1. Introduction
Environmental pollution and environmental damage are becoming major concerns in countries around the world, with the result that in many cases, national environmental regulation is being made more stringent to try to improve environmental quality. However, stricter environmental regulation may drive firms to shift their pollution-intensive industries to areas with laxer environmental regulations to reduce the costs related to the regulation; this has been described as the pollution haven effect (PHE) [
1]. Therefore, in many developing countries, less strict environmental regulation is seen as a way to greater inflows of foreign direct investment (FDI) in pollution-intensive industries. Such a phenomenon will lead to overall ecological degradation and make global environmental governance ineffective. The trend towards more FDI and the attention being paid to environmental pollution make an investigation of the impact of environmental regulation on inward FDI important in the context of developing countries.
Several theoretical and empirical studies have investigated the impact of environmental regulation on FDI. However, their findings regarding the PHE are inconclusive. Some empirical works find evidence of a PHE [
2,
3,
4,
5]. For example, Cai et al. used the Two Control Zones (TCZ) policy and Chinese samples to support the PHE through the difference-in-difference-in-differences (DDD) method [
5]. Millimet and Roy’s research also shows a similar view; that is, the severity of regulatory policies is inverse to the inflow of FDI [
6]. Others refute its existence [
7,
8,
9,
10], resulting in a lack of consensus. Jaffe et al. consider the cost of environmental regulation and pollution control to be insignificant and not enough to constitute an incentive for cross-border transfers [
7]. Eskeland and Harrison, using a sample of four developing countries—Mexico, Venezuela, Morocco, and Côte d’Ivoire—show that FDI inflows are not linked to environmental governance costs, and find no evidence of a PHE [
9].
Keller and Levinson argue that these different results are due to how differences in national environmental regulation are quantified in some empirical studies [
3]. Given the complexities related to environmental regulation, identifying a single measure that can be used across countries to proxy for environmental stringency is problematic [
11]. Other issues related to the existing empirical work are the problem of endogeneity, such as the reverse causal relationship between environmental regulation and trade [
12], and the unobserved determinants of location choice correlated to environmental regulation [
13]. In addition, since joining the WTO in 2001, China has gradually become one of the most attractive FDI destinations in the world [
14]. The large inflow of FDI in China provides a good realistic basis for our research on this topic.
Our study in the context of China’s 11th and 12th Five-Year Plans (11th and 12th FYP) SO2 emissions reduction policy uses a DDD model to investigate the PHE and province-industry panel data for the period 2001 to 2015. The results show that the 11th and 12th FYP SO2 emissions reduction policy leads to reduced inflows of FDI to highly-polluting industries in the provinces with more stringent pollution reduction targets. The heterogeneous analysis shows that the impact of environmental regulation on FDI is more significant in provinces with stronger environmental enforcement, while in provinces with weaker environmental enforcement, this effect is not significant. In contrast, the environmental policy does not have a significant effect on FDI in industries with high levels of technology, but, in the case of industries with low levels of technology, environmental policy has a negative effect on FDI. Overall, our results are robust across a range of different specifications, such as instrument variables (IV) and to the exclusion of concurrent external shocks.
We believe that our study provides reliable empirical evidence of a PHE, and contributes in two ways to work on environmental regulation and FDI flows. First, we use China’s 11th and 12th FYP SO
2 emissions reduction policy to overcome the problems related to measuring the environmental regulation stringency across different countries. This policy was formulated by the Chinese central government and implemented simultaneously in all provinces; that is, the whole country is subject to the same environmental policy. Differences in the stringency of provincial emission reduction targets are set under the same national conditions. Our focus on a single country avoids problems related to measuring the stringency of environmental regulations in different countries. Also, since China is the largest developing country in the world, there are huge differences in both inward FDI and environmental regulation across provinces, which provide sufficient variation to determine the impact of environmental regulation on the location of inward FDI [
15]. The stringency of China’s 11th and 12th FYP SO
2 policy varies widely across provinces; therefore, if reduced compliance costs matter to investors, then we should see a clear location choice effect on investment behavior across provinces [
14], so as to give credible evidence for the investigation of PHE.
Secondly, the endogeneity of environmental regulation is an issue for empirical studies [
16]. For instance, using sewage charges or pollutants to identify environmental regulation can lead to reverse causality and concerns about endogeneity [
17]. This paper uses China’s 11th and 12th FYP SO
2 policy as a quasi-natural experiment and employs a DDD strategy to investigate the PHE. Specifically, the DDD model explores three dimensions, i.e., variations across provinces in policy targets, variations in pollution intensity across industries, and time variations, which should account for the reverse causality arising from the measurement of environmental regulation [
18]. Our DDD strategy allows us to control for province-industry fixed effects, province-year fixed effects, and industry-year fixed effects, controlling for potential omitted variables all varying at the provincial (time-varying and time-invariant) and industry (time-varying and time-invariant) levels [
5].
The rest of the paper is structured as follows.
Section 2 reviews the literature and introduces the policy;
Section 3 describes the research design;
Section 4 presents the empirical results;
Section 5 discusses some heterogeneity effects.
Section 6 concludes the paper.
6. Conclusions
This paper investigates the impact of China’s 11th and 12th FYP SO2 emissions reduction policy on FDI inflows. Using a DDD strategy, we show that this policy reduced the inflow of FDI to more heavily polluting industries in provinces with more stringent reduction targets, confirming the PHE. A series of robustness tests showed that our findings are robust. We found also that the PHE is more pronounced in provinces with stronger enforcement of environmental regulation. Also, a higher level of technology (measured according to OECD definitions and differences in exports) can alleviate the deterrent effect of environmental regulation on FDI.
The findings from our study have several important implications: First of all, we used differences in the stringency of environmental regulation across Chinese provinces to provide evidence of a PHE. Environmental protection is the foundation of sustainable development. We suggest that developing countries should work towards avoiding becoming a pollution haven. Specifically, first, governments should set appropriate environmental standards to reduce the inflow of FDI in heavily polluting sectors. They should also link the effects of the implementation of environmental regulation to local officials’ performance evaluations to remove the limitations of local governments only pursuing economic effects. Second, governments should increase the frequency and intensity of monitoring of pollution sources to ensure the accurate collection of pollution information. Meanwhile, the state should be flexible and targeted to use different types of environmental regulatory tools, such as emissions trading schemes and collection of sewage charges, to mediate the contradiction between international trade and environmental regulations.
Secondly, is there a contradiction between FDI and environmental quality? We found that improving the industry technical level alleviates the negative effects of environmental regulation on inward FDI, and is conducive to both better environmental quality and economic growth. We put forward the following suggestions on this basis: First, China should further set more specific emission reduction targets and form a deep-level paradigm for pollution control through clean technology innovation. Second, governments should vigorously cultivate technical innovation talents and encourage enterprises to fully develop pollution control technologies, so as to solve the problem of excessive pollution emissions from the source. Third, governments should encourage enterprises to develop export transactions vigorously and learn from export activity [
34]. This would contribute to reducing excessive pollution by absorbing foreign advanced technology experience and balancing the effects of environmental regulation on FDI.
Third, Hong Kong and Macao investments did not appear the PHE with the support of state policy subsidies. Therefore, the premise of governments to formulate environmental regulations should be based on the actual situation of the country and have clear rewards and penalties. Governments should implement preferential policies for foreign investors who meet environmental protection standards and fully encourage international investment inflows. They should also punish or expose the polluters who violate the emission rules and strictly control the pollution within the ecological threshold.
This paper investigates environmental regulation and its impact on inward foreign direct investment (FDI) in developing countries. This academic direction has strong practical significance and is worthy of further exploration. First, future literature can explore the impact of environmental regulations on other socio-economic factors, such as exports, optimization of industrial structure, and the number of labor. Second, our data level is at the province–industry level, which is limited by the lack of FDI home country information. It makes it impossible for us to comprehensively examine the impact of environmental regulations in different countries on FDI. Future research can observe company-level or country-level data to investigate PHH and PHE more thoroughly. Third, future literature can distinguish different types of environmental regulations in detail, such as whether the impact of command-controlled environmental regulations and market-based environmental regulations on FDI differs. This exploration is of great significance for optimizing environmental regulatory tools.