USMCA Automotive Rules of Origin: Economic impacts, Competitiveness Effects, and Relevance

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William Alan Reinsch, senior adviser and Scholl Chair in International Business, testified before the United States International Trade Commission on the economic impacts and competitiveness effects of automotive rules of origin implemented in the United States–Mexico–Canada Agreement (USMCA).

Thank you for the opportunity to testify. My name is Bill Reinsch. My work on trade policy issues includes twenty years on Capitol Hill, nearly eight years as Under Secretary of Commerce of the Bureau of Industry and Security (then “Export Administration”), and fifteen years representing private companies as President of the National Foreign Trade Council (NFTC). I currently hold the Scholl Chair in International Business at the Center for Strategic and International Studies (CSIS) in Washington, D.C., where we conducted a study in 2019 of how supply chains are affected by changes in rules of origin, using USMCA autos as a case study.

Automotive Rules of Origin (ROOs) implemented in the USMCA are some of the most stringent of any trade agreement. There are three ROOs in the USMCA, all of which must be satisfied for preferential treatment: a Regional Value Content Requirement (RVC) for the overall vehicle, RVC thresholds for automobile parts, and a labor value content rule.

The Trump administration intended that these rules increase automobile and parts production and assembly in the United States. The $16 per hour labor value requirement and the RVCs, for example, were designed to incentivize production in the United States and encourage the movement of jobs to the U.S., primarily from Mexico.

Our study found that auto manufacturers will have to deal with new administrative expenses to set up compliance monitoring systems, leaving uncertainty as to how costs would be distributed through the supply chain. Implementation of the labor value content rule and increased shares of U.S. steel and aluminum used in vehicles are likely to increase production costs. Administrative, facility construction, and labor costs are also expected to rise due to shifts in the supply chain of vehicle production. Our study additionally found that in the long term the new rules would encourage manufacturing investment, assembly, and R&D in the U.S. while simultaneously slightly hindering the competitiveness of U.S. automakers abroad.

We conducted our study as the rules were being agreed to. Now, with three years having passed, the Commission is in a better position to analyze their impact. In doing so, I want to suggest several issues to which you should pay particular attention.

EV Transition

The first is the accelerated movement toward electric vehicles (EVs). Neither the negotiators at the time nor our study contemplated such a significant shift in such a short period of time. The result is that the rules were largely designed for internal combustion engine (ICE) vehicles, and so they may no longer be appropriate in this changed environment. The Commission therefore needs to examine the development of battery technology and battery supply chains closely and to evaluate the impact that existing rules will have on these shifting supply chains.

Interaction of Rules of Origin with EV tax credit

Like the USMCA, the Inflation Reduction Act (IRA) phases in its regional content requirements for tax credit eligibility to provide producers with a transition period, but it risks clashing with USMCA ROOs. Since many EV battery supply chains are not sourced from areas that meet USMCA ROO requirements, it will be difficult for EVs to meet both USMCA ROOs and the set of conditions necessary to obtain the full IRA tax incentives. The USMCA regional value content rule (RVC) is phased in over time until it reaches 75 percent on July 1, 2023, for passenger vehicles, light trucks, and certain parts. Currently at 72 percent, it is almost fully phased in. The labor value content rule (LVC) states that 40-45 percent of the content of qualifying vehicles be produced by workers who earn at least $16/hour. EV batteries are considered “core parts,” and therefore fall within the 75% threshold for manufacturers to meet the 2.5% tariff reduction.

Under the IRA, EVs are eligible for a maximum total credit of $7,500, of which $3,750 is based on the amount of the battery’s critical minerals extracted in the United States or a country with which the United States has a free trade agreement or have been recycled in North America. At least 40 percent of the value of the battery must contain critical materials extracted from these areas, and that percentage will increase incrementally until it reaches 80% in 2027. The remaining $3,750 is based on the value of the components of the battery manufactured or assembled in North America. At least 50 percent of the value of the battery’s components must come from here, and that amount will increase incrementally until it reaches 100% in 2029. The law also stipulates that qualifying vehicles cannot contain battery components or minerals sourced from a “foreign entity of concern,” Defined as China, Russia, North Korea, and Iran.

The USMCA ROO phase-in period for passenger vehicles and light trucks ends in 7 months, while the IRA phase-in period is just beginning. Those different timelines may create difficulties for manufacturers who wish to comply with both sets of requirements, although the decision of major manufacturers to apply for alternative staging regimes may make that effort easier by providing two more years for compliance.

Compliance may become easier over time as the IRA phases in, but compliance with either or both sets of standards could result in higher prices for automobiles since these incentive structures prioritize North American production over efficiency and cost to consumers. The process of changing suppliers by itself will cost money, as manufacturers have to deal with their existing contractual obligations as well as identifying, testing, and certifying new suppliers. These factors also risk slowing the deployment of green goods and technology, which conflicts with the goals of the USMCA and the Biden administration’s climate change strategy.

Overall, the current inability to source significant portions of EV batteries from North America could make it difficult for manufacturers to meet both USMCA rules and receive the full IRA tax credit. As automobile supply chains transition away from ICEs and toward EVs, it is possible that auto manufacturers will encounter a situation in which EV batteries meet the USMCA’s content threshold while failing to obtain the full tax credit if they cannot move sufficiently away from critical minerals processed in China. While the incentives in the USMCA and IRA both encourage re-shoring or “friend-shoring” of supply chains by incentivizing North American production and formalizing favorable policies for FTA partners of the United States, the result could be that companies qualify for 2.5% tariff relief and yet fail to earn the full amount of the IRA tax credit.

Job Impact

When CSIS did its study, we concluded that given the sheer scope of the automotive industry, which directly and indirectly supports more than 7 million workers, changes to the automotive supply chain in North America could result in workforce adjustments. With the USMCA grace period set to expire in 2023 for passenger vehicles and light trucks and 2027 for heavy trucks and electric light trucks, industry compliance plans should be underway, even if an ASR gives them more time. That should put the Commission in a better position than we were to estimate the likely job impact, although the shift to EVs and the major changes in supply chains that go with it may make that difficult.

One issue for the Commission to consider is the current availability of compliant parts and components for EVs as well as how long an adjustment period would be necessary to permit their development.

Cost of Compliance

Manufacturers will have to weigh whether the costs of complying with the various standards exceed the benefits being offered. The advantage of complying with the RVC and assembly requirements is that the automobile would be considered a North American vehicle and thus exempt from the 2.5% tariff. That allows manufacturers to calculate whether their compliance costs would exceed 2.5% of the value of the vehicle. If they do, companies may simply decide to pay the tariff rather than proceed with the relatively arduous process of meeting ROO requirements. If foreign manufacturers decide that it is not worth it for them to comply with USMCA requirements, that decision may lead them to reduce the amount of their North American content rather than increase it, which would be inconsistent with the objectives of the USMCA. Understanding which incentives companies are likely to find most attractive is critical to understanding the impact of the new rules.

The Commission should also evaluate the costs and benefits of “friend-shoring” policies that enable companies to obtain the full EV tax credit. There are several countries poised to take over the share of the market forfeited as companies move EV battery supply chains away from China. One country that stands to gain, for example, is Canada, although it remains unclear on what timeline Canada would be able to provide sufficient supplies since most of the processing of minerals is currently carried out in China. A comparison of the costs associated with shifting supply chains to the financial benefit gained from compliance with EV tax credit incentives could prove useful to understanding the effects of the IRA incentive structures.

Another dynamic the commission should examine is the overlap and gaps in the parallel incentive structures of the USMCA ROOs and the IRA EV tax credits. Understanding whether the incentives are strong enough to invite compliance with both, simultaneously, can help inform industry and government on the efficacy of these incentives.

Disaggregating Variables

The Commission’s analytical task will be unusually complex because so many different things are happening simultaneously. The industry’s conversion to EVs is not driven by USMCA but rather by the climate crisis, anticipated shifts in consumer demand, and government actions intended to reinforce the demand shift. The Covid pandemic has also scrambled supply chains due to factory shutdowns and logistical blockages that are ongoing. For European manufacturers in particular, Russia’s invasion of Ukraine has had a direct impact on their supply chains that include Ukrainian parts and components. The development of battery supply chains will be driven not only by the EV tax credit incentive but by the availability of the necessary minerals and processing facilities that cannot be replicated to meet either the USMCA or the IRA requirements in the short term. None of these developments are directly related to the USMCA ROOs, but all of them impact the auto industry’s planning. Separating out the USMCA-caused changes from those caused primarily by other factors will be a challenge for the Commission and underscores the complexity of these competing incentive structures.

Answering these questions will help to elucidate aspects of the USMCA that sit at the nexus of North American competitiveness, the green transition, and the great supply chain reshuffle. Thank you for your time.