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Why Environmental Regulation Is Not Scaring Off Industry – On Declining Evidence for Pollution Haven Theory

Why Environmental Regulation Is Not Scaring Off Industry – On Declining Evidence for Pollution Haven Theory

Some say strict environmental regulations in individual countries are useless, especially from a global perspective. The thought behind this view is that the actual benefit to the environment resulting from strict regulations is minor because the more polluting an industry, the more likely it will migrate to places with lower regulation. Is that true?

Location Choice Depends on Many Factors

The common belief that industries always move to the location with the lowest environmental restrictions is what economists and environmental scientists call pollution haven theory. Whether that theory is valid or not, is not as obvious as it may seem. Companies carefully choose the location of their industrial sites bearing dozens of decisive factors in mind, environmental standards being just one of them. And if we can trust a recent study reviewing the findings of many preceding pollution haven discussions, environmental standards are of less importance than many others.

Scientific Research vs. Intuitive Belief

Scientific evidence for the pollution haven theory is hard to find. An expert in this field, Arik Levinson, Georgetown University, described possible reasons in a paper available online (PDF) in the unmistakable language only true economists speak:

The pollution haven hypothesis, or pollution haven effect, is the idea that polluting industries will relocate to jurisdictions with less stringent environmental regulations. Empirical studies of the phenomenon have been hampered by the difficulty of measuring regulatory stringency and by the fact that stringency and pollution are determined simultaneously.

Jurisdictions, in this case, not only refer to states, but also provinces, autonomous regions or special economic zones where different conditions may apply than in the rest of a country. In an attempt to rephrase the above cited paragraph in simple words, I would put it like this: Scientists had a hard time finding practical evidence for the pollution haven theory because first, how do you measure how strict environmental regulations are; and second, how do you measure pollution at the same time? Levinson continued, putting the assumptions behind the theory in the language of an economist:

The premise is intuitive: environmental regulations raise the cost of key inputs to goods with pollution-intensive production, and reduce jurisdictions’ comparative advantage in those goods. […]

This phrase basically means that if you follow your intuition, it seems only logical that places with strict environmental regulations are less attractive for polluting companies since, as a consequence of the regulations, costs increase. Now intuition may provide a good hint when it comes to spontaneous and urgent decisions, but concerning the phenomenon we’re talking about, it cannot sufficiently explain what happens with polluting industries around the globe. It is just not as simple as intuition might suggest. Together with Josh Ederington and Jenny Minier, both from the University of Miami, Levinson wrote “Footlose and Pollution-Free” (PDF) in 2003. The three researchers came to the following conclusion: there are other characteristics than just its pollution intensity that account for an industry’s probability of moving in reaction to environmental regulations, namely, “the amount of trade with low income countries and the geographic mobility of the industry.” These two are the most critical elements that increase the probability that a company will relocate.

Low Risk Is Decisive, Not Low Environmental Standards

Whether or not companies are likely to react to environmental regulation changes by relocating is an interesting question. What’s even more interesting is to investigate the reasons behind a relocation that has already taken place. Why was a certain location chosen over another? It has to be said that industrial location choice is a big field of study. There are countless books and publications trying to focus on its optimization. A standard work, for instance, was published by Roger Hayter in 2004 – see the “further reading” section below.

In this big puzzle, one exemplary study dealing with gold mining companies and their choice of location specifically caught my attention. “Do Environmental Regulations Affect the Location Decisions of Multinational Gold Mining Firms?” (PDF link) is what Lise Tole and Gary Koop asked in the title of their study published in 2008. And the answer is clear: No, they don’t. Instead, gold mining companies seek a place with predictable, constant conditions. If we can believe the study’s results, instead of low environmental regulations, the companies focused on risk minimization:

Using both a conditional and a mixed logit regression approach, the study finds consistently strong country location preferences among multinational gold mining firms. These preferences paint a picture of an industry attracted to countries that are close to their head office, provide a business environment characterized by low levels of financial risk and high levels of political stability and predictability in mining operations.

Why is that? Well, supporting Levinson et al.’s “geographic mobility” finding, Tole and Koop tried to explain it as follows:

In summary: Our results suggest that gold mining firms seek security, consistency and stability both from a business and a political point of view, and prefer to stay close to home. […] Taken together, these preferences for clean, well-run countries may reflect the adoption by mining firms of a deliberate strategy intended to minimize the risks to their hugely expensive and immobile investments.

From China to China – Pollution Havens Within A Country

As I mentioned before, many studies conclude that intuition is wrong. However, there are cases where a pollution haven effect can be found. A 2009 study by Dean et al. appearing in the Journal of Development Economics (PDF download in the world bank resources) that analyzed data from 1993-1996 found that some companies were indeed relocating their industrial sites because of lower environmental restrictions:

Because it is host to the largest share of FDI [foreign direct investment] to the developing world and because environmental stringency varies among its provinces, China is an excellent setting for an investigation of the pollution haven effect. We have created and analyzed a new compilation of foreign EJVs [equity joint venture companies] into China during 1993-1996, categorized by industry, source country and province. These data exhibit wide dispersion in FDI across industries and provinces. Our evidence from conditional and nested logit analysis indicates that ECE-sourced [Ethnically Chinese sourced] FDI in highly polluting industries is significantly deterred from provinces with relatively stringent pollution regulation.

Aha! So there are companies moving to pollution havens! In other words: the study found that highly polluting Chinese companies are more likely to invest their capital in Chinese provinces with less stringent regulation. Some individual Chinese provinces plus Taiwan, Hong Kong and Macau all seem to have stricter regulations than these. Apparently, however, “PH-behavior” is only true for companies from these places:

In contrast, FDI from non-ECE [non-ethnically Chinese] countries is not deterred, regardless of pollution intensity. These findings suggest that there are important links between the investor’s source country, the pollution intensity of the industry, and PH [pollution haven] behavior.

Yes or No?

So is there or is there not a pollution haven effect?

While we find evidence of PH behavior by foreign investors in China, it is not by investors from high income countries and it is only in industries that are highly polluting.

There we go. Only companies from “poor” countries (in terms of industrial production) are likely to move their industry locations to places with even lower environmental standards. How come? Dean et al. come up with a comprehensive reason for this:

One explanation for these findings may be technology differences. Profit-maximizing behavior is conditioned by technology. As Bhagwati (2004) has argued, richer countries have higher environmental standards, which have induced innovation and production of environment-friendly technology (Lanjouwand and Mody, 1996), so that FDI from these countries often employs newer, cleaner technology even in locations where standards are relatively weak. […] In contrast, entrepreneurs in poorer countries with lower standards typically use older, less “green” technologies and may import them as second-hand machinery. If regulatory costs are non-negligible, we might expect them to affect decisions of investors from poorer rather than richer countries.

Taken together, all these findings make one thing clear: rich industrial states have no excuse left for delaying any environmental regulation. Strict environmental standards are definitely not driving industry from the “industrialized world” – that argument is invalid!

Further Reading

 

Article image edited by Moritz Bühner, based on a Wiki commons image previously used in a knowtheflow article on emission relocation.

moritzbuehner

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