The Relationship between Environmental Performance and Foreign Direct Investment: Testing the Pollution Haven Hypothesis

For many environmental assets, there is no market, and when there is one, it fails to allocate resources optimally. Hence, there is a room for the government to implement environmental policies to solve the problem of market failure. Since 1970, governments in advanced countries have implemented strict environmental policies and, as a result, the share of pollution intensive commodities has decreased significantly. The "pollution haven hypothesis" combines theories of free trade and foreign direct investment to explain the improvement of environmental quality in advanced economies. This paper uses two models to test the pollution haven hypothesis. The first model examines the effect of more stringent environmental policy on outflow of FDI from advanced countries, and the second model studies the relationship between environmental stringency and inward FDI to developing countries. The first model is estimated by fixed effects method, and the second model is estimated using GMM method. The estimation results show that FDI outflow is positively correlated with environmental performance in 28 OECD countries. As a result, we find that FDI inflow to 18 non-OECD developing countries is significant. In other words, this finding might verify the validity of the pollution haven hypothesis. The paper recommends that the attraction of foreign direct investment in developing countries should be compatible with the absorptive capacity of their environment.