Emission trading schemes (ETS) for greenhouse gases continue to develop, employing “market-based mechanisms” to “achieve environmental outcomes in the most cost- and resource-efficient manner.” Yet elements of ETS are problematic under international law because they can be deemed tariffs and thus a form of protectionism. This book, by James Munro of the Melbourne Law School and World Trade Organization, explores the legal nuances and market applications of these schemes.

The international carbon market includes private investors, financial traders, and emitters with liabilities under domestic regulatory schemes. Other market participants include government units, though their activity is “peripheral,” and “carbon funds” that simply see carbon units as another tradable asset. The core activity is trade and investment in units that represent the annual right to emit a specific amount of greenhouse gas. Munro brings needed clarity to the question of whether these activities are subject to international economic law.

His book is divided into three parts: conceptual ETS foundations, a description of carbon units, and the consistency of trading schedules.

Internationalizing a global cost / In part one, Munro notes that three international agreements comprise the climate regime under international law: the United Nations Framework Convention on Climate Change (UNFCCC), the Kyoto Protocol, and the Paris Agreement. The UNFCCC’s goal is to stabilize greenhouse gases in the atmosphere at a certain level, but leaves unresolved how the burden should be shared between countries. Kyoto “enshrines legally binding quantified targets and timetables for emissions reductions” in 35 developed countries. Paris reorients the regime to the principle that “all countries must adopt verifiable measures to mitigate climate change.”

ETS are based on the idea that economic growth and environmental protection “are presumed to be mutually supportive.” This approach, Munro writes, is intended to correct a “tragedy of the commons” by internalizing the cost of using a resource and creating a market price signal. Its key advantage lies in “allowing the market to discover the most economically and technologically efficient means of sustainably managing the resource.” An “important element” is “the characteristic of private ownership of property,” which “facilitates trade and investment in permits by private actors, the core function of a transferable permit scheme.”

Tradeable carbon units take two general forms: allowance units and offset units. Allowance units are created by a government or regulator operating an ETS and are distributed through auctioning, selling, or freely allocating units. Governments effectively control the amount of greenhouse gases that may be emitted by allocating a limited number of units. Offset units are created by private economic agents. These represent the reduction of greenhouse gases outside of an ETS, usually as the outcome of a project that removes carbon from the atmosphere (planting trees) or avoids emissions (cleaner technology).

Some schemes expressly designate carbon units as property rights. By contrast, according to Munro, Kyoto explicitly clarifies

that its carbon units do not “create or bestow any right, title or entitlement to emissions of any kind.” Similarly, the California ETS scheme states that carbon units are not property rights. California’s government reserves “the right to cancel carbon units without the consent of their owners for any reason.”

Munro observes, “There appears to be a marked lack of consistency across different jurisdictions as to how carbon units are legally classified.” The World Bank counted 24 ETS as of 2017, with most comprising cap-and-trade schemes. There is also a voluntary market that serves individuals, companies, and governments that voluntarily reduce their carbon footprint by “purchasing and cancelling” units. This market is smaller ($191 million in 2016) than the compulsory ETS market.

International trade / In the book’s second part, Munro examines whether carbon units constitute financial derivatives, transferable securities, negotiable instruments, financial assets, or other financial products. Concerning their international trade, he notes that the General Agreement on Tariffs and Trade (GATT) contains no express definition of the terms “goods” and “products,” and so it’s unclear whether ETS fall under the treaty. Munro contends GATT “paints a convoluted picture.” He offers two readings, first a narrow one that applies to “only mass-produced, physically tangible objects intended for commercial consumption that have been manufactured or processed in some way and in which property rights subsist,” and then a broad one that includes “anything of value that is capable of being possessed and traded.” Carbon units appear to qualify as goods and products under the broad reading but not the narrow one. Yet the answer is more complex, “somewhere in the midway between the narrowest and broadest possibilities.”

There is also disagreement over the status of international trade in specific financial instruments like derivatives. If units can be considered a “derivative product,” then trading in them will constitute a “financial service” under the WTO’s Annex on Financial Services. “There are some minor variations between the definition of ‘financial services’ in the Annex and some free trade agreements,” Munro notes. “It seems reasonable to conclude that carbon units will also often be regulated by financial services–related obligations under free trade agreements.” Some argue carbon units are not derivatives because the latter are based on private law contracts rather than government-issued rights. But the World Bank reports that the lion’s share of carbon units trade occurs through derivatives. The Annex covers much of their trade.

Different systems / Some governments, notably California, have refrained from conferring carbon units or similar instruments with proprietary status under municipal law. Economist John Dales, an early ETS proponent, wrote in a 1968 Canadian Journal of Economics article that “pollution rights are fully transferable property rights.” In the book’s third part, Munro notes the “differential treatment” accorded to types of carbon units depending on their jurisdiction of origin. He notes differences in ETS systems in the European Union, Switzerland, New Zealand, Norway, California, Quebec, Korea, and Australia. “Some but not all of the instances of differential treatment … give rise to prima facie violations of non-discrimination provisions,” he writes, referring to trade agreements. He singles out California and Australia as examples of ETS systems that appear to act as trade barriers. Munro notes “a deeper tension” between “certainty, predictability, and efficiency in the market” and government regulators that wish to act.

Carbon units exhibit all of the qualities of goods and products. In his conclusion, Munro notes “the volume and extent of prima facie inconsistencies” exhibited by ETS “with international economic law.” He cautions “governments and regulators” to “be alert to the prospect that aspects of their schemes violate international economic law.” Officials should take heed.