By Bob Hancké, Political Economist at the London School of Economics and Political Science

Here’s an interesting question: should the EU be allowed to grant some of its most polluting industries an exemption for carbon trading (and taxes)? The argument is that if the EU did not do this, these industries would still pollute, but in other countries (see Euractiv 22 Sept 2009) – something called ‘carbon leakage’. That puts a slightly different spin on the question, of course: if you assume that global warming is happening and bad, is the EU is better at handling highly polluting industries than countries like China and India? My friend and colleague Willem Buiter wrote a very provocative blog post on a similar issue two months ago (which you can read here), in which he argues that economic development needs are no reason to grant poor countries exemptions. Pollution is pollution, his position, regardless of who is responsible for it – there are plenty of other mechanisms to help poor countries.

My take on the issue sort of turns the question around. Leaving aside soft (or hard) protectionism, which admittedly is never far away when the EU suddenly invents sustainable industrial policy, there is a real question here. Surely you’d want highly-skilled people driving extremely fast cars or well-trained pilots in fighter jets. By the same token, you could argue, you would prefer countries that have a highly-developed engineering system and are able to develop cleaner technologies, especially for such highly-polluting industries as steel, food processing, and plastics manufacturing, to keep them. Germany, France, Sweden, and a host of other European countries have been working under strict environmental regulations for a while now, their science and technology systems know how to innovate, also – perhaps especially – in old industries, and they should therefore be allowed laxer environmental regulations.

The problem I (always) have with such arguments is not the implicit or back-door protectionism. If societies democratically choose to have extra costs associated with a particular way of life, then it is up to them. In fact, I am not even sure that the costs are higher, they are just more visible in terms of taxes or so – a matter of property rights over costs as well as benefits,  not a free lunch, in other words. And writing this from France, where farmers have been supported for generations, makes me deeply appreciate the same CAP that is usually the object of my virulent rants in seminars.

My bone of contention is that many countries became the industrial and engineering power houses they are now precisely because they never allowed slack in their system. Think about it: if you are exposed to international competition, and your domestic rules and institutions are such that there is no short-run low-cost way out (wages are ‘rigid’, as economists say, employment protection, investment in training by employers and by workers are high, and currency devaluations are not serious options), then your domestic industry will always suffer in the short and benefit in the long term. Under the conditions I describe above, industry is forced into permanent rationalization: those that can afford the costs associated with the new regulations (say the top-half in the distribution) will benefit from the system, since wages are set at more or less the average (the median of the companies, in fact) that firms can pay; the others have a simple choice move up or move out. And usually firms can rely on well-developed training systems, links with universities, and relatively compliant labour unions.

The remarkable overall effect of such regulations and constraints is that your domestic industry becomes, on average, more competitive every year. That explains why Germany is the biggest global exporter, with France not all that far behind, and why small economies in Europe often export half or more of their GDP. What made these countries strong economies was the discipline imposed by a combination of hard regulations, foreign competition, and domestic institutions that helped firms to innovate and locate themselves in technology-rich (and therefore usually less cost-sensitive) segments of the market.

And that’s the snag with this (I assume) well-meaning idea of allowing ‘carbon leakage’ exemptions to some of the EU’s heaviest industries. Such subsidies and, worse, tariffs that might follow may well end up making these firms less prone and able to sort out their carbon footprint, and possibly even less competitive than they are, in relative terms, now. And that means that, eventually, all that polluting industry is going to go abroad anyway – but at a welfare loss, roughly calculable as the subsidies and the foregone innovation. Much better, it seems to me, under these conditions, to agree on a world-wide and more elaborate Copenhagen/Kyoto protocol, have industry relocate to poorer countries, organize transfer of ecologically sustainable technologies and spend some of our R&D money on that (with tax advantages, if necessary), and sort out domestic dislocation in these polluting industries through social plans. The latter is a small cost for rich economies, and it keeps them on their toes in the right way. Everything else, I fear, will have nasty long-term side effects.