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Stringent environmental regulations do not discourage investments, finds study

Read time: 4 mins
24 May 2018
Infographic : Purabi Deshpande / Research Matters

There exists a theory among economists called the ‘pollution haven hypothesis’ that talks about how foreign investments are related to environmental regulations. It states that companies from developed countries often seek to set up manufacturing units in developing countries not only because they can obtain cheap labour and resources, but also because environmental regulations in these countries are usually lenient, reducing the cost of compliance.  But does empirical data support this hypothesis? In a new study, researchers from the Indian Institute of Technology Bombay (IIT Bombay) explored this question in the Indian context and found that the data suggests otherwise.

In the study, published in the journal Asian Development Review, the researchers note that factors like infrastructure and access to market influence foreign investments more than environmental norms.  In other words, the 'pollution haven hypothesis' fails to explain the investment patterns in the Indian context.

Foreign direct investments (FDI) into India have been significantly increasing in the recent years, especially after the liberalisation era of the early 1990s. For governments, these investments are significant to generate jobs and showcase development.  Hence, if the 'pollution haven' hypothesis is, in fact, correct, governments would then have to reduce environmental standards to attract more investments. Although there are pieces of evidence where the governments have relaxed environmental norms, this is not the case everywhere, say the researchers.

"In the People’s Republic of China, provinces compete intensely for foreign capital by offering promises of preferential treatment to potential foreign investors, which can include a tacit (or explicit) commitment to lax enforcement of environmental standards”, the researchers say, giving an example where the hypothesis holds true. However, there are cases where environmental standards were made stringent to attract foreign investments. "Foreign investors in Costa Rican banana production have insisted upon the application of high environmental standards as their European customers demand an environmentally sound product”, is an example the researchers quote of the latter case.

But, what about India? In this study, the researchers test the 'pollution haven' hypothesis for 21 Indian states and union territories from 2002-2010 by examining the impacts of environmental governance on FDI over the years.  One way to calculate the cost of compliance with environmental regulations is to add all the pollution control costs by various companies, for each state.  Although this approach is used in many previous studies, it is flawed because, if a state has many pollution-intensive units, then the pollution control cost is naturally higher even though the environmental governance in that state may not necessarily be stringent, points out the study. Therefore, it has considered the reworked metric that addresses the flaws of previous metrics, and is a more effective reflection of the level of environmental governance in a particular region.

The results revealed that states and union territories like Chandigarh, Odisha, and Karnataka have the highest environmental stringency whereas Bihar, Delhi, North Eastern states and the Andaman and Nicobar Islands exhibit the lowest.  Also, Andhra Pradesh, Punjab, Rajasthan, Odisha, Goa, and Haryana have become stringent over time, whereas Assam, Chhattisgarh, Gujarat, Delhi, Uttar Pradesh, and Uttarakhand have become lenient over time.  However, this stringency in environmental governance, evident from the cost of compliance, was found to have no impact at all on the FDI.  This finding empirically demonstrates that a region’s environmental norms do not influence the investment decisions of the foreign companies.

Apart from environmental governance, the study also considered various other factors that influence FDI in a state. It found that factors like market size and demand, the share of the manufacturing sector in the state economy, availability of power, proximity to the coast, existing investment stock, availability of resources and human capital influence FDI decisions.  It also found that higher per capita income of a region attracts more investments as it demonstrates a higher purchasing power of the people and hence, an excellent market opportunity.

The study is a right step towards demystifying the theory of ‘race to the bottom’ by relaxing all environmental regulations in the name of attracting investments, as it drains resource availability and health of the citizens.  It further notes that “foreign firms generally seek consistent environmental enforcement over lax enforcement, which may also hold true in the case of Indian states.”

So, the message is clear—the way to attract investments is not by relaxing the environmental standards, but by providing better infrastructure and market access.