Economics of trade and environment: theoretical and empirical perspectives

Meeta Keswani Mehra Professor and Chairperson Centre for International Trade and Development, School of International Studies, JNU June 11, 2019 RIS-EXIM Bank Summer School in International Trade: Theory & Practice

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Significance (1)

World economy witnessed extraordinary growth and economic integration over the last two and a half decades or so (1990-2017) Economic activity rose 3.6 times Population grew by 1.42 times Per capita GDP rose by 2.5 fold Global exports (imports) rose from 19.3%

(19.5%) of GDP to 29.4% (28.5%) of GDP 9.9 times increase in inward FDI

These trends changed composition and enlarged scale of production via specialization in production patterns across countries 2

Significance (2)

Over same period, India witnessed

8.3 times increase in total GDP

1.54 fold increase in population

5.4 fold increase in GDP per capita

Exports (imports) rose from 7.1% (8.5%) of GDP to 18.8% (22%) of GDP

169 fold increase in inward bound FDI (for developing countries as a group it was much lower)

Above trends have permitted unprecedented economic growth rates, in general

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Significance (3)

Accelerated economic growth rates achieved at a cost ↔ large scale environmental deterioration ↔ air/ water pollution, climate change, deforestation, species extinction, land degradation

On one hand, trade and FDI perceived to bring higher income and well-being (more efficient resource allocation), also seen as magnifiers of environmental deterioration, especially in developing countries

On other hand, growing environmentalism seen as an impediment to freer cross-border commodity and investment flows – non-tariff barriers

Central question ↔ how trade liberalization and capital mobility affect sovereign nations’ environment, environmental policy and welfare

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Overview (1)

Environmental effects arise in economic (production and consumption) activities, but get accentuated either due to market failures or policy failures

In first-best world, where policies to internalize environmental costs are in place, trade always improves aggregate welfare.

Present these distortions, trade could potentially exacerbate consequences of poor environmental policies by affecting level and geographical distribution of pollution.

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Overview (2)

In general, issues are intertwined and contentious

Impact of freer commodity trade on pollution level and its geographical allocation and welfare implications

Freer FDI flows on the level and geographical distribution of pollution

Effect of environmental regulation on trade (market access) and investments flows (inter-jurisdictional competition for attracting capital)

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Trade liberalization and environmental quality

Debate centers around three effects

Scale effect: trade causes expansion in economic activity ↔ negative environmental

outcome

Composition effect: change in mix of output as pollution intensive industries relocate due to

trade ↔ positive or negative environment

effects

Technique effect: income gains from trade induce switching to new and cleaner methods of

production ↔ positive environment effects

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Model outline (1) Small open economy producing two goods: X & Y using

capital (K), labor (L) and CRS production technology KX/LX>KY/LY. Pollution, T, generated in production X the polluting good, and Y the numeraire good r, w and τ represent prices of K, L and T. p=pX/pY relative price of good X, q<p relative producer price

due to presence of pollution taxes, τ. pW is the relative world price V=pW.X+Y value of output Then, T= t.ΩX.V, where ΩX= pW.X/V, is the share of the

pollutive good X in aggregate value of output, and t is the pollution intensity

Change in aggregate pollution is sum of changes in intensity of pollution, composition of output and scale of production

dT/T=dt/t+dΩX/ΩX+dV/V

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a

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Figure 1: The scale effect

Scale effect (2)

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a

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Figure 2: The composition effect

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Composition effect (3)

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a

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Figure 3: The technique/ income effect

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Technique/ income effect (4)

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Some theoretical results (1)

N-S model of small open economy Copeland and Taylor: scale effect associated

with trade causes worsening of environment in both countries, composition effect improves environment in N and worsens it in S, and technique effect improves it in both

Composition effect dominates, thus environment in N improves and in S deteriorates due to trade

Welfare of both N & S rises, but in some cases, N may suffer a welfare loss, when pollution is transboundary

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Some theoretical results (2)

N-S Model of large open economy

Mehra and Das: Incorporation of terms-of-trade effects + complete specialization in production ↔ N (cleaner good) and S (dirtier good)

both N & S reduce their pollution due to trade

Inspite of better environment both countries may gain or lose in welfare from trade

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Key empirical results: mixed (1)

Investigation of effect of environmental standards on firms’ comparative advantage & trade. Low and Yeats (1992): cross-country RCA indices for

pollutive trade between 1967/68 to 1987/88. Share of dirty goods originating rose from 22-26% in developing and fell from 78-71% in developed countries. But, claim that significance of trade liberalization in causing this trade pattern unclear.

Lucas, Wheeler & Hettige (1992): 1960-80 - trade openness contributes to cleaner growth by changing output mix toward cleaner sectors. Also, countries with faster growth & less trade distortion experience a slower rise in pollution intensity.

Mani & Wheeler (1999): fraction of dirty output in total fell in OECD and rose in developing countries ↔ result cannot be ascribed to freer trade as most of output for domestic use and not exports.

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Key empirical results (2)

Antweiler et al (2001): use panel data on trade and SO2 concentrations for developed and developing countries between 1971-96. Trade alters output mix toward greater pollution intensity for capital abundant countries ↔ 1% increase in scale raises pollution concentration by 0.25-0.5%, but income gains reduce concentrations by 1.25-1.5% via technique effect.

Dinda (2006): another panel estimate for CO2 confirms pollution haven effect for 1965-90. In general, CO2 emissions and CO2 intensity are negatively related to trade openness index. But, more capital-intensive (OECD) countries get cleaner as trade is liberalized as compared to less capital-intensive (non-OECD). In general, emissions in OECD countries fall, those in non-OECD rise.

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Key empirical results: Indian context (4) Gamper-Rabindran and Jha (2004): panel estimates - changes in

composition of pollution content of net exports in pre- & post-liberalization period. Find that industrial sectors having higher (esp. water pollution) intensity had higher increase in exports in the post-1991 period than cleaner goods -- India becoming more specialized in dirtier exports.

Mukhopadhyay & Chakravarty (2005): input-output analysis of exports from India vis-à-vis imports -- changes in pollution intensity between 1991/92 and 1996/97- ratio of weighted emissions defines the pollution terms-of-trade - ratio found to be less than unity, implying India’s exports have lower embodied pollution than imports - comparative advantage of India lies in cleaner goods. However, ratio increased from 0.5 in 1991/92 to 0.53 in 1996/97 for CO2 and other local pollutants - thus reduction in gains during reforms period.

Thus, use of more recent data and methodologies -- more definitive results emerging for developing countries, including India.

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Foreign direct investment (FDI) & environment

Similar to goods trade, international capital mobility (esp. FDI) is seen to accentuate environmental degradation – esp. in developing countries Driven by higher returns as capital moves from

capital rich N to capital scarce S, the laxity of environmental standards in S attracts an unduly high proportion of it into more environmentally sensitive sectors.

Analyze theoretically, the effect of FDI flows from N to S on environment and welfare under perfect competition.

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The model (1) N-S model of capital mobility, where N is capital-rich

and S is capital scarce Both produce one good Y as a function of K, L and

pollutive input, T; Y=F(K,L,T) with CRS Endowments of K and L are fixed and T is policy

determined Perfect competition and profit maximization imply

that r=FK, w=FL, τ=FT, with r, w and τ being rewards to K, L and T.

Absent capital mobility, the SWF of country i is: Ui=F(Ki,Li,Ti) - φ(Ti,Tj), φT>0, φTT>0 With capital mobility, N exports capital to S and the

latter’s SWF is modified to: US=F(KS,LS,TS) - r(KS-KS) - φ(TS,TN) Additional negative middle term to reflect outflow

from debtor country 18

The model (2)

The analogous welfare expression for N has a positive term for inflows into creditor country

In the absence of environmental distortion, standard gains from capital movement accrue

In the presence of environmental distortion, two situations could arise Supplies of environmental input are not

adjusted in response to K movement, thus, no change in disutility from pollution & standard gains reaped

Environment policy adjusted, and change in aggregate welfare for the S is

dUS/dKS = (FK-r) + (FT-φTS )dTS/dKS -

φTNdTN/dKS

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The model (3)

Thus, 3 effects stem due to FDI:

First term is positive, as capital flows in.

dTS/dKS>0, (complementarity between K and T), & (FT-φT

S), gap between marginal product and marginal damage of environmental policy change-environment policy too stringent (lax), sign will be positive (negative). Thus, sign of second term ambiguous.

Third term captures transfrontier pollution effect-as dTN/dKS<0, environment resource use falls in N and benefits S.

Overall impact on environment and welfare of both countries remains unclear.

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Key theoretical findings (1)

McGuire (1982) and Rauscher (1992): pollution in K importing country always raised and K exporting country always lowered as output composition changes in response to regulated country driving out pollutive production to unregulated country.

Rauscher (1997): these results carry over even when pollution taxes are adjusted optimally by countries.

Copeland and Taylor (1997): when factor abundance determines trade patterns, K mobility causes world pollution to rise (from free trade levels), as pollution intensive production shifts to S (having laxer environment policy). If income differences lead to goods trade, then income induced differences in pollution policy may imply that K mobility causes a fall in world pollution. (N imports the K- or T-intensive good; pollution in S rises and in N falls.)

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Key theoretical results (2)

Das and Mehra (2000): Capital mobility with global pollution causes

pollution to fall in creditor N and rise in debtor S and world pollution to rise when environmental policies are adjusted non-cooperatively.

Cooperation entails more stringent environmental policy and fall in global pollution, but this is not a disincentive to FDI, as commonly feared (due to relative changes in return on K). Pollution in N falls, and in S it may or may not rise.

These results go through irrespective of whether environment is a normal good or a neutral good.

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Some empirical findings: somewhat inconclusive (1)

Liang (2006): panel regression of Chinese city level SO2 emissions over 1996-2003 on FDI, and other variables ↔ emissions found negatively related to FDI. A 1% increase in FDI led to 0.6-0.7% fall in emissions.

He (2006): another estimation for China yielded contrary results. Using panel data over 1994-2001, found significant and positive effect of scale and composition effect of FDI on industrial SO2 emissions. Adjusting for the technique effect as well (which lowered pollution), a 1% increase in FDI caused a 0.098% increase in emissions.

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Some empirical findings: for India (2)

Gamper-Rabindran & Jha (2004): regress FDI inflows in manufacturing pre- and post-1991 period.

Shows positive and significant effect of FDI on environmental pollution - increase in air and water pollution intensive FDI in post-reforms period

Only caveat is absence of technique effect as emissions intensity taken to be time-invariant.

Qualitative analysis by Jha (2003) points toward both positive and negative effects of FDI on environment in India. Observably, most FDI focused in environmentally-sensitive sectors but, linkage between growth of these sectors and FDI per se remains weak.

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Environment policy, trade and industry location: analytical model (1)

`Tariff jumping’ commonly cited as motivation for FDI, providing firms means to enter protected markets

More recently additional factor ↔ environmentally less conscious (developing countries) have become pollution havens by attracting FDI inflows

Take N-S model of capital mobility. Capital market clearing characterized by FK

N(KN=KN-I,LN,TN)=rN=r=rS=FKS(KS=KS+I,LS,TS)

This yields, I=I(TN,TS), and r=r(TN,TS).

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Capital market equilibrium: analytical structure (2)

r(KN;TN) r(KS;TS)

B ON OS A

E

r(KS;TS’)

B’

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TS’>TS

Empirical support (1) Tobey (1990), Grossman and Krueger (1993): cross-sectional/

country data & factor-endowment framework ↔ stringency of environmental standards not a significant determinant of trade.

Busse (2004): cross-country (119) & industry regression of net exports ↔ none of policy stringency variables (environmental governance/ participation in international treaties) had any significant effect on exports of select industries, except iron and steel.

Han (1996): panel data estimates ↔ found significant negative effect of environmental regulation on industry competitiveness ↔ effect wears out over time due to fall in abatement costs, new vintage K etc.

Levinson & Taylor (2004) and Ederington & Minier (2003): incorporated endogeneity of pollution policy ↔ industries having larger increases in pollution control expenditure also had larger imports or a positive elasticity of imports to environmental control costs for US-Canada trade & US respectively.

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Empirical support: Others and India (2)

Eskeland and Harrison (1997): panel investigation for four countries (Mexico, Venezuela, Morocco and Cote d’Ivoire) ↔ no support for effect of environmental regulation on FDI flows or of concentration of TNCs in pollution intensive sectors

Mani (1997): analysis for India using a logit model of decision of new industry location in pollutive sectors in 1994 ↔ for all industrial groups, environmental stringency does not have a negative effect on plant location decision ↔ in fact, a 1% increase in environmental spending in state plan increased probability of plant location by 0.09, 0.08 and 0.05% in Gujarat, Maharashtra & Madhya Pradesh

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Empirical support: for India (3)

Pargal and Mani (2000): more recent analysis for India is more revealing ↔ focus on citizen’s activism while investigating effect of environmental regulation on plant location ↔ finds that industry is attracted toward locations having lower labor costs, higher labor productivity, better quality of inputs, improved infrastructure, lower number of pollution related cases (lax environment policy), lower p c income (lower WTP or cost of environmental services) and lower voter turnout (absence of citizen’s activism)

Thus, more recent and rigorous analyses are more revealing and conclusive

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Environmental standards and market access

Bhagwati’s principle of targeting suggests that environmental distortions are best attended to by environmental policy ↔ once corrected, trade will enhance welfare

However, there is apprehension that, driven by competitiveness concerns, developed countries may be induced to impose stringent environmental standards on imports from developing countries, thus posing a market access barrier

Theoretically, first-best policy option ↔ expand scope of trade agreements to incorporate coordination of environment policy (Ederington, 2001).

But, to be efficient, environmental standards to be differentiated across nations, and within it, across jurisdictions to reflect local environmental and economic situation (Bhagwati & Srinivasan, 1996) ↔ diversity in taxes not merely natural but also legitimate

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Empirical evidence (1)

Notwithstanding theoretical nuances, use of environmental requirements – ecolabels, product standards, technical regulations, packaging and recycling requirements on health/ safety/ environmental grounds abound Columbia’s flower exports to Germany hit (25%

decline during 1995-96) by latter’s FLP . Thai textile exporters had to conform to production

methods prescribed by EU, unwarranted and expensive

Indian producers of textiles and leather facing costs of ecolabel compliance prohibitive-33% of export price (Kaushik, 1999)

Indian leather and textile industry facing TBT and SPS related bans.

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Market access: empirical evidence

Kadekodi et al. (2002): leather and tea sectors ↔ formulated an index of environmental

regulation (imposed by different importing

countries) it was found –

Tea sector ↔ definitive support for breaks in exports to

developed countries but not those toward developing

countries

Leather sector ↔ environmental regulation enhanced

prospects for exports ↔ firms responded positively to

comply with EU regulations and managed to maintain

their competitiveness

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To sum up

Theoretically, trade may or may not create pollution havens, especially if countries are large open economies or trade in emissions accompanies trade in goods. Free capital mobility may also not result in creation of pollution havens when either countries have strategic interest in restricting capital outflow or if countries cooperate on environmental policies.

Empirically, more definitive evidence to support the claim that developing countries are facing adverse environmental outcomes due to free goods and investment flows.

In developing country milieu, there is mixed support for adverse effect of environmental regulation on FDI flows – depends on data and methodology – more categorical findings for India in terms of role of environmental governance and citizens’ activism deterring FDI

Effect of environmental requirements on market access are large and looming – developing countries have had little choice but to comply

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Select readings Anriquez, G.,`Trade and the Environment: An Economic Literature

Survey', Working Paper No. 02-16, Department of Agricultural and Resource Economics, The University of Maryland, 2002.

Copeland, B. R., and Gulati S., `Trade and the Environment in Developing Countries' In Lopez, R. and Toman, M.A. (Eds), `Economic Development and Environmental Sustainability: New Policy Options, The Initiative for Policy Dialogue Series’, 2006, 178-216, Oxford University Press.

Copeland, B. R., and Taylor, M.S., `Trade and the Environment: Theory and Evidence’, 2003, Princeton University Press, Princeton and Oxford.

Mehra, Meeta K., `Trade, Environment and Natural Resources: A Developing Country Perspective’, In Chopra, Kanchan and Dayal, Vikram (Eds.), Handbook of Environmental Economics in India, Forthcoming, Oxford University Press.

Rauscher, M., `International Trade, Foreign Investment, and the Environment', Maler, K-G and Vincent J.F. (Eds.), `Handbook of Environmental Economics: Economy-wide and International Environmental Issues’, Volume 3, 2005, 1403-56.

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