Agglomeration Effects in Foreign Direct Investment and the Pollution Haven Hypothesis

Abstract

Does environmental regulation impair international competitiveness of pollutionintensive industries to the extent that they relocate to countries with less stringent regulation, turning those countries into"pollution havens"? We test this hypothesis using panel data on outward foreign direct investment (FDI) flows of various industries in the German manufacturing sector and account for several econometric issues that have been ignored in previous studies. Most importantly, we demonstrate that externalities associated with FDI agglomeration can bias estimates away from finding a pollution haven effect if omitted from the analysis. We include the stock of inward FDI as a proxy for agglomeration and employ a GMM estimator to control for endogenous, time-varying determinants of FDI flows. Furthermore, we propose a difference estimator based on the least polluting industry to break the possible correlation between environmental regulatory stringency and unobservable attributes of FDI recipients in the cross-section. When accounting for these issues we find robust evidence of a pollution haven effect for the chemical industry. (2003) is an exhaustive source of information on the subject of international environmental agreements. 2Electronic copy available at: http://ssrn.com/abstract=1138337 work that documents the importance of agglomeration effects for industrial location choice, the environmental economics literature has, by and large, ignored the implications of this finding for the study of pollution havens.We use longitudinal data on outward FDI flows of German manufacturing industries in 163 destination countries to test the pollution haven hypothesis conditional on industrial agglomeration -proxied by cumulative FDI -in the destination country. To this end, we develop a two-step estimator that explicitly accounts for the endogeneity of cumulative FDI and other country characteristics. Our method controls for unobserved heterogeneity at the country level and flexibly accommodates dynamic specifications of investment demand.Furthermore, our use of a survey measure of the stringency of environmental regulation is novel to the literature, as most existing research relies on measures of pollution abatement cost that may be endogenous to plant location decisions. We find that ignoring agglomeration externalities masks the pollution haven effect in the chemical industry.The paper is structured as follows. The next section reviews the literature on FDI and environmental regulation. Section 3 describes the econometric framework, and section 4 summarizes our data, along with explaining why Germany is a relevant country for such an analysis. In section 5 we report and discuss our results. Section 6 concludes.

Mapping international flows of electronic waste

“…On the other hand, in a study of the EU, Cave and Blompist (2008) find that the pollution haven hypothesis holds for energy-intensive trade, but not for toxicintensive trade while Zhang and Fu (2008) find that Chinese provinces with stricter environmental enforcement receive lower inflows of foreign direct investment. Wagner and Timmins (2008) find strong support for the pollution haven…”

Does Lax Environmental Regulation Attract FDI When Accounting for 'Third-Country' Effects?

“…This result was partially corroborated by Elliott and Shimamoto (2008), who …nd that stringer regulation in Japan has discouraged japanese pollution-intensive industries to allocate FDI to the Philippines and Malaysia. More recently, Wagner and Timmins (2008) …nd that the German chemical industry is the only pollution-intensive sectors in Germany to have relocated to countries with less stringent regulation once agglomeration e¤ect are taken into account.…”

“…In this study, agglomeration e¤ect is measured by lagged FDI in ‡ows, since the inclusion FDI stocks led to multicollinearity problems. The inclusion of the lagged dependent variable turns the model into a dynamic panel model (Waldkirch and Gonipath (2008), Wagner and Timmins (2008)). This lagged FDI can also partially capture infrastructure in the host country.…”

“…The major limitation of this variable is that SO2 emissions may re‡ect environmental stringency in a narrow way. Moreover, just like CO2 emissions, SO2 series are constructed from fuel consumption data, rather than directly observed (Wagner and Timmins (2008)). Despite this, SO2 emissions constitutes a good proxy for environmental policy.…”

International Direct Investment and Transboundary Pollution: An Empirical Analysis of Complex Networks

“…Of the papers that have examined PHH, the majority generally find strong linkages between foreign direct investment (FDI) and local environmental pollution [4][5][6]. Some research suggests that pollution transfer occurs only in marginal industries or in certain OECD and Asian countries [7][8][9]. A growing body of literature, however, argues that rather than exacerbating environmental concerns, international investment has positive effects on the host environment, which benefits from the scale effect and the technique effect.…”