than US$50/TCO2e;
• the regulators’ reported findings that no incremental reductions can be associated with the cap and trade measure at CO2 allowance prices under US $130/TCO2e;
• the regulators’ reported findings that electricity sector could deliver 55% of the state’s required reductions if the sector is included under the cap and trade regime;
• one has to ask: what is the rationale for deciding that the cap and trade system should be implemented at this time?

Obviously, a rational analysis would ask and answer the following questions:

• what are the estimated incremental costs, in UA$/TCO2e, of ratcheting up any or all of the the RPS, EPS, LCF standards and ratcheting down the tailpipe GHG standards for new vehicles compared to the US$130/TCO2e floor at which the cap and trade regime will have an impact on state-wide GHG levels, and
• how do the compliance costs associated with making the existing mandates more stringent in the short term compare to US$130/TCO2e?

Further, the California product/performance standard incorporate credit trading and limited credit banking (also market measures, but not deemed to be :market measures” in the attached CARB/CPUC definition of the term in this decision). The CA regulators have not asked or answered the question: what might be the impact on long-term compliance costs if the terms of the product/performance standards were extended to 2035, with (1) increases in strigency built into the 2020, 2025, 2030, 2035 compliance years in the standards that will be made law in or before 2010, and (2) increases in the banking terms for over-compliance credits. At this time, the state regulators have approved proposals to limit REC (credits under the RPS rule) banking for as little as 3 years and have not yet approved the inclusion of a bankable over-compliance credit under the LCFS. Credits issued under the New Vehicle standard are perpetually bankable, but the state has a long history of unilaterally discounting banked ZEV and PZEV credits under its vehicle tailpipe emission regulations (which have been operating since 1991), so the auto manufacturers are unlikely to value the bankability of those credits without a formal long-term commitment from the state. Credit banking under a series of known and increasingly stringent product/performance standards is the only mechanism that rewards corporations for early overcompliance and innovation that results in quantum leaps in emission reductions. (The cap and trade system actually inhibits innovation, as do short limits on credit banking under product/performance standards.)

Canadian negotiators should ask: why are US regulators so quick to default to cap and trade when their own analysis clearly suggests that alternative measures (product/performance standards with longer series of increasingly stringent targets, complimented with longer credit banking provisions) would likely result in lower cost compliance with any given absolute GHG objectives?
What’s Going On?
My research suggests that the principal rationale for GHG quota allocation and cap and trade rules is to protect US plant operators’ interests at the expense of foreign suppliers of energy and carbon-intensive goods. Given the choice between the demonstrably more efficient, lower cost mandatory measures with credit trading provisions that will support free trade in equally GHG-intensive goods and services, and the cap and trade option–which protects US industry at the expense of foreign suppliers and resulting in higher costs for American consumers–the US regulators’ are revealing a consensus that favours the higher cost protectionist strategy over the lowe cost free market strategy.

Canadian regulators, decision-makers and negotiators should study the attached CARB/CPUC decision and consider the full strategic implications of the regulators’ decisions (1) not to analyze the cost impacts of further evolution of the product/performance standards, (2) to default to quota allocation and trading after implementing the first round of more efficient measures, and (3) to unecessarily limit crediting and credit banking terms in the product/performance standard rules.

Ensuring Canadian Success in the Future GHG Regulation-based Trade Dispute With the US
If Canadian regulators:

1. elect to implement more market-friendly and scientifically defensible intensity-based product/performance standards derived from but not identical to the California/US RPS/RES, New Source/Supply GHG Emission Performance Standards for Electriciy and Natural Gas, a new Canadian CAFE standard for vehicles (again derived from but more flexibile than either the proposed US federal or CA standards) and Canadian Low Carbon Fuel Standard that is scientifically more defensible than the inherantly protectionist CA proposal, and
2. incorporate over-compliance credit trading with lengty credit banking terms, then,
3. Canada can use existing US analysis of different measures–including the attached CARB/CPUC decision–to defeat any attempt of the US federal or state governments to protect US industry at the expense of Canadian industry through the US GHG quota allocation and trading rule, or the establishment of a US International Reserve Allowance requirement, or US disapproval of the nature and denomination of Canada’s 2020 and later national GHG targets under World Trade and NAFTA dispute resolution processes.

If Canada can demonstrate that our exports are less GHG intensive than US comparables, and/or that those of our exports which have higher GHG intensities are bearing a higher effective (direct or indirect) carbon charge under the Canadian regulations than is applied to US comparables under the US rules, then the international trade tribunals have to rule that any discrimination against Canadian exports breaches existing trade treaties.

The key to Canadian success at the international tribunals is the definition of “comparable”. The US always has and will continue to adopt the position that they can descriminate against imports originating in nations that have not implemented environmental protection measures that are “comparable” to US measures. The WTO has considered the US’s position on and definition of “comparable measures” on a number of occassions in the past, the most notable recent case being the 1997 WTO ruling on the US’s 1993 Reformulated Gasoline Standard.

In this and other precedents (and, I would argue, in the future…notwithstanding the precedents), US trade negotiators argue that under world trade rules the term “comparable measures” means that the US trading partner has to implement regulations (including reporting rules) that are identical to the US rules. So, for example, if the US elects to rule that US aluminum producers have to cut direct and electricity-related GHGs by 20% from 2005 levels by 2020, we can anticipate that the US will take the position that they can impose a carbon tariff on any aluminum imports that originate in a nation which does not promulgate the same 205 reduction obligation from the same base year. But US aluminum producers currently discharge between 10 and 11 TCO2e per tonne of aluminum they produce, while Canadian aluminum producers discharge between 6 and 9 TCO2e per tonne of aluminum produced (85% of which is currently exported to the US). Under the US proposed rule-making strategy, the US government attempts secure US aluminum market share for any US plant operators who cut GHG discharges from current levels to 10 TCO2e/TAl in 2020, at the expense of Canadian aluminum producers who might still discharge 6TCO2e/TAl in 2020, because the Canadian regulators failed to order or the Canadian aluminum producers failed to comply with the order to cut GHGs per unit of aluminum output by 20% from 2005 actual levels.

The good news is that every time (and there are a few) the US has attempted to apply this strategy to discriminate against imports, WTO trade tribunals have ruled that the US has erred in its definition of “comparable measures”. The WTO has consistently ruled that “comparable measures” are regulations that have comparable environmental outcomes or effects. Based on precedent, we know that the WTO will rule that the US breaches international trade rules by discriminating against the lower-GHG import in favour of the higher-GHG domestic supply.

The US can be anticipated to argue, in more general terms, the right to discriminate against Canadian exports if they deem Canada’s 2020 and later year nation-wide targets not as aggressive of the US targets, and on the basis that Canada’s facility-level reporting regulations are inadequate and, therefore, Canada’s aggregate GHG estimates are unreliable.

With respect to disputes base on future national targets–whether these targets are legally binding or not–Canadian negotiators must note that the neither the US nor any US state has never, in its history, physically complied with any emission target and timetable that has been embedded in law or policy. Canadian negotiators should argue that national targets are not “measures” for purposes of determining whether national actions to protect the environment are comparable.

With respect to facility-level emission reporting rules, the US negotiators have a valid point. However, Canadian negotiators must refuse to comply with existing US demands that Canada impose identical-to-US facility level reporting rules and to directly share facility-level data–including commercially sensitve operating information and information about proprietary processes–to the US EPA. Canada has to substantially revise existing pollution and GHG reporting rules. But Canadian rules should not ever become as invasive or administratively costly as existing and proposed US reporting obligations. It will be strategically important for Environment Canada to pre-empt US tariffs based on the inadequacy of our reporting requirements by implementing new Canadian air pollutant and GHG reporting regulations before the end of 2012. But while these new rules will be more invasive and costly to administer than existing Canadian rules, they must not go as far as existing and proposed US facility-level reporting requirements and Canadian negotiators must formally notify the US government that it is our government’s expectation that the US will accept the Canadian government’s assessment of facility-level GHGs and that the Canadian government will not remit raw plant data to the US EPA. In this context, the government of Canada should have asked the WTO to review the US Renewable Fuel Standard (RFS, which became law in full effect on September 1, 2007) as an international trade law breach, by now. Hopefully Canada will launch a US RFS challenge in the near future, as a signal for what is to come if the US elects to unfairly discriminate against Canadian exporters under GHG regulations that parallel the foreign supplier requirements outlined in the existing US RFS.

If the US Knows It Will Lose a Trade Dispute, Why Will Congress and State Governments Still Proceed to Misinterpret “Comparable Measures”?

US negotiators appear to have developed “Plan A” and “Plan B” negotiating strategies. First, US negotiators are still focussed on convincing Canadian negotiators to sign a preliminary agreement in which we agree: (1) to implement nation-wide 2020 and later GHG limits that meet with the US (not the WTO) definition of “comparable”, (2) to implement a Canadian GHG quota allocation and trading regime by a certain deadline, (3) that each party can freely allocate or auction up to 75% of its national quota allocation on any basis that nation deems appropriate, (4) at least 25% of each nation’s domestic quota will be auctioned to the highest international bidder, every year, without restrictions on auction participation and (5) that there will be North American free trade in any national GHG quota units that either pary assigns to any person. US negotiators hope to leave any discussion of the details of national strategies to further negotiations that will not commence unless and until after Canada signs this preliminary agreement to principals. If/when the Prime Minister of Canada signs a preliminary agreement that contains these principals, we will have undermined any future international trade rule defences against any demonstrably unfair and protectionist US quota allocation. So US negotiators currently perceive that an opportunity exist to convince Canada to give up keep rigthts we hold under current world trade rules. I percieve (but may be wrong) that Canada’s negotiators have recognized the risks associated with any US proposal to sign an agreement on principals in advance of seeing any details of the US domestic implementation plans.

Under “Plan B” the US will still implement domestic quota allocation and trading rules that unfairly discriminate against Canadina imports using the definition of “comparable measures” that WTO tribunals have already, repeatedly, rejected. The fact is that it will take 5 to 10 years for Canada to complete the WTO dispute resolution process (including appeals). The US’s ability to maintain discriminatory policies through the 10 year dispute resolution process should result in a massive redirection of value-adding investment and reinventment from Canada to the US, the capital loss from which Canada will not easily recover after the fact. A WTO ruling which will do no more than allow Canada to discriminate against US imports–a measure that increases the cost of living for Canadians, not Americans–does nothing to compensate Canada from the damage the US domestic cap and trade rules can inflict on our economy.

For this reason, Canadian should start formally, publicly, graciously, diligently explain to all publics (Canadian, US, European, Asian, UN, WTO, IMF) the full implications of US global GHG quota allocation and trading proposals for international trade and the related wealth transfer from energy, food and building products exporting nations to the wealthy import-dependent nations, as soon as possible. It is only through educating the general publics, environmental community and other key social stakeholders that Canada can mobolize major portions of the public–including the US public–against the US proposal to increase the US cost of living to protect the interests of multinational corporations who elect locate manufacturing facilities in the US (in exchange for a excessive US GHG quota advantage) instead of locating those facilities where they are best placed to manufacture low-GHG goods and services at least cost to US consumers.

Ensuring Canadian Success in the Future GHG Regulation-based Trade Dispute With the European Union and Japan
We anticipate that both the EU and Japan also plan to discriminate against Canadian exports, even though their targets are exports that may be less GHG intensive than their domestic product comparables. The EU and Japanese arguments will be that Canadian chemical, forest products, coal, aluminum and iron & steel exports enjoy a price advantage due to Canada’s failure to comply with our Kyoto First Commitment Period nation-wide emission limits. Under WTO and GATT rules, it appears that a tribunal should uphold Kyoto Protocol parties’ rights to impose tariffs on our exports reflecting the difference between our actual export prices and the prices our exporters would have had to charge to recover the costs of complying with meaningful GHG reduction objectives over the 2008 through 2012 period. Canada has to mobilize a different strategy to address the trade sanctions that will emerge from across the oceans, but a good defence exists in this context as well.

April 15, 2009