Striking a Balance on Local Content Requirements in Trade Agreements: The Case of the Energy Sector

| 15 March 2024
Trade, Blog | Tags: Energy, Global Value Chains, Renewables

The new trade agreement between India and EFTA States includes commitments on an important yet often overlooked form of trade restrictions: local content requirements. The use of this kind of policy has risen starkly in recent years. Global value chains in the energy sector are a case in point. While these policies can sometimes be used to reach specified goals, they often have adverse effects. This article delves into how trade agreements can help strike a balance on local content requirements for an affordable, secure, and clean energy future.

Last Sunday, India and the European Free Trade Association (EFTA) concluded 16 years of trade negotiations with the signing of a “Trade and Economic Partnership Agreement” (TEPA). The agreement includes commitments on an important yet often overlooked form of trade restrictions: local content requirements (LCRs) i.e., policies mandating that goods or services be sourced from local providers. (For more, see Box below.)

LCRs matter. They can be a serious impediment to building resilient global value chains (GVCs). A case in point is their role in the energy sector for an affordable, secure, and clean energy future. As can be seen in Figure 1, globally, between 2008 and 2023, the use of LCRs has risen each year. This translates into a stark net growth in LCRs since 2008 by over 5,000.[1]

Countering this trend is critical. And to this end, Free Trade Agreements (FTAs), such as TEPA, can play a decisive role. They can help strike a balance on LCRs by eliminating the most damaging ones, helping domestic industries become globally competitive without resorting to LCRs, and retaining policy space where warranted.

Global Value Chains Swamped in Local Content Requirements

Governments have introduced a multitude of LCRs. LCRs in the value chains for the energy sector provide a wealth of illustrations. Some date back to the recovery efforts from the global financial crisis (2007/08). Others are a reflection of more recent geo-economic competition between states over green industries. Governments deploy LCRs for a variety of objectives, including technology transfer, employment generation, and economic diversification. LCRs have been adopted by developing and developed countries alike, and have affected the entire value chain across the spectrum of renewable energy systems, from the extractive sector to manufacturing and deployment of energy systems, such as solar or wind.


Box: Understanding Local Content Requirements (LCRs)

There is no generally agreed definition of what constitutes an LCR. Very broadly, LCRs are policies that contain specific targets on sourcing or production from the local economy that companies are required to meet. What is considered “local”, can vary from highly specific places to regions spanning multiple countries. The targets may be qualitative or quantitative. An example for qualitative targets is when companies are required to establish a joint venture with a local company. An example for quantitative targets is when access to subsidies – or the right to be active in a place – is conditioned on a specified amount or value of sourcing from local companies.

LCRs are a subset of more generic “local content policies”. This term is often used to include a large variety of policies that are intended to foster local linkages – from policies that improve the local business climate to adjusting tariff rates. It also includes requirements for companies without specific targets, such as requirements for companies (1) to sign agreements with local communities, (2) to commit to fair and equitable opportunities for local companies, or (3) to publish plans and reports about their local procurement.

LCRs generally increase sourcing costs in the targeted industry by reducing companies’ choice of sources. Theoretically, the immediate cost increases they trigger can be balanced out through cost-reductions in the long run, e.g., by fostering innovation and global competition through the market entry of further players.

De facto, LCRs have sometimes been effective in reaching their specified goals. Consider Morocco, which employed LCRs for wind power in the fabrication and assembly of masts for wind turbines. As it built a utility-scale wind sector, the achievement of said requirements seems to have been supported by synergies with existing, related industries in the automotive, aeronautics, and electronics industries in addition to various educational programs to train the necessary technically skilled workforce. In India, between 2013-2017, LCRs contributed to the growth of local capacity for specific solar modules, with growth rates of 27% per year. In Brazil, the national development bank BNDES incentivized localization through low-interest loans for renewable projects with LCRs. These, for instance, helped Brazil develop a wind manufacturing industry in less technologically sophisticated parts, such as blades, towers, bearings, and castings.

 

Figure 1:  Since 2008, the Global Use of LCRs has Increased Every Single Year. The blue bars represent the number of new or strengthened LCRs, the red bars reflect the number of policies reducing or removing them in each calendar year. The grey bars show the net increase in LCRs since 2008, separated into the lighter grey representing the net increase in LCRs in government procurement and the darker grey representing the net increase in all other LCRs. The number of existing LCRs from before 2008 is not captured in this graph, so the total number is likely higher. Graph & calculations by author. Original data: Global Trade Alert.

While LCRs have sometimes been used successfully to reach specified targets, they generally increase costs, restrict competition, and reduce investment in the targeted and related industries. Often, LCRs are poorly designed and adverse outcomes can frequently be attributed to overly prescriptive, mandatory local content requirements in combination with misaligned policies. One example can be found in Nigeria, where strict LCRs on sourcing and employment in the oil and gas sector seem to have been ineffective at fostering local companies as local suppliers lacked the capacity to meet the high targets and could not draw on enough sufficiently skilled local workers.

In addition, where LCRs are used successfully to attain their specified objectives, they may still cause an aggregate loss in national income and number of jobs. In Argentina, the mining industry was required to source transport services locally. A model estimating the economy-wide effects indicated that the LCR may achieve its specified goal but have adverse effects on the economy as higher demand for local transport services from miners would lead to higher costs for transport across the whole economy.

Strengthening the GVCs for Sustainable Energy by Balancing LCR Commitments

Given these potential up- and downsides of LCRs, and the large variability in outcomes, how can Free Trade Agreements (FTAs) strike the right balance in support of an affordable, secure, and clean energy future?

Broadly speaking, on the one hand, FTAs can help enforce existing commitments under the WTO, namely to not use LCRs for goods, neither directly (compelling companies to source goods with local content) nor via subsidies (with access conditioned on meeting LCRs). In contrast, LCRs in services and government procurement remain broadly available unless countries have made further commitments in the WTO or beyond. In these cases, FTAs can reduce and limit harmful LCRs while retaining policy space where there is evidence that LCRs can play a positive role.

How can this balance be achieved?

First, FTAs are a prime opportunity to enact best practices for LCRs by committing to avert future LCRs and to phase out existing ones. Countries should fortify their multilateral commitments on goods and strengthen their commitments in the services sector and government procurement.

Second, ambiguities should be removed to ensure policy certainty. An example for such ambiguities can be found in the EU’s current proposal for the FTA with India where the article on LCRs in the chapter on “Energy & Raw Materials” is unclear about which industries it covers.

Third, where trading partners want to retain “water”[2] in their schedules, they should commit to “sunset clauses” on LCR policies and/or upper limits on costs. Retaining water may be especially relevant for sectors in which local opportunities could be unlocked at relatively low costs, e.g., services related to construction, operation, and maintenance of solar and wind power, or where the policies may support indigenous or historically disadvantaged groups. In some cases, requiring local partnerships may be warranted, e.g., if there are technical reasons to do so. A case in point is the exception on this type of LCR in the EU-Kazakhstan Enhanced Partnership and Cooperation Agreement (EPCA)[3].

Free trade agreements are critical to strengthening cooperation in GVCs across the global economy, including those in the energy sector. They can remove especially damaging LCRs and help industries progressively graduate from the support that LCRs provide. At the same time, they can be designed to retain relevant policy space. Striking a balance on this is essential for an affordable, secure, and clean energy future.

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[1] Calculations by the author, based on data by the Global Trade Alert, accessed February 26, 2024. The calculations included all policies under UN MAST chapters “I1 Local Content Measures” and “M3 Government Procurement Local Content Requirement”, with policies classified as red or amber being counted as raising LCRs, and policies classified as green being counted as reducing LCRs.

[2] «Water» is trade jargon for policy space that remains available and is currently unused.

[3] EPCA Article 147 on renewable energy states: «2. Each Party shall: (a) refrain from maintaining or adopting measures requiring the formation of partnerships with local companies, unless such partnerships are deemed necessary for technical reasons and the Party maintaining or adopting such measures can demonstrate such technical reasons upon request by the other Party;» (italics added by author).

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