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What do NAFTA renegotiations mean for the North American energy

sector?
By Laura Dawson 1

Director, Canada Institute, Wilson Center

March 31, 2017

Energy is important to the NAFTA economies. Abundant and affordable energy is one of
the key engines of North American competitiveness in the world. But, the NAFTA as an
agreement has few direct linkages to the energy sector. It seems surprising that a sector
that represents such a large part of NAFTA trade has such a limited relationship with the
major legal agreement governing cross-border commerce when energy too travels across
borders. An understanding of the basic rationale for trade agreements helps to explain why
this is the case.

Trade Agreement Mechanics

Canadas oil, gas and electricity exports represent some 25 percent of Canadas total goods
exports to the United States. Agriculture represents 7 percent of Canadian exports to the
United States but much more time and effort is spent on negotiating trade in foodstuffs
than trade in energy. This asymmetry is the result of opposing market dynamics that affect
the two sectors and the role played by trade agreements to mediate these dynamics.

In agriculture trade, the objective is to protect domestic producers against foreign


competition while allowing some foreign producers into the market in order to satisfy
consumer choice and encourage competitiveness. Think of it as a tripartite relationship
comprising a willing domestic buyer, a willing foreign seller and a wary domestic
competitor. In traditional energy trade, the domestic competitor is largely absent from the
mix. Consumers (represented by large resellers or distributors) have been eager to buy.
Producers have been eager to sell and the only impediments were infrastructure and other
distribution challenges. In 1994, when the NAFTA came into force, the major question was
how to keep the foreign energy taps turned on, not how to keep foreign product out.

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For more information, please contact Laura.Dawson@wilsoncenter.org

1
Security of supply was such an important issue in the early 1990s, that the NAFTA contains
a proportional access clause (Article 605) which guarantees that Canada will supply
historically consistent volumes of oil to the United States. 2 Mexico, for its part, sought to be
excluded from any energy trade commitments in the NAFTA in order to preserve full
control over its state-owned sector.

Today, a number of the key dynamics have changed. First, while security of supply is still a
priority for the United States, imports of foreign oil are less important to the United States
today than they were a quarter century ago because of the shale gas and oil revolution
brought about by hydraulic fracturing technology. With access to new oil and gas reserves,
combined with an end to the U.S. prohibition against crude oil exports, the United States is
not only a customer for Canadian oil producers, it is increasingly becoming a competitor.

Secondly, Mexico has made a serious commitment to privatizing its energy sector and
increasing competitiveness through increased exposure to international market forces,
investment, and technological know-how. Consequently, Mexico may be nearly ready to
take on the NAFTA commitments affecting energy trade.

Where does the NAFTA intersect with the North American energy economy?

Tariffs, usually the most important part of a trade agreement, are about the least important
part of the NAFTAs reach into the energy sector. Basic commodities such as oil, natural gas
and electricity move across the border duty free. Manufactured products related to the
energy trade such as turbines, solar panels and nuclear reactors attract modest duties of
less than five percent. Following is a partial list of tradeable energy goods by customs
codes.

Table 1: Examples of Tradeable Energy Goods

Customs
Classification Description
2709 Petroleum oils and oils obtained from bituminous minerals, crude
2710 Petroleum oils and oils obtained from bituminous minerals, other than crude
2716 Electrical energy
2844 Radioactive chemical elements and radioactive isotopes (including the fissile or fertile
chemical elements and isotopes) and their compounds; mixtures and residues
8401 Nuclear reactors; fuel elements (cartridges), non-irradiated, for nuclear reactors;
machinery and apparatus for isotopic separation;
8541 Diodes, transistors and similar semiconductor devices; photosensitive semiconductor
devices, including photovoltaic cells whether or not assembled in modules or made up

2A 2006 memo from the Library of Parliament clarifies that Article 605 was intended as a way to prevent
government from intervening in market forces of supply and demand, such as the 1980 National Energy Program,
and not as an impediment to the day-to-day operations of the energy sector. See Michael Holden, Canadian Oil
Exports to the United States Under NAFTA (Ottawa: Parliamentary Library and Research Service, November 2006).

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into panels; light-emitting diodes (LED); mounted piezoelectric crystals; parts thereof
8502 Electric generating sets and rotary converters [including wind powered]
Source: World Customs Organization

The NAFTA energy chapter has a relatively narrow scope applying to basic oil, gas, mineral
and petrochemical products. Other areas where the NAFTA affects energy are in the
provisions dedicated to investment, services, movement of persons, government
procurement, and rules of origin.

Investment rules are particularly important for energy companies that have operations in
different countries. Investment agreements set out the terms under which foreign
investors can operate. Most importantly, they provide options for legal recourse in the
event of expropriation or other government policy changes affecting the value of an
investment. These protections are covered in the NAFTA Chapter 11 provisions on
Investor-State Dispute Resolution (ISDS). For the energy sector, ISDS rules help to mitigate
investment risk in countries where rule of law is not effectively enforced. The NAFTA was
the first modern free trade agreement to contain ISDS provisions. They are now found in
many trade and investment treaties and are increasingly becoming the global norm.

Services Even though neither the NAFTA nor WTO contain specific commitments for
energy services, the sector utilizes services across a range of WTO-designated sub-sectors
including transportation, consulting, engineering, construction, business, financial, legal
and information technology. Services rules define what services sectors may be open to
foreign providers and they are categorized according to how services are provided (in
person, digitally, etc.) Due to the specialized skills needed for various stages of resource
development, energy companies are particularly interested in the rules governing the
movement of persons, including intra-company transferees and personnel sent on short
assignments such as site inspection.

As an extension of its services obligations, NAFTA contains a dedicated chapter on the


temporary movement of people but the provisions that permit facilitated access for certain
occupations and skills have not been updated since 1994. These will likely remain under-
developed because of U.S. political concerns over the intersection between trade-related
labor mobility and broader immigration concerns. In the meantime, restrictions on travel
and immigration to the United States are providing Canada with an unintended talent
boom as more skilled workers are choosing to come north.

Government Procurement rules come into play when the buyer is a state or state-
controlled entity. These rules stipulate who is allowed to bid on government contracts and

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how these are transactions are carried out. Overall the trend is moving towards greater
openness by sub-federal governments towards foreign suppliers and more competitive
tendering processes. However, this movement toward openness has progressed very
slowly and can easily be interrupted by Buy Local provisions that reserve public
purchasing to domestic suppliers. It is important to note, however, that despite White
House promises to impose Buy American rules on steel used to produce pipelines, pipelines
tend to be privately owned. While pipeline owners could voluntarily undertake to use U.S.
steel in order to generate good will or expedite the approval process, the government
procurement rules and penalties cannot be applied to private firms.

Rules of origin are used to determine whether a product has sufficient content produced
within the trade bloc, thus allowing for preferential treatment under the NAFTA. For
example, a car must have 62.5 percent of its content sourced in the United States, Canada,
or Mexico (a cumulative total) for it to be considered originating, i.e. eligible for duty-free
treatment under the NAFTA.

Rules of origin play a unique role on the export of Canadian oil sands products. Some
heavy crude is too viscous to ship through pipelines without diluting it first. The addition of
certain kinds of lighter petroleum products, referred to as diluents or condensates, results
in a blended export product that is able to meet pipeline viscosity and density
specifications. 3 But there have been a few instances where the origin of this blended
product has been questioned by U.S. customs officials. 4 Even though the percentage of the
diluent in the total shipment may be small (around 30 percent or so), some blended heavy
oil exports have still been subject to additional duties. Origin challenges also affect other
energy products where co-mingling occurs in a storage facility or blending process.

Since the diluent issue is more of a technical challenge than intentional trade
protectionism, it should be possible to find a solution that satisfies buyers, sellers, and
customs officials. The broad strokes of a solution may already be at hand. The TPP text
contains provisions that allow for the inclusion of diluent levels of up to 40 percent of the
final volume of the product without affecting the origin classification (thus allowing the
final product to qualify for preferential tariff treatment). The TPP also contains provisions
allowing up to 25 percent of non-originating material in blended products. Adopting the
TPP rules into a newly-negotiated NAFTA should not be difficult with sufficient industry
support from the three NAFTA states.

3
Western Canada Select is Canadas heavy oil export benchmark product. The product is comprised of
conventional heavy and bitumen crude oils that are blended with sweet synthetic and condensate diluents.
4
Importers are required to produce certificates of origin for all the inputs contained in a final product.

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Whither Renewables?

Canadas renewable energy and decarbonization objectives were closely aligned with those
of President Obama and his prospective Democratic successor. However, the Trump
administration has significantly diverted from this path. New climate change mitigation
policies are not among the Presidents priorities and many existing policies and programs
are set to be eliminated. 5 Canada will continue to find allies in U.S. states where
decarbonization reforms are already institutionalized but there will be little new
cooperation on bilateral (or trilateral) climate change initiatives.

David Goldwyn, the State Departments Special Envoy for International Energy Affairs from
2009 to 2011 predicts that the U.S. will not pursue more ambitious climate commitments
until 2020 at least. Until then, U.S. progress on climate mitigation may be found in
technological, not policy, advances. 6

U.S. divergence from the climate agenda will have some effect on trade policy to the extent
that there will be little appetite for strengthened measures in NAFTAs environmental side
agreement nor will trade preferences for green products and services attract much interest
from U.S. trade negotiators.

If and when carbon pricing becomes more established across state and provincial
boundaries, energy and trade officials will have to give serious consideration to the
imposition of tariffs on products moving from low-cost carbon jurisdictions to high-cost
carbon jurisdictions. This problem will be particularly acute for energy intensive trade-
exposed (EITE) industries. Far sighted policymakers will put this issue on the agenda now,
looking at models for similar tax rebates for exporters such as exist in Canada for the goods
and services tax (GST).

Market Disruption

Trade agreements do not have many direct ties to the energy sector so perhaps the most
important effect of the NAFTA or its dissolution is its contribution to secure, integrated,
cross-border supply chains and their impact the overall economic health of North America.
Market closing activities that increase prices, increase trade barriers and weaken investor
confidence will decrease demand for energy products and divert investment and talent to
other parts of the world.

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See, for example, the March 27th executive orders pertaining to climate http://www.vox.com/energy-and-
environment/2017/3/27/14922516/trump-executive-order-climate
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David Goldwyn, The Outlook for Energy Under a Trump Administration: Major Volatility Ahead, (Atlantic Council,
January 2017)
http://www.atlanticcouncil.org/images/publications/The_Outlook_for_Energy_Under_Trump_web_0106.pdf

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Is there a Plan B?

Although presidential campaign rhetoric has been toned down from ripping up the NAFTA
to merely tweaking it. Businesses and policymakers have been struggling to predict what
modifications are likely or possible. If the NAFTA were to be eliminated, Canada would
continue to have both a bilateral free trade agreement with the United States (the 1989
Canada-U.S. Free Trade Agreement) and the bilateral agreement with Mexico that was
created as part of the NAFTA 7 but a patchwork of agreements would be nowhere near as
robust in breadth and depth as the NAFTA.

While many, especially in Canada and Mexico, have been calling for the NAFTA to be
reviewed and renewed, the timing of the renegotiation is particularly poor. Mexicos
energy reforms are on track to finally bring Mexico fully onside with the NAFTA energy
commitments (and even encourage greater levels of trilateral energy cooperation). This
momentum is now probably lost because of the distraction of defending the entire trilateral
economic relationship.

Even more serious is that fact that Mexico is facing a presidential election of its own. The
leading candidate to defeat the incumbent PRI party is Andrs Manuel Lpez Obrador of
the PRD. His campaign is fueled by Mexican backlash against President Trumps anti-
Mexico words and deeds. Observers of Mexican trade and politics agree that the incumbent
PRI cannot make NAFTA concessions to the United States during the campaign period and
still hope to win the election. This fact mitigates against a quick NAFTA re-negotiation,
especially one in which the United States gets everything it asks for.

One recent glimmer of hope is that the head of the White House National Trade Council,
Peter Navarro, seems to have shifted away from a focus on rectifying trade deficits and is
now promoting strengthened North American regional competitiveness in the world. 8 But
the details of how this will come about are not clear, especially when Buy American, Hire
American, continues to be the rallying cry of the Trump White House.

The U.S. administration has made it clear that it expects a re-negotiated NAFTA to deliver
tangible gains in U.S. manufacturing employment. Economists have pointed out that U.S.
manufacturing output is actually higher now than it has ever been and many advanced
manufacturing jobs are going unfilled because U.S. workers lack the requisite skills. This
suggests that an educational or social policy response may be a better approach than using
trade policy negotiations to fix labor market dislocations. The NAFTA, in particular, has

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Both Mexican and Canadian officials have recently reaffirmed their commitment to the latter.
8
Bloomberg Politics, Trumps Top Trade Advisor Quietly Seeks an Alliance With Mexico (March 15, 2017)
https://www.bloomberg.com/politics/articles/2017-03-15/u-s-sees-mexico-as-part-of-regional-powerhouse-
navarro-says

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been incrementally creating integrated, low-friction trade and commercial policy for more
than 20 years.

Now, the NAFTAs success is a problem. There are simply are not enough areas of the
agreement where substantive changes could be made without significantly disrupting
cross-border supply chains. Most of the tariff barriers have been removed. Most of the
non-tariff differences have been aligned. What remains are areas of national trade
protectionism held in place by domestic political interests, such as the U.S. Jones Act
governing navigation and Canadas supply management policies to protect domestic dairy
and poultry producers.

The issues that can be done quickly such as adopting new measures on rules of origin for
diluents from the TPP will not deliver the results the U.S. administration is looking for.
Coming after Canada on softwood lumber and Mexico on trucking rules will satisfy narrow
U.S. constituencies but it wont provide the broader employment gains the White House is
seeking.

Another option is to step away from the trade rules contained in the NAFTA and consider
the spirit of the trilateral cooperation and how this could be harnessed to provide access to
the trade benefits that bypassed many workers in Donald Trumps America (and Canada
and Mexico as well).

A positive agenda would include cooperation by trilateral businesses and governments to


fix problems of coordination, information, and regulatory duplication. It would include
voluntary undertakings by industry as an alternative to mandatory trade obligations to
invest in skills, retraining, education, portability of benefits and facilitated worker mobility.
Partnerships with educators and organized labor would also have to play a role.

For the energy sector, an ideal framework upon which to build is the existing North
American Energy Ministers Working Group on Climate Change and Energy. Some
rebranding may be necessary to align the focus toward regional energy competitiveness
but the collaborative mechanism remains a valuable tool. Some potential work areas that
are both relevant and aligned with White House goals are:

Regulatory alignment and cross-border cooperation (including reforms to pipeline


permitting);
Infrastructure development;
Infrastructure security and resilience;
Inclusion of Mexicos energy sector in the NAFTA;
Secure access to affordable energy in the U.S. and the Canadian far north; and
Energy efficiency

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Many of these initiatives are in progress elsewhere, such as in the Canada-United States
Regulatory Cooperation Council, but they could be amplified by the trilateral ministers
group.

Conclusions

Trade, investment, and energy products continue to move around the world. New markets
and new competitors emerge every day. The EU searches for a post-Brexit path to
economic reconciliation, and China continues to extend its global economic reach. The
question for North America is whether it will become weaker as a result of beggar-thy-
neighbor policies that fracture a well-functioning trading system or whether it will find a
way to leverage its endowment of skills and resources to become more competitive in the
world. The North American energy sector is threatened by the demise of the NAFTA for
reasons largely outside of its control but the continuation of healthy North American
supply chains requires all shoulders to the wheel, including those who buy, sell, and
regulate North American energy.