Pollution Havens are not a Myth!

This column argues that laxer environmental standards significantly explain the location choice of polluting affiliates. Both globalization and corruption open the door of Pollution Havens

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by Fabien Candau, Elisa Dienesch

With the withdrawal from the Paris climate agreement, Donald Trump opens a dangerous Pandora's box for the environment. Is it possible that the world’s second largest emitter of greenhouse gases also becomes the world's new favorite pollution haven?

It is beyond the scope of this column to predict such an outcome, but in a recent paper (Candau and Dienesch, 2017, JEEM), we characterize the main features of pollution havens: lax environmental regulation, good market access and corruption opportunities. We analyze the location choice of European-controlled enterprises and we find new results concerning the Pollution Havens Hypothesis (PHH).

When considering the impact of environmental standards on relocation of multinational firms, economists tend to dismiss their significance. Some authors have even advocated that the flight of physical capital in countries with laxer environmental standards is a "popular myth" or a delusion.

They argue that 1) the cost of environmental norms is too small to cause relocation 2) countries with lax environmental standards have repulsive characteristics such as poor institutions and bad governance which represent a cost for multinational firms.

We revisit this question, showing instead that pollution havens are a reality fostered by globalization and bad governance.

Pollution Haven, from the myth to the reality

In the early 2000s, it was quite common to consider that there is no evidence of pollution havens. Laxer environmental standards could not significantly explain the location choice of polluting plants.

However a growing number of articles have successfully found this effect for inward, outward, and outbound foreign direct investments (FDI) in the context of the United States (see Rezza (2014) for a meta-analysis). While the discussions on PHH have thus far relied to a great extent on data from the United States, a similar analysis for Europe has been neglected. This is surprising since the European environmental policy has been quite active over the past few years.

Furthermore, Europe and its neighborhood have changed; post-communist economies (central and eastern European countries, Russia, and China) as well as partners in Maghreb (e.g., Tunisia and Morocco) have now reached an intermediate level of bad governance - good enough to conduct business (e.g., without risk of expropriations) but still poor enough to allow businesses to pollute with unspoken license.

Lastly, access to the European market has been vastly improved thanks to multilateral, regional, and preferential trade agreements, which make relocation outside Europe and/or at its periphery less costly. As a result, Europe is the perfect field to analyze the PHH and its interaction with governance and trade integration.

Market Access

Countries with stringent environmental rules have advantages that can overtake the environmental cost (e.g. better infrastructures, larger market size, better endowment in human capital etc).

In order to operate in the largest markets, firms agree to pay the highest environmental costs, but if these costs are excessive, they move out, particularly if they can secure access to consumers from a peripheral location and follow laxer environmental standards.

By improving market access to developed countries from pollution havens, globalization erodes the advantage of locating plants close to the point of consumption. Market access is thus a central variable to understand the reason behind the change in locations of polluting firms.

Our results show that firms are motivated to reach new markets through the market potential offered by the partner while a good market access from Europe retains activities. There are multilateral gains provided by the destination. Relocation is also clearly motivated by the market potential offered by European nations themselves in their own markets, matching the fragmentation process and the need to re-import cheaper inputs from abroad.

Corruption

It is true that countries with lax environmental standards have repulsive characteristics such as poor institutions and bad governance which represent a cost for multinational firms. However, for polluting firms, this negative and direct effect, is balanced by a positive and indirect one: corruption can be a tool to reduce the stringency of environmental policies (we call this the "Corruption Paradise Hypothesis").

Challenging the potential endogenous bias of environmental regulation and the ambiguous role of corruption on location choices with an original two-step procedure, we find evidence that corruption indirectly increases the number of relocations of polluting firms to pollution havens

Conclusion

Market access matters to explain Pollution Havens, this leads to a logical question: does protectionism the cheap way to reduce relocation? We are skeptical, according to our estimate, the protection of the European market (e.g., a carbon tax on imports) to stop relocations to pollution havens must be high (a decrease of the European market for Morocco and Tunisia equivalent to 13%) not to say prohibitive (31% for China), which will have substantial effects on firms competitiveness and on consumers welfare.

A global agreement on environmental standards is the obvious solution, but it is also obvious that it is an utopia. More certainly local fights and solutions can be found, but the future looks definitely less bright with validations of the Pollution Haven Hypothesis than without.

Reference:

F. Candau, E. Dienesch, Pollution Haven and Corruption Paradise, Journal of Environmental Economics and Management, Volume 85, September 2017, Pages 171–192. Working Paper