FDI and environmental regulation: pollution haven or a race to the top?

• Published in: Journal of regulatory economics Vol. 41; no. 2; pp. 216 - 237
• Main Authors: Dong, Baomin, Gong, Jiong, Zhao, Xin
• Format: Journal Article
• Language: English
• Published: Boston Springer US 01-04-2012; Springer Nature B.V
• Subjects: Analysis; Climate change; Developing countries; Economic incentives; Economic theory; Economics; Economics and Finance; Emission standards; Emissions; Environmental incentives; Environmental policy; Environmental protection; Environmental regulations; Environmental tax; Foreign direct investment; Foreign investment; Globalization; Greenhouse gases; Host country; Hypotheses; incentives; Industrial Organization; International investment; International market; International trade; LDCs; Liberalization; Market shares; Microeconomics; Multinational corporations; Original Article; Pollutants; Public Finance; Regulation; Studies; Tax rates; Trade-off; Trans-boundary pollution; H41; Emission standard; Race to the bottom; F12; Regulatory chill; FDI; Q20
• ISSN: 0922-680X; 1573-0468
• DOI: 10.1007/s11149-011-9162-3

Increasing foreign direct investment (FDI) flows accompanied with globalization have raised the concern of a “race to the bottom” phenomenon in environmental protection. This is because footloose investors of “dirty” industries tend to relocate to “pollution havens” of the developing world. However when pollutant is transboundary (as in the case of greenhouse gases), the source country’s incentive to relocate and the recipient country’s willingness to host such industries are not straightforward. This article studies the relationship between FDI and environmental regulation using a North–South market share game model in a two-country setting, when pollution is transboundary. Contrary to the pollution haven hypothesis, our model shows that if market sizes of the two countries are small, FDI will raise the emission standard of the host country, resulting in a “race-to-the-top” phenomenon; but if market sizes are large enough, FDI will not change the emission standard of the South (from its laxest form), a finding that is consistent with the “regulatory chill” argument. Equilibrium FDI is contingent on the fixed cost of FDI, as the traditional proximity–concentration tradeoff theory predicts.