A trade war between the United States and China over solar panels is brewing.

The U.S. has accused China of illegally subsidizing its domestic manufacturers, which have enabled them to ramp up panel production even as prices fell, and “dumping” goods into the U.S. marketplace. Chinese panel manufacturers are also believed to have few environmental restrictions, which further slash their costs.

At the behest of a consortium of U.S. solar panel companies, the Obama administration imposed a series of temporary tariffs on Chinese solar panel imports, with the levies ranging from 31 percent to 250 percent. As a result, Chinese solar sales in the U.S. dropped by 64 percent in April and 45 percent in May, according to the Coalition for American Solar Manufacturing. In response, the Chinese government and solar panel industry have filed complaints, accusing the U.S. of trying to “protect its own industry amid an economic downturn,” the Wall Street Journal reported.

China has literally taken over the world’s solar panel manufacturing industry, as Chinese companies provided 68 percent of the world’s panel supply last year — a sharp rise over 2009′s 40 percent — London-based researcher Bloomberg New Energy Finance estimates. Conversely, U.S. panel manufacturing share has fallen to just 9 percent in 2011 from 23 percent in 2009. The European Union has lost traction, as well, producing only 11.5 percent of the world’s solar panels in 2011, a drop from 19 percent in 2009.

The heavy competition from China slashed U.S. and EU manufacturers’ profit margins, cutting solar panel prices by as much as 50 percent in the last year alone. A dozen American companies have gone into Chapter 11 bankruptcy.

While talks continue between the Chinese commerce ministry, the U.S. International Trade Commission and the U.S. Commerce Department, the EU has been making noise about similar anti-dumping legislation against China, with EU solar and wind trade groups calling for an investigation. Solarworld AG, Germany’s largest solar-panel maker, is leading a group of manufacturers to request the EU Commission open an investigation and impose tariffs — a decision that has further outraged China, which says the actions could trigger a “wholesale trade war” between China and the EU and the U.S.

What will happen if there is an all-out trade war?

It is important to note that not everyone is in favor of the tariffs. Some green groups in Europe believe that the EU should welcome Chinese imports because they make solar and wind energy more affordable. Critics of the tariffs in the U.S. point out that China is effectively subsidizing the U.S. with more affordable technology by boosting associated services and jobs such as installations.

They also say that spurring renewable energy proliferation that will lead to lower energy prices across the board. In addition, the tariffs may backfire in that they may actually yield benefits for other Far East nations such as Taiwan and South Korea, all of which may increase manufacturing to fill the holes in the market left by the tariffs against China.

But pro-tariff groups note the long-term health of the market. The Coalition for Affordable Solar Energy (CASE) acknowledges the drawbacks of a trade war in a new report, but it also warns of long-term damages. CASE’s logic is that a renewable sector in which low cost is king eliminates the incentive to innovate, and the the flood of Chinese components may lead to short-term gains but cripple long-term development.

CASE’s report stated:

If the goal is to create a global energy system that is largely carbon free, continual dependence on subsidies, whether domestic and legitimate or foreign and mercantilist, is not the way. Driving innovation is.

Matthew Stepp, one of the authors of the report, told Ars Technica that it is important for the U.S. to create an effective solar market policy because it could well serve as the foundation for future policies for next-generation renewable energy technologies.

“For the U.S. to out-innovate, it must still prosecute green mercantilist policies,” Stepp said. “China is dominating first-generation silicon-based solar PV. But the U.S. has been a leader in second-generation thin-film solar technologies and is currently investing significantly in third- and fourth-generation solar designs that use nanotechnologies. What’s to stop China from simply doing what it’s doing now in first-generation solar to next-generation solar … and unfairly subsidize and export dump their way to market dominance?”

Clifton Yin, a clean energy policy analyst at the Information Technology and Innovation Foundation (ITIF), expressed optimism for the U.S. solar industry. He said the Obama administration’s tariffs will work to the U.S.’s advantage.

“The tariffs are meant not only to level the solar market playing field for U.S. manufacturers, but also to discourage unfair Chinese trade practices and hopefully serve as a wake-up call for Chinese policymakers,” Yin said. “However, even in the absence of the Chinese government changing policies, there is a lot that U.S. solar panel manufacturers can do. There needs to be a renewed focus on research and development and innovation to develop solar products that are much more cost and performance effective. Ultimately, they’re not only competing with cheap Chinese panels, but also cheap fossil fuels everywhere,” he added.

The ultimate goal, Yin said, should be spurring cost reductions and performance improvements such that solar is competitive with fossil fuels without relying on subsidies.

One guaranteed investor — the U.S. government — may disappear. The federal Production Tax Credit (PTC), a major wind and solar energy tax subsidy, is set to expire at the end of the year, and its renewal is uncertain. While efforts to renew the PTC are underway, it is a politically volatile issue, and even its supporters acknowledge that it is unlikely for action to be taken before the presidential election in November.

Solar and wind companies always have had trouble attracting investors, as new-technology innovators are never popular with investors looking for a sure shot. And with the PTC’s future being uncertain, U.S. solar and wind interests are on tenterhooks.

It’s no secret that the U.S. solar industry has been in trouble. A number of solar companies have gone under, most notably Solyndra, which flamed out after it had received a $535 million federal loan guarantee.

The next victim was First Solar, which went public in 2006, became the world’s largest solar panel manufacturer and topped Forbes’ list of America’s 25 fastest-growing tech companies. In July, however, the company laid off 2,000 employees and closed a factory in Germany as its shares tanked.

Growing global energy demand and policy changes mandating use of alternative energy mean that the solar industry will not go away, but U.S. solar panel manufacturers certainly have their work cut out.

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