Market Redirection Leakage in the Palm Oil Market

Highlights

• Unilateral tariffs or bans on palm oil imports, to limit importation of deforestation, lead to market redirection leakage.

• Combining tariffs with output subsidies can reduce leakage.

• Reducing transaction costs of switching to forest friendly production complements output subsidies in reducing leakage

Abstract

Tropical deforestation and forest degradation (DD) are linked to international trade in commodities like palm oil, and implicated in biodiversity loss and global greenhouse emissions. Regulations to save these forests, including embodied DD tariffs or bans on unsustainably produced imports, are typically fragmented, permitting DD activities to find coverage gaps and create DD leakage. The forestry literature has focused on the competitiveness leakage channel, with DD implicated production shifting from strictly to laxly regulated jurisdictions. Less recognized is the market redirection channel. Production need not move. Instead, sales are rerouted to less selective markets. Using the example of palm oil, we develop a model in which one importing region imposes an embodied DD tariff. Some exporters may face transaction costs to switch to low DD production. With a common DD tariff policy across all importers being both improbable and burdensome to exporters, we investigate unilateral approaches. Contrary to a unilateral ban, or tariff, on unsustainable imports, which creates market redirection leakage, the second best optimum combines the unilateral damage based tariff with an output subsidy. The output subsidy encourages exports to the tariffed market.

Introduction

Reducing tropical deforestation and forest degradation (DD) in developing countries is essential to limit global warming and preserve biodiversity (Stern, 2007; Seymour and Busch, 2016; Giam, 2017). Clearing for export-oriented agricultural commodities is a driver of tropical deforestation. Curtis et al. (2018) estimate that globally about 27% of all forest disturbance between 2001 and 2015 was commodity driven. Palm and soybean production are examples that are implicated in countries such as Malaysia, Indonesia and Brazil (Carlson et al., 2018; Curtis et al., 2018).

Developing countries often lack the capacity or motivation to curb DD on their own. Assistance and/or pressure from regulations imposed by developed country importers can help, but diverse application across jurisdictions offers fragmented coverage, leaving leakage channels through which DD can be maintained. The forestry literature has emphasized the competitive leakage channel; differential imposition of regulations on suppliers of forest products, promoting the geographical displacement of DD implicated production from more to less strictly regulated jurisdictions (Murray et al., 2004; Gan and McCarl, 2007; Lim et al., 2017). It can be avoided by uniform application of regulations across all sources of supply. We focus on a leakage channel not well recognized for forest products, the market redirection channel that occurs when regulations are applied differentially across markets. Producers need not move, but instead create leakage by rerouting their sales to less selective markets. In energy markets it is known as the energy market channel (Bohm, 1993; Larch et al., 2018).

Using the example of palm oil as the product, and a DD embodied tariff as the main regulatory instrument, we develop a model in which not all importers are concerned about the forest loss embodied in their imports, nor willing to impose embodied DD tariffs. We also allow that, due to transaction costs, not all developing country exporters respond to importing country tariffs by switching to forest friendly production practices. In the unlikely event that all importers imposed tariffs, market redirection leakage would be avoided. Contrary to a unilateral ban, or tariff, on unsustainable imports, which creates market redirection leakage, the second best optimum combines the unilateral damage based tariff with an output subsidy. The output subsidy encourages exports to the tariffed market. If transaction costs are sufficiently low the exports to the tariffed market will also be sustainably produced.

The next section provides background on the palm oil market. Section 3 discusses the literature on leakage. Section 4 models four importing or exporting entities in the palm oil market; an embodied DD tariff imposing oil importer, an importer that does not impose the tariff, an exporter who always responds to the tariff by producing sustainably, and a competing exporter who, depending on the transaction costs of certifying sustainable production, will produce all or a portion of its production unsustainably. Section 5 presents policy recommendations.