2.1 Local Content Requirements Prohibitions and Non-Discrimination under WTO Law

LCRs condition the grant of a subsidy on producing a certain value added locally, on the use of local inputs, on the use of equipment produced locally, or on achieving a certain investment threshold in local production or research facilities (see, e.g.: Hufbauer et al., Reference Hufbauer, Schott, Cimino, Vieiro and Wada2013; Hestermeyer and Nielsen, Reference Hestermeyer and Nielsen2014; Batra and Bafna, Reference Batra and Bafna2018; Ornelas and Puccio, Reference Ornelas and Puccio2020).

All the measures challenged by India had some kind of LCR, as reported in Table 1.

Table 1. Local content requirement in the US State measures challenged by India

Source: Authors’ elaboration from US–Renewable Energy.

These kinds of LCRs were the main reason for the different WTO disputes that took place since 2010 on subsidies for renewable energy.Footnote ⁴ In these disputes, local content requirements were always challenged under Article III of GATT, under the TRIMS agreement, and under the SCM agreement. Indeed, LCRs have trade distorting effects, giving competitive advantages to domestic products as opposed to imported goods, and for this very reason are prohibited by several WTO provisions (Grossman, Reference Grossman1981; Bagwell and Sykes, Reference Bagwell and Sykes2005).

Following past jurisprudence on LCRs, the panel in US–Renewable Energy found the measures to be in violation of Article III:4 GATT, which prohibits more generally any regulations giving less favorable treatment to imported goods as opposed to like domestic products. The panel in US–Renewable Energy applied a four-step analysis to check the compatibility with Article III:4 GATT.Footnote ⁵

First, the imported good and the domestic good required must be ‘like’ products. As LCR provides discrimination on the basis of origin, it is not problematic to determine that the imported good and domestic good were ‘like’ products as they are often identical. The panel simply confirmed that where a measure distinguishes product solely on the basis of origin, a detailed analysis of likeness is not necessary.

The second element under Article III:4 GATT concerned whether the requirement or advantage is derived from a law or regulation or requirement that affects the internal sale, offering for sale or purchase, transportation, distribution, or use of the good. Given the broad definition given to this phrase in WTO jurisprudence, the panel conclusion was straightforward, as all the measures identified by India were based on legislative instruments issued by State entities.

The third part of the panel's analysis focused on the impact that the measures, covered by Article III:4 GATT, have on the conditions of sale or purchase of imported goods and that create incentives or disincentives to buy foreign goods as opposed to domestic ones. The panel recalled that LCRs were found in past jurisprudence to necessarily affect the condition of competitions between domestic goods and imports and rejected the US claims according to which India had not proven that the measures created disincentives to buy imported products as opposed to domestic ones.

Finally, Article III:4 GATT requires that imported products are accorded ‘less favorable’ treatment than the like domestic product, which implies that the challenged measures are not giving equal opportunities for imported products to compete with like domestic products. The US argued that the less favorable treatment test required India to provide at least some proof that the measures created incentives to buy domestic goods. However, the panel recalled the Appellate Body report in Thailand–Cigarettes, explaining that Article III:4 GATT covers also potential discrimination and therefore likelihood that the discrimination really occurs is not necessary. In other words, Article III:4 GATT applies also to de jure and not only to de facto discrimination. As LCRs require purchase of domestic products in order to obtain a certain advantage (a direct subsidy or tax exemption), they create de jure incentives favoring, domestic products over imported goods. Therefore, LCRs were automatically considered to give ‘less favorable’ treatment to imported goods. This is why LCRs (including in the energy renewable cases) were always found to be in violation of Article III:4 GATT.Footnote ⁶

Once the violation of Article III:4 GATT was established, the panel exercised judicial economy on India's claims under the TRIMs and the SCM agreements. The main reason for exercising judicial economy was that the prohibitions of LCRs under Article 2.1 and 2.2 of TRIMs and Article 3.1(b) and Article 3.2 SCM are narrower than the prohibitions under Article III:4 GATT.

Indeed, Article 2.1 of TRIMs imposes a prohibition to introduce any trade-related investment measure violating Article III or Article XI GATT. Thus, Article 2.1 TRIMs incorporates the prohibition enshrined in Article III:4 GATT but applies it only to trade-related investment measures. A representative list of trade-related investment measures inconsistent with Article III:4 GATT are included in an annex as per Article 2.2 TRIMs. The cases Canada–FIT and India–Solar Cells clarified that LCRs fell under Article 1(a) of the list annexed to TRIMs. These cases also confirmed that, if the TRIMs measure falls under the illustrative list, it is automatically found to be in violation with Article III:4 GATT.Footnote ⁷

With respect to the SCM, the panel refers to the Brazil–Taxation dispute. In Brazil–Taxation, the Appellate Body highlighted that, while Article III:4 GATT would prohibit any degree of LCR, the SCM must still allow some kind of legitimate requirements to define those goods entitled for domestic support. In that sense, not all the LCRs violating Article III:4 GATT would be in violation of the SCM.Footnote ⁸ Therefore, finding a violation of Article III:4 GATT was considered by the panel in US–Renewable Energy as sufficient to also violate the SCM. This position of the panel in US–Renewable Energy is only true because the US did not raise Article III:8(b) GATT. As we will see in section 2.2 of this paper, Article III:8(b) GATT exonerates subsidies given exclusively to domestic producers from certain disciplines of Article III GATT (including Article III:4 GATT); those subsidies would still need to comply with the narrower restriction under the SCM.

Therefore, the panel considered that, if the US were to bring its measures into compliance with Article III:4 GATT, it would necessarily restore any violations under TRIMs or the SCM.Footnote ⁹

2.2 The Difficulty of Justifying Local Content Requirements under Articles XX or III:8 GATT

As opposed to its predecessors, the US did not try to raise justifications either under Article III:8 GATT or under the general exceptions provided in Article XX GATT.

The previous jurisprudence has made it abundantly clear that it is difficult to justify LCRs under Article XX GATT. However, the inability to raise justifications under Article III:8(b) GATT could lead to inconsistency under WTO law with regard to the treatment of LCRs in subsidies.

3.1 Subsidies in the Theory of Economic Policy

The theory of economic policy focuses on policy choice in an economic environment characterized by significant spillovers, domestic and international, from a policy act. This theory is just a framework for thinking about policy choice.Footnote ¹⁵ Specifically, we proceed by answering the following three questions:

1. 1. What is the objective?

2. 2. What is the set of available instruments?

3. 3. Of the available instruments, which achieves the goal at lowest cost?

The first step in answering the first question is to determine whether the objective is economic or not.

An economic policy goal recognizes that under well-specified and well-understood conditions, economies may fail to produce fully efficient outcomes. The goal of policy in these cases is to find an intervention that moves the economy toward (optimally to) full efficiency. Standard cases are externalities (e.g. pollution), or imperfect competition (e.g. oligopoly).

A non-economic objective is a goal that is not related to breakdown in the efficient functioning of the economy, but the pursuit of which involves interference in the economy. For example, it may be an objective to increase the amount of education taken by citizens, not because it makes them more productive but because it makes them better citizens. Most governments have more-or-less explicit income distribution goals that have nothing to do with productivity. Many industrial policies are justified on the basis that those industries are essential to national pride (e.g. space exploration) or national survival (e.g. military expenditure). From the perspective of the theory of economic policy, the issue is never whether, or not, these are ‘good objectives’. We simply take it as read that these are policy goals, legitimately arrived at, and it is the job of the analyst to suggest the best way to pursue that policy.Footnote ¹⁶

The second step is to specify in as much detail as possible the way that goal is embedded in the economy. Economic objectives come equipped with a natural representation of the issue. There must be a ‘distortion’ that is causing the economy to underperform relative to the policy objective, and we can use the undistorted economy as a baseline from which to compare the extent of deviation from maximal efficiency. We presume that the policy-maker's objective function provides a measure of the gain from reducing the inefficiency in question.Footnote ¹⁷ Measuring the direct gain is only half the problem, we also need to evaluate the gains and losses that result from policy spillovers. We take it as a definition of a significant policy that there are spillovers – across sectors, across households, and across national economies. Some of these spillovers will be universally positive (e.g. reduction of pollution), but the same policy will also affect relative prices (and thus distribution of national income) and, in a dynamic international economy, spillovers may affect the competitive condition of national industries and future national income. Non-economic objectives are considerably more difficult. In principle, the same logic applies: we compare the objective function before and after implementation of the policy. The problem is that here there is no natural metric for the evaluation. If we cannot say how big, or small, the gain is, we cannot say how that compares to the costs and benefits of the spillovers. If we cannot make such a comparison, we cannot talk sensibly about policy choice as an optimization problem.

Suppose that the goal is to stimulate the use of renewable energy.Footnote ¹⁸ We presume that this is an economic goal. That is, for some reason, the market is not supporting the efficient level of investment in, and production of, renewable energy. The first question to be answered is to what degree is the market failing to provide support for renewable energy. The fundamental issue is why this might be the case. Without an account of cause, it is essentially impossible to talk about appropriate policy (to say nothing of deciding if there is a problem at all). Compare two claims: first is the argument that this industry will never be profitable, but will provide a social benefit that exceeds the private cost; or, second, that international competition forecloses an otherwise profitable industry that with some fixed period of support could become profitable (essentially an infant industry argument). For the first, in addition to providing evidence of the benefits that will flow from support for the industry, there is the question of why the industry will never be profitable. With that proven, the other essential piece is to identify the margin by which the sector fails profitability. The infant industry case is clearer, but much more problematic. Once it is shown that the industry can become profitable (and sufficiently profitable that, along with social benefits, it covers the cost of the intervention), it is immediately clear that the problem is not profitability, but some form of capital market failure. In either case, if the goal is environmental and not industrial, it is never going to be first best to interfere with competition (domestic or international).

Suppose, then, that we have determined the source and magnitude of the market failure that is interfering with achieving optimal efficiency. The next step is to produce an inventory of available policy instruments. Governments have many (MANY) policy instruments at their disposal, but the number that have direct relevance for any given specific policy goal will be more limited. A standard illustration of the logic of instrument comparison is the fact that the economic effect of a k% tariff on a specific commodity can be precisely replicated by the simultaneous application of a k% production subsidy and a k% consumption tax on the same commodity. The importance of this fact is that each of the components of the tariff creates independent and additive welfare costs. Thus, if the goal is to stimulate production of a sector, the consumption tax component, if it has any effect at all, is to work against the goal and reduce consumer welfare. Thus, applying a production subsidy alone will achieve the production goal at lower cost, or permit achievement of a greater degree of stimulation at the policy optimum. There are, of course, many other instruments that might move output in the right direction: input subsidies (including employment subsidies or accelerated depreciation of capital equipment), taxation of sectors that compete with the preferred sector for resources, and many others.

In addition to instrument specific relative costs (i.e. tariffs v. production subsidies), in thinking about costs we also need to consider the details of spillovers from the focus of the policy intervention to households, firms (and sectors), and countries. As we have already noted, success in accomplishing a goal is not a complete answer to the policy choice problem. We need to think about the costs associated with choosing a policy and, in addition to the direct costs (e.g. subsidies, etc.), the spillovers play a major role here. Governments have many objectives and policies that emerge from complex political environments are often in conflict with one another. Thus, a policy that seeks to stimulate output in some specific sector will generally have an effect on income distribution that could interfere with the state's income distribution goals.Footnote ¹⁹ This is a cost of the policy in question. In an environment of scarce resources, resources used to provide a subsidy may mean some other policy cannot be pursued. This is an opportunity cost of the policy in question. Finally, of course, the policy may affect world prices (terms of trade) and spill over to the policy goals of other governments. While this is unlikely to be seen as a cost to the home government in a first-order sense, it is internalization of precisely this sort of spillover that Bagwell and Staiger emphasize as the foundation of the WTO (Bagwell and Staiger, Reference Bagwell and Staiger2002). It should be clear that these costs could overwhelm any benefit and certainly imply much lower levels of intervention at the optimum than would obtain without their explicit consideration.

Return to the case of renewable energy promotion as an economic objective. We have just seen that if a general production subsidy will accomplish the goal, a tariff (or some other border policy) will do so as well but at higher cost. Given the nature of the cases considered here, the production process is complex, and benefit may be had by subsidizing particular components of the production process. In particular, in addition to direct subsidies to the purchase of particular inputs, the government might choose to condition access to the subsidy based on location of production of those inputs (i.e. local content rules). There is a sizable economics literature on local content rules, but the main point here is that such rules will raise the cost of achieving the goal (otherwise, there would be no need for the rule).Footnote ²⁰

In thinking about the spillovers from environmental policies, unlike our usual presumption that spillovers are expected to be negative (and possibly large – thus, at least in part, the existence of the WTO), positive international spillovers are likely to be a feature. If the objective of a country’s policy directed to support renewable energy is at least partially about global warming and climate change, and if that policy is successful at achieving such an objective, it will also indirectly benefit other countries as all are affected by climate change and global warming. This case raises a tricky issue in developing evidence-based policy – only some of the spillovers will be carried by price.

The last stage in the theory of economic policy algorithm is selection of the (constrained) best instrument from the inventory identified in the second stage. This is the stage where the theory respects the constraints on policy choice that emerge from the political system. That is, once we have ranked the members of our inventory of instruments in terms of benefits (in terms of achievement of the expressed policy goal) net of the direct and indirect (i.e. spillovers) costs, it is almost trivial to say that we should pick the instrument at the top of the list. The problem is that some of those best instruments may not be available. One possibility is that the state lacks resources to pursue the optimal policy (e.g. subsidies). However, it is at least as likely that opposition to some policies comes from politically influential groups whose interests are damaged by spillovers from the policy. Thus, instead of the first-best policy, the constrained best (generically referred to as 2nd best) is the optimal choice. However, the further down the list we go in pursuit of a politically sustainable policy, the less of our goal we are able to achieve at the optimum, because the cost rises as we go further down the list.

The upshot of this somewhat meandering overview of the theory of economic policy is that, for the case of environmental policy, and most other policy goals as well, some form of subsidy will be the preferred policy. As has been widely noted in the law and economics literature, this raises difficult issues for WTO jurisprudence. Sovereign governments have many perfectly legitimate, economic and non-economic, reasons to intervene in their economies and it will often be the case that the optimal form of intervention will be a subsidy of some kind. From the point of view of system design, this is what we should want. It is all well and good to talk about minimizing the effect of these policies, but our starting point is that significant policies have significant spillovers.

3.2 Political Economy Issues in Environmental Subsidies

When we think about justifying the form or magnitude of a given subsidy, we return to the third stage of the theory of economic policy algorithm: choice from constrained sets of instruments. Unlike border measures that are unambiguously about trade and can be evaluated relatively straightforwardly in terms of price-carried externalities that the WTO was invented to deal with, environmental subsidies (like most subsidies whose first-order justification is domestic) emerge from a domestic political process involving very different interests and institutions than those producing tariffs (or other border measures). As environmental issues become increasingly significant (and they are becoming increasingly significant), the demands by national civil society for state action will also grow. How governments respond to these demands will affect not only the legitimacy of the state, but also the legitimacy of the market (domestic and international). Political sustainability of policy will be an essential part of the policy calculus. The links to trade policy make this a tricky issue for the WTO, but it should be recalled that environmental policy is also linked to a variety of domestic policies (local development, regional and inter-group equity concerns, general technology policy, etc.).Footnote ²¹ All of these are at least as important as trade and most are more significant to national politicians.

We noted earlier that the state must be represented by an objective function and we expect that objective function to vary systematically across states. First, and most simply, taking the issue of, say, response to global warming in isolation, different states may well view the issue differently. A standard example is states that view the issue as defined by current scientific consensus, even if that consensus is characterized by relatively weakly held priors, versus those states who apply a precautionary principle.Footnote ²² These preferences will help define domestic policies and the willingness to engage in certain forms of trade. In addition to preferences with respect to environmental issues directly, the way the issue relates to trade will be a function of all the things that determine policy with respect to trade: endowments, technologies, household preferences, competitive conditions, etc. We have already noted that these all affect the optimal (and constrained optimal) policy. However, even in the nearly institution free political environment considered in most political economy research by economists, these factors will also affect the political demands facing a state. Until very recently, one of the distinctive facts about the politics of trade is that it has not been effectively linked to other domestic issues. As Nelson (Reference Nelson1989) argues, the striking success of liberalization in the post-War era has been in no small measure a function of the fact that trade never became a public political issue. As a result, it could be handled by technocrats with only very weak connections to other issues. This is certainly not the case with environmental policy which is linked to a variety of domestic policies (agricultural policy, local development, regional and inter-group equity concerns, general technology policy, etc.). Because the relative weights of these other issues in the determination of environmental policy differ significantly across countries, and those differences affect the institutional form and the (public and private) political definition of the issue. That in turn affects the set of policies in the constrained inventory and their ranking under the state's objective function. All of these flow from differences across national civil societies and the institutions that map civil society, and the economy, into the state. Which is to say that they will produce very different selections from even a common inventory of policies.Footnote ²³

Consider the case of local content rules essential to the renewable energy cases that are the subject of this paper. On their own, these seem to be straightforward violations of national treatment. Furthermore, on purely economic grounds, if the issue is promotion of renewable energy, local content rules would seem to be less efficient than an unconstrained subsidy policy. We have already noted that the theory of economic policy would be skeptical of such a claim. That is the burden of defending a local content rule on purely economic grounds would be heavy. However, the political context could change that calculation. If we start from the recognition that a subsidy policy requires the deployment of scarce fiscal resources, as opposed to some more direct, and costly, form of protection, and recognizing that those fiscal resources must be raised from domestic residents, it is clear that some form of priority to domestic firms in accessing those resources may make the policy more politically palatable.Footnote ²⁴ Those losses should be weighed along with the generally positive spillovers from use of renewable energy.

This is thrown into particularly high relief when the policy is adopted by a sub-national government. Most states are constrained by their constitutions to maintain a balanced budget, so the need to justify any new fiscal expenditure (including tax expenditures) is a real constraint. Interestingly, the US Supreme Court has recognized the right of states to engage in discrimination under very specific circumstances (these include local content rules in the allocation of subsidies). While it is exceptionally unlikely that these policies seek explicitly to burden international trade, they privilege local firms (primarily relative to other US firms). While the Commerce Clause of the US Constitution, and its extension via the Dormant Commerce Clause, outlaws virtually all attempts by states to interfere in interstate commerce, the Court has accepted as constitutional the granting of monetary subsidies that are available only to in-state firms (Coenen, Reference Coenen1998). The basic logic is that citizens have a privileged right of access to fiscal resources raised from them for the provision of public goods. Interestingly, the Court and general legal commentary seems to see a justification in terms of legislative accountability; subsidies are more visible than benefits that run through taxes and, because of that visibility, the public politics are more likely to restrict interest group abuses. That is, as Coenen (Reference Coenen1998) notes, the Court seems to recognize a particular right that runs through democratic legitimation that applies to direct subsidies but not to indirect subsidies.Footnote ²⁵

As Cosbey and Mavroidis (Reference Cosbey and Mavroidis2014) pointed out in their analysis of a similar case, the current WTO jurisprudence on subsidies is problematic. In a sense, it goes back to a time when border measures were the main issue facing the WTO and there was an attempt to fit subsidy rules into a similar framework. Of course, the goals remain the same – creating a stable regime that balances the gains from liberalization while protecting the needs of sovereign governments – but the environment is very different. With the rise of global warming as an issue of first-rate importance and the rise of China as a power of first-rate importance, those rules no longer serve their larger purpose. It behooves us, as it did Cosbey and Mavroidis, to use this opportunity to think through the next steps.