Despite frequent criticism, Ross Garnaut is no cold-war warrior for the left. On the contrary, he’s a committed pro-market economist with a deep understanding of the ill effects of unnecessarily interfering with free markets.

That’s why, as a pivotal figure at the centre of a historic macroeconomic reform, he must make a stand on the protectionism Labor is embracing en route to creating a carbon tax. Day after day, Labor is taking the moral high ground in parliament, boasting of its love of free markets, and pillorying the opposition for backing a carbon-reduction scheme that relies on a bureaucratic tendering process.

Up to a point the government is right — great swathes of economists back the idea that the market will find “millions of ways”, as Labor puts it, to innovate and reallocate capital to optimise the Australian economy once carbon has been priced. But what Labor is not saying is that it has unnecessarily committed itself to a form of protectionism that could easily be avoided with a little help from the global trade umpire, the World Trade Organisation.

To understand how it works, one only has to look closely at the call made yesterday by Bluescope chairman Graham Kraehe for carbon “border adjustments” to be set up alongside the carbon tax.

In a speech to the National Press Club, Kraehe said that under a border adjustment scheme “Imports would be taxed with the same carbon tax that is applied to Australian-made goods, while exports would receive a rebate. This would be fair and equitable.”

A spokesman for Senator Christine Milne, who recently had a heated public exchange with Bluescope over compensation for emissions intensive trade exposed businesses (EITEs), told me the Greens were open to the idea of border adjustment “though we’re not vigorously pursing them”.

And they certainly aren’t backing Kraehe’s other demand — that EITEs be exempted from the carbon tax locally until similar carbon prices are in place abroad.

Kraehe’s border adjustment call has real merit — and it was hasty, and wrong of Trade Minister Craig Emerson to rule out “carbon tariffs” two weeks ago. For a start, Emerson must ditch that language — a carbon tax border adjustment is no more a “tariff” than the goods-and-services tax border adjustments that Australia already has in place, and that exist in most countries imposing similar value-added taxes.

Emerson’s argument, that a carbon “tariff” was in some way a return to protectionism could not be more wrong. By ruling out border adjustments, Labor is forced to rule-in direct subsidies to EITEs — the compensation packages now being negotiated by Labor in closed-door meetings with the directors trade-exposed companies.

Economist Richard Denniss, executive director of progressive think tank The Australia Institute, yesterday told me that border adjustments rely on a very simple principle — the differential price applied to carbon emissions between trading partners.

While most nations are yet to set formal carbon prices, the Productivity Commission has been asked by the government to calculate the “effective carbon price” imposed by our major trading partners — through, for instance, public investment in renewable energy or mandated use of renewables by power companies.

Taking China as an example, the Productivity Commission is expected to return a figure of about $A16/tonne.

Australia’s direct carbon price is expected to be about $26 a tonne, but supplemented with our own RET scheme impost — which is pushing power retailers into sourcing 20% of their power from renewables by 2020 — we might come out with a starting “effective carbon price” of, say, $36.

So in doing business with China, Australia overall faces a $20/tonne additional cost for its CO2 emissions.

Thus, under Kraehe’s plan, every tonne of steel brought into the country would be taxed for the number of tonnes of CO2 emissions that went into its manufacture. And every tonne of steel Bluescope exported would attract the same value in export rebates. (I am leaving aside, for the moment, Bluescope’s claim that its operations are much more carbon-efficient that most steel mills in China).

Under this proposal, trade is free in both directions. There is no protectionism at all as long as Australia’s border adjustment price is set correctly for each of its trading partners — not difficult to do on an annual basis, particularly for trade-exposed bulk commodities such as steel, aluminium and alumina.

The political problem with setting up such a scheme would be the temptation to tweak the border adjustment prices to give Australian firms an unfair advantage — a slippery slope back into protectionism. That’s where the WTO comes in — with its oversight, a transparent set of carbon-tax border adjustments could be given a clean bill-of-health to prevent disputes with our trading partners.

The flip-side of this proposal — and the one that Garnaut needs to speak out on more forcefully, and more often — is the subsidy-based approach currently under negotiation with the Labor leadership. As Denniss points out, there are two sides to protectionism — tariffs and subsidies. And Emerson has committed his side of politics to the latter.

It is not too late to save face and reverse this position. So far, Garnaut has obliquely criticised Labor for its behind-closed-doors negotiations — in his speech to the Press Club last week he criticised the Rudd government’s record on this, saying that during the CPRS negotiations the government was “getting back into a world where favours were negotiated by individual businesses where there weren’t disciplines on the policy process”.

That’s what’s happening today. While it might stick in his craw, Garnaut last week recommended three years of compensation modelled on the pre-lobbying version of the CPRS compensation, then a shift to “principle-based policy” after that.

This is a huge compromise. It does not send the right price signals to major emitters in the short term, but it also raises a longer-term risk — that future governments won’t have the political nerve to unwind the compensation.

Australia’s carbon reduction scheme should be aimed at reducing carbon emissions within our own borders, in the knowledge that failing to do so leaves us unacceptably exposed to future trade sanctions from, in particular, China, the EU and the US.

The beauty of a carbon-tax border adjustment is that is can encourage our economy to shift away from carbon-intensive activity, and harmonise our position with out trading partners’ efforts to do the same, as they arise.

Of course, Kraehe’s other demand — that EITEs be exempted from the carbon tax until formal carbon prices have been set overseas — would become unnecessary if border adjustments were put in place. And nor will it be granted if Labor ploughs ahead with its current compensation plans.

Garnaut is clearly irritated by the current round of EITE negotiations and if he is biting his tongue it’s most likely because he wants to see a market-based mechanism created — he may see the taint of subsidies, that risk becoming entrenched as carbon protectionism when other nations strengthen their carbon pricing efforts, as a necessary evil to achieve that.

But it doesn’t have to be that way. Border adjustments are fair. They are not tariffs. They are not protectionist. And Garnaut should publicly explain this to Labor before we get stuck with compensation payments that in a carbon-constrained trade environment will soon start to look like straight protectionism.

*This article was first published on Business Spectator