Social Regulations As Trade Barriers: How Regulatory Reform Can Also Help Liberalize Trade

As U.S. regulatory reformers scrutinize the costs and benefits of federal regulations, they should also heed the regulation-related complaints of unfair trade practices from America’s trading partners. For just as many U.S. health, safety, and environmental regulations impose substantial costs on American industry without yielding significant gain to society, some also disproportionately burden foreign producers seeking to do business here.

Criticisms of U.S. regulations by foreign firms are not always well founded. Just because a regulation imposes undue strains on importers does not automatically make it protectionist. But as a brief review of two important U.S. social regulations – fuel economy standards and rules for reformulated gasoline – will show, the regulatory burdens imposed on domestic firms are often closely connected to the emergence of new nontariff trade barriers. In cases such as these, trade liberalization and regulatory reform can be mutually reinforcing.

U.S. Fuel Economy Standards

When Congress faced the challenge of formulating a long-term plan to reduce the nation’s use of oil during the early 1970s, federal price controls on fuel were encouraging excessive consumption. Nowhere was this more apparent than in automotive fuel use, which accounted for 25 percent of American energy demand and the dominant share of domestic petroleum consumption. But fearful of a political backlash from ending price controls – let alone adding to the price with a new fuel tax, the policy adopted by virtually all other advanced nations -Congress shifted the burden of conservation onto motor vehicle manufacturers. It established fuel economy standards for all passenger vehicles sold in the United States. Beginning in the 1978 model year, the average fuel economy standard for all cars produced by each company was set at 18 miles per gallon. (Since 1990 the requirement for passenger cars has been 27.5.)

But the corporate average fuel economy (CAFE) standards are a dubious means of conserving energy. Their biggest shortcoming is that they focus the entire effort to reduce fuel consumption at the point of vehicle purchase. Once a consumer has bought a relatively fuel-efficient vehicle, he or she has no further incentive to drive less, or more slowly, or carpool – all good ways to conserve energy. In fact, because a new vehicle gets better gas mileage, motorists are inclined to drive more. Between 1973 and 1994 the average cost of motoring an extra mile fell by one-third, driving up the use of vehicles and driving down – by between 10 percent and 30 percent – the potential fuel savings from CAFE.

Although nearly 20 years of CAFE standards have helped improve overall fuel efficiency in the United States, a gas tax would have been much more efficient. According to Robert A. Leone and Thomas W. Parkinson, a “gasoline tax required to match CAFE’s conservation effect would have reduced producer and consumer welfare by 8 cents a gallon saved while the regulatory alternative actually reduced welfare by around 60 cents a gallon saved.” Pietro Nivola and Robert Crandall estimate that a tax of (at most) 25 cents a gallon beginning in 1986 would have yielded as much, if not more, oil conservation as was achieved by CAFE through 1992.

Meanwhile, total fuel usage by all U.S. motor vehicles grew by 50 percent between 1970 and 1988. Average motor fuel consumption per vehicle in the United States has remained twice as high as in Europe and Japan. U.S. gas consumption reached a record 7.79 million barrels a day in 1995.

Fuel Standards and Trade Disputes

Although CAFE may not have cut the U.S. use of oil, it has improved the competitive position of the American auto industry by handicapping European makers of luxury cars. Nearly all the vehicles turned out by Jaguar, BMW, Volvo, Saab, Mercedes Benz, Rolls-Royce, and Porsche are high-end products with relatively low mileage per gallon. Unlike their U.S. and Japanese counterparts, these automakers have no smaller, more fuel efficient vehicles to bring up their corporate average fuel economy. In 1991, although the European manufacturers’ cars accounted for only 4 percent of U.S. sales, they paid 100 percent of CAFE penalties. Indeed, in the 20-year history of these regulations, these auto makers are the only companies who have ever paid a CAFE penalty. And the penalties, amounting to $5 for every tenth of a mile per gallon that their fleet falls below 27.5, multiplied by the number of automobiles sold in the United States, have been substantial. Between 1985 and 1989 BMW paid CAFE penalties totaling $32 million, Mercedes-Benz $85 million, and Jaguar $27 million.

In 1993 the European Union filed a complaint with GATT alleging that American CAFE rules constituted a nontariff barrier. In the fall of 1994, a dispute settlement panel found the CAFE fleet-averaging procedure did not violate the GATT, primarily on the grounds that it did contribute toward achieving a legitimate regulatory objective, namely improving fuel efficiency. Although it agreed with the EU that the U.S. policy objective could be achieved in ways that were less restrictive of trade, especially by increasing the U.S. gas tax, it declined to hold the U.S. regulation to the “least trade restrictive” standard.

Although American environmental groups and the Clinton administration expressed delight and relief at the outcome of the dispute, the victory was pyrrhic at best. For the least trade-restrictive policy option is also the most sensible for American energy policy. A serious gasoline tax would not only lower fuel consumption at a fraction of CAFE’s social cost, but would also avoid any discrimination among producers of European, Japanese, and American luxury vehicles. More important, by truly reducing the consumption of oil, it would curb American dependence on foreign energy sources – a more useful policy objective than reducing American dependence on foreign cars.

U.S. Clean Fuel Standards

A major focus of the federal government’s effort to improve air quality over the past quarter century has been reducing automotive emissions. During the 1970s regulatory efforts targeted changes in engine technology. In the late 1980s, as Congress began another major rewrite of the Clean Air Act, Washington began contemplating changes in the composition and content of motor fuels as a way to further reduce automobile emissions. Following considerable controversy, the 1990 Clean Air Act Amendments set new standards for gasoline content, a change aimed at improving air quality for the nearly 89 million Americans living in so-called nonattainment areas – cities where air quality does not meet federal standards for ozone concentration.

The law defines nonattainment strictly and precisely: if the fourth-highest daily one-hour reading recorded on any monitor during the preceding three years shows an ozone concentration greater than 0.12 part per million, the area is not in compliance with federal ozone standards. If compliance were instead measured by the average reading, the number of nonattainment areas would fall significantly. The average readings in most nonattainment areas exceed the federal standard in less than 1 percent of the hours monitored. In fact, with the exception of Los Angeles, almost all nonattainment areas meet federal standards more than 99.4 percent of the time. Moreover, most ozone comes from emissions from pre-1983 cars, which are gradually being phased out. In addition, the precise nature and extent of the health effects of prolonged exposure to ozone have yet to be demonstrated, while the costs of reducing VOC (volatile organic compounds) emissions that produce ozone are extremely high. According to the Office of Technology Assessment, reducing VOC emissions by 35 percent from their 1990 levels will cost between $6.6 billion and $10 billion a year by 2004.

Gasoline Standards as Trade Barriers

On December 15, 1993, the EPA issued regulations implementing the reformulated gasoline provisions of the 1990 Clean Air Act. The rules required the sale of cleaner-burning gasoline in the nation’s smoggiest cities beginning January 1, 1995. To avoid disrupting the fuel market and to provide refiners enough time to adjust their production, the EPA decided to issue a five-year interim standard rather than a fixed one. Between 1995 and 1997, refiners were required to reduce the amount of olefins (a chemical that leads to emissions of nitrogen oxide, which in turn contribute to ground-level concentrations of ozone). The reductions would be made on a percentage basis, using 1990 as the base year.

But though American refiners could use their actual 1990 production as their baseline, foreign refiners were required to measure their improvements not against their own production but against the U.S. average or statutory baseline. And to prevent refiners from dumping high-emission reformulated gas byproducts into conventional gasoline, all nonreformulated gasoline sold in the United States had to be at least as clean during 1995-97 as it was in 1990, with, again, the 1990 base calculated differently for foreign and domestic refiners.

The EPA recognized that this rule would make it harder for foreign refiners to sell their gasoline in the United States. EPA Assistant Administrator Mary Nichols told a Senate committee that she was “motivated by a desire to lean in the direction of doing something that would favor the competitiveness of U.S. petroleum companies vis-ê-vis Venezuelan companies.” Publicly, however, the agency claimed that it would be impossible to hold foreign and domestic producers to the same standard because in 1990 few importers collected the data needed to set their own baselines.

Venezuela, a major supplier of imported gasoline to the United States, immediately filed a formal complaint with GATT, arguing that the rule violated GATT’s national treatment clause by holding a like product to different standards depending on its country of origin. Not eager to risk losing a trade dispute in the midst of the Uruguay Round GATT negotiations, the Office of the U.S. Trade Representative pressured the EPA to modify its rule. Prudently, the office considered it “essential to try to make our country’s environmental objectives and trade objectives compatible where possible.”

In response, the EPA proposed a corrective rule that would allow foreign refiners to establish their own baseline as long as they could supply it with the necessary data. In effect, the rule exempted Venezuela, because only its national oil company, Petroleos de Venezuela S.A. (PDVSA), appeared to have the required data. At the same time, to ensure no significant deterioration in U.S. air quality, the new rule provided that any increase in the volume of gasoline imports from their 1990 levels would have to meet the statutory baseline.

The compromise outraged both environmentalists and the U.S. refining industry. EPA’s amended rule appeared to confirm environmentalists’ fears that trade liberalization would compromise domestic regulatory standards. And domestic refiners, having been forced by the 1990 Clean Air Act to invest billions of dollars in new technologies for refining gasoline, now wanted protection from less expensive gasoline imports. Industry representatives claimed that the EPA’s decision created “uncertainty” about the government’s standards for reformulated gasoline. Led by Sun Oil, a major marketer and refiner in the Northeast, where virtually all Venezuelan gasoline is sold, a coalition including the National Petroleum Refiners Association, the American Petroleum Institute, and several major American companies lobbied to have Congress overturn the EPA’s revised rule. The effort, strongly supported by environmentalists, was effective. In August 1994 the Senate amended the EPA appropriations bill to prohibit the agency from implementing the new regulation. Later the House approved the change, and the EPA was forced to reinstate the original rule – one that did little to improve environmental quality while serving as a trade barrier.

The WTO Dispute

Venezuela, of course, resubmitted its complaint, first with GATT and then with the newly established World Trade Organization, which convened its first dispute settlement panel to hear the case. Venezuela’s financial stakes were considerable: PDVSA had already embarked on a $1 billion refinery upgrading program, most of which was contracted to U.S. engineering and construction firms, to meet U.S. reformulated gasoline requirements and double its gasoline exports to the United States. Unless the rule was changed, exports to the United States would fall by 50,000 barrels a day, costing PDVSA $150 million a year in sales through 1997.

The environmental stakes in the trade dispute ranged from modest to nonexistent. The average olefins content of Venezuelan gasoline is double that of the Clean Air Act baseline. According to a federal report, reformulated gas “produced to Venezuela’s 1990 baseline would have as much as 13.9 percent greater NOx emissions than U.S. average RFG.” This in turn could significantly increase ozone levels in the Northeast, where nitrous oxide triggers ozone formation.

Congressional testimony revealed, however, that 59 of 88 domestic refiners had olefin levels higher than the statutory baseline to which foreign refineries were being held. Only 16 domestic refiners were able to meet the parameters of the statutory baseline. Indeed, an internal EPA memo noted that “some domestic refiners have some individual gasoline baseline parameters that are as dirty or dirtier than PDVSA’s,” adding that the overall NOx increase from permitting PDVSA to use its 1990 baseline would be much less than 1 percent. Moreover, Venezuelan gasoline is comparatively clean in other respects. PDVSA’s planning manager for refining emphasized, for example, that “Venezuela exports only unleaded regular gasoline to the U.S. and, when compared with U.S. regular gasoline with which it competes, it has the same or lower sulfur and olefins content.”

The dispute over the health effects of Venezuelan gasoline appeared to have less to do with environmental protection than with the use of environmental rules to allocate market shares, internationally as well as domestically. Not surprisingly, PDVSA’s demand that it be permitted to use its own baseline was strongly endorsed by the Society of Independent Gasoline Marketers of America, whose 250 members account for 20 percent of domestic motor fuel retail sales and depend on a diversity of supply sources to remain competitive with the fully integrated oil companies.

Only 3-7 percent of the gasoline used in the United States is imported, and of this about 20 percent, roughly 70,000 barrels a day, comes from Venezuela. But gasoline markets are regional, and foreign refiners have supplied about 16 percent of the gasoline sold on the East Coast and 20 percent of that sold in the Northeast. Restricting gasoline imports would curtail competition there, and consumers in the region would wind up paying considerably more for gasoline in return for little or no improvement in air quality.

On January 17, 1996, the WTO issued its ruling. Noting that the U.S. standard clearly accorded imported gasoline less favorable treatment, it asked whether the different treatment was necessary for the United States to achieve the legitimate objective of cleaner air – and concluded that it was not. The United States had not demonstrated that its air quality would suffer if foreign refiners were allowed to use their individual baselines rather than the U.S. statutory average. Moreover, if doing so did result in adverse environmental impacts, the appropriate U.S. policy would be to tighten requirements slightly on both imported and domestic gasoline, not to hold them to different standards.

The United States appealed the decision to the WTO internal review board, which affirmed the panel’s ruling the following April. On June 19, 1996, the Clinton administration announced it would propose changes in the application of clean air rules to imported gasoline to bring the United States into compliance.

Better for All

Many social regulations clearly make the American public better off, even though they may vex foreign firms. But as the history of the CAFE and reformulated gasoline rules shows, regulations deemed abrasive by U.S. trading partners can also turn out to be questionable as domestic policies. In both cases, the interests of the American public would have been better served had the United States chosen to accomplish its legitimate policy objectives by adopting the least trade-restrictive alternative. In both cases, the interests of foreign producers and of the American public actually complemented one another. Thus the complaints of America’s trading partners about the discriminatory effects of some U.S. regulatory policies warrant serious reflection. Trade agreements can help improve domestic regulatory policies because they can highlight rent seeking that is masquerading as consumer or environmental protection. Just as U.S. efforts to pressure Japan to open its markets have frequently reinforced internal Japanese efforts to reform that country’s economy, so might America’s trading partners play an equally constructive role in reforming some U.S. regulatory practices. What may be good for them is sometimes also better for us.