Foreign Direct Investment and the Choice of Environmental Policy

We use a simple two-country oligopoly model of intra-industry trade to examine the implications of foreign direct investment for the pollution haven hypothesis and environmental policy. Countries which lower environmental standards to be more competitive in world markets generate pollution havens if environmental policy is exogenous. However, if FDI is a viable option as a mode of entry, profit-shifting considerations weaken in favour of environmental considerations and FDI recipients tighten environmental policy, reducing incentives to relocate production. Interestingly, when countries are sufficiently similar in their environmental awareness, "grey" countries can become greener than originally "green" countries but firms in the latter still engage in FDI in the former, in spite of the stricter standard they face, in order to level the playing field. We derive conditions under which FDI-receiving countries have incentives to manipulate their environmental standards to prevent or attract FDI, potentially eliminating or creating pollution havens.