FDI and Environmental Standard: Pollution Haven or a Race to the Bottom

Abstract

Freer Foreign Direct Investment (FDI) flows accompanied with globalization have raised the concern of a "race to the bottom" in which environmental standards across countries level down because footloose investors of "dirty" industries threaten to relocate to "pollution havens" to the developing world. This paper studies the relationship between FDI and environmental standards using a North-South market share game model when pollution is transboundary (as in the case of greenhouse gases). Contrary to the pollution haven hypothesis (PHH) or race-to-the-bottom corollary, our models shows that if market sizes of the two countries are small, FDI will raise the emission standard of the host country, or a "race to the top"; but if market sizes are large enough, FDI will not change the emission standard of the South (which is in the laxest form), a finding that theoretically supports "regulatory chill" argument. Equilibrium FDI is contingent on the fixed cost of FDI, as traditional proximity-concentration trade-off predicts.

Keywords: FDI, emission standard, race to the bottom, regulatory chill

JEL Classification: H41, Q20, F12