Academic journal article Asian Development Review

Does Environmental Governance Matter for Foreign Direct Investment? Testing the Pollution Haven Hypothesis for Indian States

Academic journal article Asian Development Review

Does Environmental Governance Matter for Foreign Direct Investment? Testing the Pollution Haven Hypothesis for Indian States

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Over the past 3 decades, developing economies have witnessed a significant inflow of foreign direct investment (FDI). Total FDI flows to developing economies as a share of the world total increased from 17% in the early 1990s to 52% in 2013 (UNCTAD 2013). FDI inflows to developing economies were buttressed by the liberalization process embarked on by many economies in the early 1990s and the high growth rates that resulted from such reforms. Many host economies also devised suitable incentives to attract FDI. Another reason often cited in the literature is that relatively lenient environmental regulations in an economy can attract FDI. This is a process that has been described as a "race to the bottom" (Grossman and Krueger 1991, Xing and Kolstad 1998). Keller and Levinson (2002) posited that a key factor influencing a foreign firm's choice of location could be the compliance costs of local environmental regulations.

One of the ways in which compliance costs can be measured is to look at how much firms are spending on pollution abatement. If these costs are aggregated across firms in a particular location, they reflect the environmental governance aspects in that location. All other things being equal, a firm in one Indian state having higher pollution abatement expenditures in comparison with another firm in the same sector in a different state indicates more stringent environmental governance in the first state. This paper seeks to identify the impact of actual abatement expenditures on the location choices of foreign firms in India by computing an index of abatement expenditure for firms in each state using plant-level data from the Annual Survey of Industries for the period FY2002-2003 to FY2009-2010.1

Earlier studies attempting to measure environmental regulations have used either pollution intensity (see, for example, Mani, Pargal, and Huq 1997; Jha and Gamper-Rabindran 2004; Dietzenbacher and Mukhopadhyay 2007) or pollution abatement costs divided by one of the following: total employment, gross state domestic product (GSDP), or a state's manufacturing output without controlling for industry characteristics (see, for example, Friedman, Gerlowski, and Silberman 1992; Duffy-Deno 1992; Crandall 1993). A key problem with such measures is that they fail to adjust for industrial composition. States that are home to pollution-intensive industries such as steel, fertilizers, and chemicals will incur relatively high pollution abatement costs whether or not they have stringent regulations. Thus, pollution abatement costs that account for industrial composition are needed to assess a state's regulatory stringency.

In this paper, I compute industrial-composition-adjusted abatement costs using unit-level data from the Annual Survey of Industries for the period FY2001-2002 to FY2009-2010. The data are aggregated at the National Industrial Classification (NIC) 3-digit and 2-digit levels, and then computed as an index. Subsequently, I use panel data techniques to test for the pollution haven hypothesis for 21 major states in India. The results do not validate the pollution haven hypothesis in the Indian context.

The remaining paper is organized as follows. Section II explores how FDI and the environment are linked. Section III discusses measurements of environmental governance in the literature. This is followed by an explanation of the methodology used to assess the role of environmental governance on FDI in different Indian states in section IV, which also explains the methodology used to construct the industrial-composition-adjusted environmental governance index. Descriptive statistics and other control variables are given in section V. Section VI reports the estimation results. The paper concludes with a discussion of the policy implications in section VII.

II.The Relationship between Foreign Direct Investment and the Environment

The relationship between FDI and the environment in the literature can be grouped into three main strands: (i) environmental effects of FDI flows, (ii) competition for FDI and its effects on environmental standards, and (iii) cross-border environmental performance (Pazienza 2015). …

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