Journal of Global Resources

Volume 3
July 2016
Page 129-138
ISSN: 2395-3160 (Print), 2455-2445 (Online)

16
IS FOREIGN DIRECT INVESTMENT A DANGER? FOREIGN DIRECT INVESTMENT
AND THE ENVIRONMENT
Teklehaymanot Geremeskel Weldemichel
Lecturer at the Institute of Environment,
Gender and Development Studies, Mekelle University, Ethipia
Email: geremeskel@hotmail.com
Abstract: Globalization and trade liberalization are the features of contemporary world’s
political economy. Large numbers of multinational companies are relocating their firms in
different countries through Foreign Direct Investment (FDI). Competition to receive FDI
among countries is growing and countries use several means to attract foreign investors to
produce export products. Providing good infrastructure, cheap labor and good governancein host countries are among the central factors in attracting companies (MNCs). Scholars
argue that countries can also lower environmental regulations to attract investors fromstrictly regulated countries and this indeed determines the location decision of particularly
pollution intensive industries. However, the empirical validity of this hypothesis is muchcontested and there are many disagreements among scholars. With careful review ofliterature, I conclude that absence of international consensus upon environment andincreased liberalization would in fact lead to chilling effect on environmental regulationinternationally.
Key words: Globalization, Direct Investment, Environmental Regulations, Liberalization
Introduction
Increased liberalization of trade and flow of capital in the world led FDI (Foreign Direct
Investment) to be very significant source of GDP (Gross Domestic Product) growth forcountries. Hence, countries are competing to be the most attractive places for multinational
companies’ investment in many ways. On the one hand, provisions of less expensive labor
force, good infrastructures, and good governance/bureaucracy are at the center of thecompetition among nations to attract foreign investors. On the other hand lenientenvironmental regulation is seen as a means of attracting investors and particularly thoseinvesting on environmentally damaging dirty industries. The “Pollution Haven Hypothesis” isa prominent argument about the competition among countries to attract foreign investors byhaving less regulation for environment. According to this hypothesis, countries compete tobe less costly to invest in, by lowering their environmental regulations and taxes, which theeconomists call “race to the bottom”. There are arguments and counter arguments about
this hypothesis in the literature and it’s important to look in to it in detail so as to understand
why these hypotheses does/not work. Although, some scholars prove that it does not work
“empirically”, many others argue that there is no reason why countries do not compete to be129very attractive in whatever way they can, given the absence of international consensus
about the environment and the liberalization of trade.
In this paper I reviewed the various views of different scholars about the relationshipbetween Foreign Direct Investment (FDI) and environment. The first part of the paper is an
introductory explanation of the relationship between the environment and foreign direct
investment. This is followed by the main argument about the negative effect of FDI on theenvironment. The third part will be a counterargument from the proponents of free trade(liberalization) against the negative views of foreign direct investment. The last part isdiscussion of the strengths and limitations of both views from different authors’ and mypoint of view followed by a short conclusion.
Relationship between FDI and Environmental Regulations
Different arguments have been made about the relationship between environmental
regulations and the flow of capital in the form of Foreign Direct Investment. Do globalizationand free trade negatively affect environmental regulations by promoting competition forlower stringency in environmental regulation (“race to the bottom”)? Or does globalization
affect environment positively by promoting stringent environmental regulation in hostcountries known as “the bottom rise” (Wheeler, 2001) or “pollution halo” (Gray, 2002)
effect? These are important questions in investigating the relationship between the flow ofForeign Direct Investment and its effect on the environment. What does “race to the bottom”
mean? And what do we mean by “rise of the bottom”?
Given the fast globalization pattern and free international flow of capital,
multinational companies are investing in their countries of preferences. The location ofindustries can be determined by several factors such as availability of inexpensive labor
force, quality of infrastructure, good governance, availability of natural resource and otherrelated factors in host countries. Scholars also assert that, countries (and particularly poor
countries) may use environmental regulation as an incentive to attract foreign investors.
That is, countries may compete to lower their standard of environmental regulation to attract
foreign investors and thereby move towards lowering international stringency ofenvironmental regulation. This termed as “race to the bottom” (Dasgupta et al., 2002; Deanet al., 2005 ; Gray, 2002).
On the other hand, some scholars and particularly those advocators of free trade
see the effect of FDI as positive and leading countries to raise their environmental quality.
The argument on this side is that, FDI raises the stringency of environmental regulations ofpoor countries by improving their economic capability. This is called “the bottom rise” (Coleet al., 2006; Wheeler, 2001) or “pollution halo” (Gray, 2002) phenomena. Wheeler argues
that “the poorest societies improve their environmental quality as investment increases
employment and income”. By this he means foreign direct investment helps societies toimprove their capacity to avoid environmental problems.
The varying views about the effects of Foreign Direct Investment on environment
can be grouped in to three categories. The first group is the proponents of “Pollution Haven
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Hypothesis” in which there is a fierce debate about the negative effect of FDI on
environmental regulation. The “race to the bottom” model is the most contested part of thisargument (Bommer, 1999; Cole et al., 2006; Dasgupta et al., 2002; Dean et al., 2005 ; Lu,
2010; Mabey & McNally, 1999). The second is the group which views FDI s impact as
positive and advocate for expansion of foreign investment to improve environmental qualityof poor societies. Finally, a third category in which I label myself as well is the group whichlooks in-depth and beyond investment on environmentally damaging manufacturingindustries when dealing with FDI’s impact on the environment. The following sections of thepaper will be about these positions.
How does FDI negatively affect environmental regulations?
Although it is highly advocated and promoted in recent decades, Foreign Direct Investment
is also criticized for its environmental impacts. Several studies have identified the conditions
under which FDI can negatively affect the environment. One of the most important results ofthese studies is that of foreign direct investment negatively affects the environmental quality
by lowering the standards/regulations on environment. The increased demand for FDI andcompetition to attract foreign investors leads countries to lax their environmental regulation.
In other words, poor countries lower their environmental regulation to attract investors fromcountries where there is stringent regulation and high tax for pollution. As a result thosecountries with lower environmental regulation will have high agglomeration of dirty
industries which in turn affect their environment. According Ederington et al. (2004), free
trade means greater specialization and concentration of certain type of products in somecountries which in turn means greater concentration of polluting industries in somecountries and cleaner industries in others. This is termed as “pollution haven hypotheses”.
The pollution haven hypothesis is one of the most contentious and highly debatedpredictions in the international political economy in relation to environment and trade(Taylor, 2005). Pollution Haven hypothesis refers the idea that investors will choose to
locate their industries in places where there is cheaper and more efficient production interms of regulatory requirements(Gray, 2002; Taylor, 2005). The relocation of Californiantanneries to Mexican free trade zones is example of multinational companies choice oflocation to use lenient regulations in Mexico and relatively stringent environmental
regulations in the US and Canada (Taylor, 2005).
Dean et al. (2005 ) explained the main argument in the pollution haven hypothesis is
as ‘poorer countries my undervalue environmental damage in order to attract more foreign
direct investment which in turn could generate a “race to the bottom” with all countries
lowering environmental standards in order to attract and retain investment .. According tothis argument, there is no reason why countries do not use environmental regulation to
attract investment as they do with their resource or labor. On the other hand, Bommer(1999) explains the hypothesis in relation to environmental regulation and competitivenessof firms with foreign competitors. Firms in countries with stricter environmental regulation
face difficulty to compete with firms producing in countries with less strict environmental
regulations due to increase in the cost of production, which finally lead firms to relocate
their plant to countries with lenient regulations. He used the term “strategic relocation” to131explain the reason why multinational companies relocate their firms and relates relocation
with trade liberalization. Trade liberalization increases the probability of strategic relocation
because it intensifies competition which lead firms to loses of market share and decline inincome. Thus, when environmental regulation are made even very slightly stringent, thealready weak firms(already hit by liberalization) fail to afford cost of clean technology (costof pollution abatement) and make strategic capital flight to poorer countries where there isno environmental regulation and fierce competition(Guoming et al., 1999). As a result,governments in high income countries face a challenge of rising capital out flaws and they
start relaxing their environmental standards. Nevertheless, this is fruitless effort because
the poorest countries have no environmental standards at all. This finally leads to “race tothe bottom” in which all countries converge to the “hellish pollution levels” (Bommer, 1999;
Dasgupta et al., 2002; Wheeler, 2001).
A clearer example of a pollution haven hypothesis based study comes from
Jorgenson (2006) in which he criticizes foreign capital penetration as environmentally
damaging for developing countries. Based on analysis of empirical data from 53 countries
he found that capital penetration in the manufacturing sector affects growth in organic waterpollution intensity in poor countries, whereas the effect is insignificant in developed
countries. Hence, level of development has significant effect on the extent to which capital
penetration effect the environment. This could be due to the higher standard ofenvironmental regulation in developed countries and a relatively lower in low income
countries which result in the agglomeration of dirty industries in the latter group. Other
reasons can include Clapp (1998)’s point that multinational companies could be employing
less clean technology in developing countries and a relatively cleaner technology in highincome countries. According to Jorgenson foreign capital has built-in incentive to ignore
environmental externalities in favor of maximizing profit(Jorgenson, 2006, p. 726).
The nature of multinational firms also highly matters according to Gray (2002). Raceto the bottom according to Gray happens particularly in Export Processing Zones, where
governments exempt requirements such as taxes, tariffs and give institutional duty freestatus to foreign firms engaged in exports. Governments in poorer countries establish
Export Processing Zones (EPZs) in which foreign investors are exempted from certain
requirements including loose environmental regulations. This promotes „race to thebottom (Gray, 2002, p. 309). List and Co (2000) also attested that, difference in stringency
of environmental regulation will inevitably result in flight of capital and affect location of
MNCs firms.
As a solution to racing to the bottom crisis, proponents of the “pollution havenhypothesis” recommended a higher and globally uniform environmental standard ofregulation. Tariffs and other trade restrictions should be used as means of neutralize thecost advantage of countries which are unwilling or unable to enforce the universal
standards. Governments of less-developed countries should reconsider the impacts offoreign investment and pursue domestic policies and programs which held accountabletransnational firms for their environmental damaging practices (Jorgenson, 2006). Bommer
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(1999) also suggests the importance of strong environmental interest groups to avoid
strategic relocation of multinational firm by lobbying the use of cleaner technology insteadof strategic relocation from stringent environmental regulations in developed countries.
Jorgenson (2006) suggest as „austere form of regulation can be more successful atinternational level. Clapp (1998) also suggests several measures to discourage flow of dirty
industries to low income countries. First, political opposition by tightening and enforcing
environmental regulations in developing countries either by individual or by setting global
standards will be effective. However, he admits that this measure could be very unpopularamong industrial sector at global level and developing country governments. Second,
disclosing the hazardous effects of dirty industries to poor communities where MNC wish tolocate. This is also unpopular among governments and MNCs.
Deconstruction of the “pollution Haven Hypothesis”
Several scholars and particularly those proponents of free trade have strongly criticized thishypothesis for being empirically less valid. They argue that the „pollution havenhypothesis has only an air plausibility and is empirically flawed. Dasgupta et al. (2002)
argue that reduction of environmental regulation is not substantial incentive compared tothe other location incentives faced by businesses to lead them relocate their firms.
Furthermore, Dasgupta and his associates argue that, imports by developing countries fromhigh income countries have been more pollution-intensive than their exports to thedeveloped countries in recent years. They explained that pollution havens can happen in
extreme cases as in the 1970s when OECD countries tightened their environmental
regulation with no countervailing change in the developing countries. In this case theregulatory cost was significant to lead multinational companies relocate their plants todeveloping countries. However, this has happened only for short time until poor countries
narrow the gap by introducing stricter environmental regulation, to halt the flow of polluting
industries through regulatory means.
Wheeler (2001) identified five major problems with the “race to the bottom model”.
Fist, he shares Dasgupta and associates argument that, pollution control is not critical cost
factor for most private firms to lead them decide location based on it. Other factors such as
abundance of natural resource and inexpensive labor, good governance and distance tointernational market are more important than regulatory issues to determine location
decision for multinational companies. Second, the model view poor people as passive andirrational who only seek job and capital at the expense of their environment. Wheeler cited
examples of situation in which local people resisted against environmental destruction byforeign companies. He stated “…low income communities penalize dangerous polluterseven when formal regulation is weak or absent” to emphasis the invalidity of the pollution
haven hypothesis’s view about people(p. 232).
Third, rising income strengthens regulation (i.e. countries regulate pollution morestrictly as they get wealthier). Hence, FDI helps countries to get wealthier which in turn leadthem to regulate their environment. This is similar idea to environmental Kuznets curve’s
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idea about economic development and the environment. Environmental Kuznets curve
according to Dasgupta et al. (2002) shows an inverted U relationship between
environmental pollution and economic development. At the beginning of industrialization
people are more concerned about jobs and employment than environmental qualities which
result in rising pollution level but this changes when income rises and society start to valueclean environment and countries start to strengthen their environmental regulation. The
assumption here is that rise in income leads to greater care for environment.
Fourth, local business control pollution because abatement reduces costs, Nehrt(1998)in his article Maintainability of First Mover Advantages When Environmental
Regulations Differ between countries also support this idea and stated as “companies thatinvested earlier in environmental technologies perform[ed] better financially”. In other words
basing his idea on Porter’s (1990) work Nehrt (1998) explained it clearly that, “firms incountries with lenient regulations inevitably will face tougher regulations and companies
headquartered in countries that had tough regulations earlier and that innovated newtechnologies of reducing pollution will enjoy some sort of first mover advantage”. Hence,firms start to lobby their government to toughen environmental regulations (p. 79). Gray
(2002) termed this as the “pollution halo” phenomena or the “California effect”. This isbecause of the positive spillover of efficiency in industries due to higher standards in
California leading industries in other parts of the US to adopt similar standards ofenvironmental efficiency.
Fifth, large multinational firms generally adhere to OECD environmental standards
in their developing country operations. Based on these evidences he argues that theassumptions of “race to the bottom” model are not realistic and its predictions areinaccurate. It is extremely unlikely for a race to the bottom to happen in a realistic view ofthe world.
Although these arguments seem sound and based on empirical evidences, they are
not immune to the hairsplitting criticisms from the side of the proponents of the Pollution
Haven Hypothesis. The following section is a discussion of the main arguments of the
proponents of the pollution haven hypothesis as a response to the criticisms by proponents
of free movement of capital.
Discussion
Which position is right? Is the pollution haven hypothesis right and that the location ofindustries and particularly pollution-intensive industries are determined by the strength ofthe environmental regulation in host countries? Or is the “pollution halo effect” right andforeign direct investment is positively affecting the environment? It may seem beside thepoint to the context of FDI and environment, but Hardin’s (1968)1 concept of “tragedy of1

Garrett Hardin(1968), ‘The tragedy of commons’. Science, 162(1968):1243-1248. In the absence ofinstitutions which regulate the use of common resources, individuals will use it to its maximum point. He uses
the dilemma when an individual animal herder put one additional animal to a common grazing land without134

common” is of relevance in explaining the global situation under which investment is taking
place at this time. The increased globalization of environmental issues without international
consensus coupled with trade liberalization will eventually lead us to “tragedy of commons”
where there is no single body addressing environmental concern. Every country strives toattract investors and produce as much as it can without much concern for theenvironmental impacts and by externalization of common global costs. This has happened
and will continue to happen under liberalization.
The proponents of free trade argue that most multinational companies follow theirhome countries environmental standards when the establish firms in the south (developing
countries). However, this has been contested and proponents of the pollution havenhypothesis have argued that MNCs use old technologies with more pollution when they
invest in developing countries than home countries. Clapp argues“… while MNCs are well placed to facilitate the development and transfer of clean
technology to the south without the outside pressure of imposed regulation by the states in
the north and south alike, without public embarrassment techniques practiced byenvironmental NGOs, and without a sort of outside financial assistance, global industry ishighly unlikely to invest in cleaner technologies… Meanwhile, investment in clean-up, rather
than clean technologies by MNCs only masks the problem.” Clapp (1998, p. 92)
Furthermore, Lu (2010) found a difference on the sensitivity of the type of industries
to environmental regulations. Chemical products, iron and steel products and paper
products (pollution intensive) are highly influenced by regulation, where as non-metallic andnon-ferrous metals products (less pollution intensive) are not sensitive to regulation (p. 28).
Although the proponents of the free trade argue that the assumptions of pollution havenhypothesis would not happen because OECD countries have regulated and laid tariff on theimports of products from less environmentally regulated countries, this in my view cannot
avoid the inevitability of the problem. This measure has two problems to be applied toreduce the effect of FDI on the environment. First, Guoming et al. (1999) from their study on
investment and environment in China concluded that export oriented firms are moreenvironmentally sensitive than market seeking FDI in developing countries. If this is true thetrend at this time shows that, many multinational companies invest in poorer countries not
only because of the presence of cheap labor and resource but also market due to the highpopulation and resulting consumption in host countries. Therefore, the impact of restrictionof exports to OECD countries is insignificant in altering the flight of dirty industries to poorer
countries. Countries could attract foreign investors to produce for domestic consumption
and laying tariff and restrictions for exports in such countries products by developed
countries might not lead to better environmental regulations. Second, this argument
contradicts with the aims of World Trade Organization (WTO) i.e. liberalization of trade. If
OECD countries restrict the entrance of products from poor countries, they are still violating
the most important rules of WTO. Third, Dasgupta et al. (2002) rightly argued that “tradeinternalizing the cost of adding it, because he/she receives only a fraction of the cost shared by all membersof the community. i.e. Maximizing individual profit at the expense of sustainability communal resource.

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and sanctions are inappropriate and ineffective levers for narrowing the regulatory gap
between low and high income countries”. They rather suggest narrowing the gap by
developing the regulatory capacity of poor countries.
Most of the arguments of the proponents of free trade are towards the difficulty toempirically test the pollution haven hypothesis. The pollution haven hypothesis istheoretically plausible but difficult to support it with empirical evidences. But this does notmean, that the hypothesis is wrong and with no implications. Different authors argued that,
it is because of the weaknesses in the tools of obtaining the so called “evidences” whichlead scholars to think this hypothesis is weak and criticize its basic assumptions. According
to Mabey and McNally (1999) the use of aggregated data in the analysis of flow of pollution
intensive industries is one of the limitations of those who criticize the pollution havenhypothesis particular and the negative effect of FDI on the environment in general.
However, the hypothesis is also limited in its scope when dealing about the“environment”. It focuses on the effect of industries and particularly “dirty industries” andresulting pollution, and gives less emphasis to the effect of foreign direct investment on thegeneral environment. Such issues as expansion of mechanized agriculture and resulting
forest depletion, and over exploitation of natural resources by foreign firms for export todeveloped countries market are not addressed in this hypothesis. As a result the arguments
against it also focus on the pollution coming from dirty industries and neglect the effect offoreign direct investment on environment. Here, the marginalization concept of Blaikie(1985)2 is important in dealing how the expansion of capitalist production affects the longstanding relationships between the environment and local people. Large scale mechanized
agriculture; extensive natural resource extraction and other export based manufacturing byforeign firms displace local land users to marginal lands with steep slopes which lead todestruction of the marginal environment.
Mabey and McNally (1999) argue that the debate between both positions is limited
and has not helped us to move forward in policies at international level. The relation
between the environment and foreign investment is more complex than covered in the„pollution haven “pollution halo” debate. Environmental effect of FDI should go beyond
simple pollution due to pollution intensive industries and include other very significant
effects such as over exploitation of natural resource. According to these authors
competition for FDI is “depressing” and “chilling” environmental standards at international
level. However, the effect is not only through the relocation of dirty industries to lessenvironmentally regulated areas. Not only pollution-intensive but also resource intensive
industries have preference for low environmental standards and this leads countries to lesstighten their environmental regulations to attract pollution and resource intensive industries.

2

Piers Blaikie (1985) the Political Economy of Soil Erosion in Developing Countries. The concept ofmarginalization….encroachment of the privatization of land … forces marginalized people to use the commons
more intensively and contributes to the shrinking potential of the commons themselves…this in turn leads to thedegradation of the environment (p. 130).

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Competitions to attract pollution and resource intensive industries may not be overt “race tothe bottom” but chilling effect on regulation and its enforcement (p. 5).
As a solution to the wider impact of liberalization on the environment Mabey and
McNally suggest several measures at international and national level. First, increasing hostcountries capacity to regulate and constructing international environmental standards on along term. Second, since the first solution is not effective for short term, improving theenvironmental quality of Foreign Direct Investment by home countries is important asbuilding institutional capacity is not easy and may take long time. (1999 see the original).
Clapp (1998) also outline major measure which should be taken at international level
including by MNCs themselves.
Conclusion
From analysis of the both sides of the arguments and the wider politics of environment intoday’s world, it is safe to conclude that, if countries are not competing to the bottom as the“pollution haven hypothesis” proponents argue, they are not also competing to have themost stringent environmental regulation. I can borrow Gray’s term “stuck at the bottom
effect” or “regulatory chill” in which countries refrain from enacting stricter environmental
regulation due to fears of losing a competitive edge against other countries in obtaining
foreign direct investment(Gray, 2002, p. 301). Disagreements among powerful countries
such as China and USA in international climate deals are testimonies of regulatory chill.
They do not want to take the lead to implement stricter environmental regulation because offears of economic failure due to outflow of capital. Hence, there is no reason for poor
countries to strengthen their regulation and fail to receive capital flow through FDI while thewhole world is competing for it. Given the absence of international agreement onenvironment and unfair trade relationships countries will still continue striving to be as open
as possible for foreign direct investment to improve their GDP growth externalizing theenvironmental costs to the whole world.
Acknowledgement
I thank Professor Jo Jakobsen for the guidance he provided me when I was working on thisarticle which was originally a term paper for his course in international relations. Thank you
my friends Mily and Hans for your encouragement during my times in the office. My fiancée
Ina Tvedt Solberg played most of the roles of building my personal future as an academic
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