Foreign Direct Investment and Environmental Policy: Have Location Factors Been Neglected?

Abstract

This paper analyzes the effect of asymmetric environmental policies on firms' international location strategies in pollution-intensive sectors, when countries differ in terms of market size. The model shows that, when the tighter mitigation measures are introduced by the larger country and unit transport cost is high, the probability of firms not relocating abroad via foreign direct investment increases with market asymmetry. Furthermore, in some key scenarios, the total relocation outcome predicted by the pollution haven hypothesis is never an optimal strategy. The analysis suggests that international environmental rules should take account of differences in countries' market size and thus ability to attract production.