Effects of Openness and Trade in Pollutive Industries on Stringency of Environmental Regulation

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Effects of Openness and Trade in Pollutive Industries on Stringency of Environmental Regulation Matthias Busse and Magdalene Silberberger* Ruhr-University of Bochum Preliminary version Abstract This paper analyses the impact of trade in pollution-intensive industries on the stringency of environmental regulation. Using fixed-effects regressions for a panel of 54 countries and the period 1998 to 2008, we find that a high share of exports in pollution-intensive goods is positively associated with environmental stringency, while there seems to be a negative connection with imports from dirty sectors. JEL Classification: F18, Q56, Q58 Key Words: Environment and Trade, Pollution Havens, Environmental Policy, Openness, Competitiveness *Corresponding author, Ruhr-Universität Bochum, Department of Management and Economics, GC 3/145, Universitätsstr. 150, 44780 Bochum, Germany, phone: +49-234-23421, e-mail: magdalene.silberberger@rub.de. 1

1. Introduction The discussion of environmental issues in economic literature started in the early 1970 s after the release of the Limits to Growth report issued by the Club of Rome. After the emergence of the first environmental policies the major fear was that stringent environmental regulation would increase production costs and lead to a migration of industries to less regulated countries. The general concern was that lower environmental regulations would create a competitive advantage for less stringent countries mostly developing countries which would then turn into pollution havens (Dean 1992). In all these studies, environmental policy had been treated as exogenous until in the late 1990 s researchers argued that environmental policy is endogenous because it is influenced by different political and economic factors (Ederington and Minier 2003). More recently, there have been theoretical and some empirical studies addressing this issue and dealing with possible determinants of environmental stringency. While various studies have tried to determine the interaction between environmental regulation and other political indicators as well as trade openness, almost all of them used cross-sectional data. The notable exception is Damania et al. (2003), who have concluded a study on the effects of trade liberalization and corruption on environmental policy using panel data. Their findings show that a more open economy will have more stringent environmental policy, but the authors do not distinguish trade in different types of goods. Our paper regards trade in so called pollutive-industries (e.g., industries with relatively high pollution-abatement costs). The prediction is that a high share of exports in pollution intensive goods might translate into a lower level of environmental stringency, because of the fear that higher environmental stringency increases the costs of production in sectors with relatively high abatement costs and leads to a loss in competitiveness in these industries. A high share of pollution intensive exports usually goes hand in hand with a strong lobby opposing more stringent environmental regulation, which according to Fredriksson et al. (2005) is negatively correlated with environmental stringency. This paper is structured as follows: In the first part we explain the relevant variables as well as the methodology. The indicator used as the dependent variable is the World Economic Forum indicator of environmental stringency. In the panel data analysis, we control for trade openness in general and exports and imports in pollution-intensive goods. We also include a 2

set of control variables that seem to be relevant in the context of environmental regulation. Our empirical results show that openness, as well as, exports and imports are significant, but the results differ depending on whether the country is developing or industrialized. The paper concludes with some policy implications. 2. Variables and Methodology We use the World Economic Forum (WEF) indicator of environmental stringency (the variable is labelled EnvReg) drawn from the Global Competitiveness Reports between 1998 and 2008. Based on expert surveys, the indicator ranges from 1 (low stringency of environmental regulation) to 7 (highest stringency of environmental regulation) and is the only indicator on environmental stringency available for a longer period of time. We employ economic and political explanatory variables, the most important economic ones being Openness, Exppol, and Imppol. Openness consists of the total imports and exports of a country as a share of GDP, while Exppol (Imppol) decribes pollution-intensive exports (imports) as a share of total exports (imports). Mani and Wheeler (1999) define a set of dirty industries depending on the level of abatement expenditures per unit of output. We use the five sectors that Mani and Wheeler consider to be the most important ones: Iron and Steel, Non-Ferrous Metals, Industrial Chemicals, Pulp and Paper and Non-Metallic Mineral Products. According to previous literature, there is a positive correlation between openness to trade and stringency of environmental regulations, while the expected coefficient for Exppol would be negative. A high share of exports in pollutive-industries usually implies a high importance of these sectors in a country s economy and therefore more power to its lobby. In a theoretical model, Schleich (1999) has shown that lobbying by a polluting industry can lead to a lower environmental quality than the social optimum. Imppol is expected to be positively correlated with EnvReg. When looking at competitiveness concerns as a factor that influences environmental regulation, it can be assumed that countries with relatively high imports of pollution-intensive goods have no incentive to lower environmental stringency. In contrast, these countries import pollution-intensive goods because of their priority for the environment and their preference to not produce dirty goods in their country. These countries are more 3

likely to have stringent environmental policy than countries producing and exporting pollutive products. Apart from the three trade variables we use GDP per capita (GDP) from which we expect a positive impact on environmental regulation. In general, higher income increases demand for environmental quality which translates into higher stringency of environmental regulation if governments are responsive to the increased demand (Copeland and Taylor 2004). In addition, we employ a set of control variables that we expect to be a significant determinant of environmental policy. We use political rights (Polr) as a variable for democratic participation. It ranges from 1 to 7, with 1 representing the highest freedom in the electoral process, political pluralism and participation, and functioning of government and 7 being the lowest degree of freedom (Freedom House 2010). We expect this variable to increase the stringency of environmental regulation. The other political variable we employ is corruption (Cor). In general, corruption reduces the level of environmental stringency, so that a decrease in corruption is associated with more stringent environmental regulation, although the effect may be conditional on other factors such as trade openness or political stability (Fredriksson and Svenson 2003). Finally, we add the share of urban population (Urban) as a proxy for the population that is exposed to pollution. Our sample consists of 54 developed and developing countries for the period 1998 to 2008. We estimate a fixed-effects model as the Hausman test indicated that a random effects estimator would be biased. The specification of the model reads as follows: ( 1) Envreg + λ + ε it = α i + β1opennessit 1 + β2exppolit 1 + β2 Im ppolit 1 + γ' X it 1 t it where EnvReg it denotes the environmental stringency indicator for country i in period t, α i is the country fixed effect, Openness it, Exppol it and Imppol it are the trade variables of interest. X it denotes the set of control variables, λ t is a set of time dummies, and ε it stands for the error term. All independent variables enter our model lagged by one year for two reasons. First, changes in any of the trade or political variables will probably not be reflected in environmental regulation instantly, but with a time lag instead. Second, we are faced with a possible endogeneity problem between current realizations of Envreg and some of the independent variables. This problem can be mitigated by using lagged values. 4

3. Empirical Results Following the specification of the model we now turn to the empirical results. Table 1 shows the results for two different samples. Apart from the full sample, we run further regressions for the developing country sub-sample, as it can be argued that the determinants of the stringency of environmental regulations might differ in these countries. For both samples, we start with a benchmark regression and then add each of the control variables one by one (Models 1 to 3). In Model 4, we include all control variables simultaneously. We find that Exppol is significant and positive in all cases, whereas Imppol is significant but negative. Also, we find highly significant positive effects for GDP in all regressions. Openness has a positive effect on EnvReg, but is only significant at the 10 percent level in Models 1 and 4. All included control variables are insignificant in our regressions, meaning that there is no observable connection between the political variables and the stringency of environmental regulation. The overall fit of the estimations made in Models 1 to 4 measured by the R 2 ranges from 0.42 to 0.46, which is a very good fit. With respect to the economic significance of the models we found that an increase by one within standard deviation of Exppol (0.095) increases EnvReg by about 0.09 to about 0.1 depending on the model. With a mean of 4.44 for the Stringency of Environmental Regulation this corresponds to a rise of about 2.0 to 2.2 percent, a modest but not negligible result. For Imppol this impact is about half as big and negative, so that an increase in Imppol by one standard deviation decreases EnvReg by about 1.1 percent. An increase in the standard deviation for GDP has a slightly bigger positive impact of about 3 percent and Openness has the strongest association with EnvReg of about 18 percent for Models 1 to 4. Next, we split the sample into developed and developing countries and focus on the subsample for developing countries (Models 5 to 8). In general, the results are similar to the ones for Models 1 to 4, but there are some important differences. In contrast to the whole sample, GDP is not significant any more. Exppol and Imppol remain significant and with same sign as in Models 1 to 4, but the coefficient for Imppol increases, while the coefficient for Exppol decreases slightly. Openness, which was significant in two cases for the whole sample, is insignificant in all four cases for the developing country sample. As already observed in the 5

complete sample, neither of the control variables is significant at the conventional 10 percent level. As expected, our measure for overall fit has decreased and now lies between 0.25 and 0.26. This is still reasonable considering the heterogeneous country sample and the short period of time that we used. Since Openness and GDP are not significant in the developing countries subsample, we only need to focus on Exppol and Imppol. For an increase by one standard deviation in Exppol EnvReg rises by about 2.2 to 2.4 percent. Similar but negative results can be found for Imppol where an increase by one standard deviation reduces EnvReg by about 1.8 to 2.0 percent. 4. Policy Implications Interpreting theses results it can be argued that an increase in GDP per capita does not per se influence environmental regulation. The different results for developing and developed countries show that a rise in GDP is only associated with more stringent environmental regulation if high-income countries are included in the sample. Therefore, it is not enough just to focus on income if one aims to increase environmental stringency. Openness to trade has the expected result, but does not seem to be a relevant factor for developing countries. Also, according to our data, a high export share in pollution intensive does not lower environmental stringency as would have been expected. Instead, we find strong evidence that there is a positive correlation between Exppol and EnvReg. Apparently, competitiveness concerns do not influence environmental policy makers or the lobby against more stringent environmental regulations is not strong enough. A possible explanation is that most pollutive industries are in fact capital intensive and if a country s share of dirty industries increases it is already in some sort of transformation process from a developing to an industrialized country, which are on average more environmentally aware than developing countries. Furthermore, our study has shown that concerns about countries with comparative advantages in dirty industries engaging in a race to the bottom with respect to environmental stringency are not legitimate. 6

On the other hand, imports of dirty goods are negatively associated with the stringency of environmental regulation. The effect is stronger for developing countries than it is for the full sample of countries. However, these results do not suggest that developing countries should specialize in pollution-intensive goods and export these in order to increase environmental regulation and in the long run decrease their pollution. Yet they do imply that the composition of imports should not be ignored when looking at possible determinants for the stringency of environmental regulation. 7

Table 1: Trade and Environmental Regulation Dependent variable: EnvReg All countries Developing countries Independent variables Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8 Openness 0.0687* (1.696) Exppol 1.029*** (3.338) Imppol -1.585** (-1.980) 0.082*** GDP (4.607) -0.00906 Cor (-0.202) Polr Urban 0.0438 (1.017) 0.980*** (3.144) -1.528* (-1.959) 0.082*** (4.596) -0.0436 (-0.884) 0.0668* (1.678) 1.044*** (3.450) -1.523*** (-1.994) 0.0757*** (4.068) -0.0297 (-1.110) 0.0534 (1.214) 1.001*** (3.146) -1.587* (-1.941) 0.0724*** (3.762) -0.0117 (-0.249) -0.0481 (-0.946) -0.0384 (-1.354) 0.0583 (1.274) 0.916** (2.399) -2.187** (-2.083) 0.0460 (0.707) 0.0500 (0.920) 0.0250 (0.495) 0.846** (2.137) -2.304** (-2.366) 0.0325 (0.518) -0.0331 (-0.765) 0.0499 (1.131) 0.872** (2.365) -2.196** (-2.371) 0.0661 (1.028) 0.0335 (1.161) 0.0183 (0.347) 0.848** (2.070) -2.261** (-2.048) 0.0579 (0.835) 0.0699 (1.177) -0.0195 (-0.429) 0.0375 (1.173) Observations 350 346 347 337 167 163 176 154 Countries 53 52 52 51 26 25 26 24 R 2 0.45 0.46 0.42 0.46 0.25 0.25 0.26 0.25 Notes: Significance at the 10, 5, and 1 percent level is denoted by *, **, and ***, respectively; t-values are reported in parentheses; time dummies not shown. 8

References Copeland, B. and M.S. Taylor (2004), Trade, Growth and the Environment, Journal of Economic Literature 42, 7-71. Damania, R., P.G. Fredriksson, J.A. List (2003), Trade liberalization, corruption, and environmental policy formation: theory and evidence, Journal of Environmental Economics and Management 46, 490-512. Dean, J. (1992), Trade and the Environment, A Survey of the Literature, World Development Report 1992: Development and the Environment, Washington, DC: World Bank. Ederington, J. and J. Minier (2003), Is environmental policy a secondary trade barrier? An empirical analysis, Canadian Journal of Economics 36, 137-154. Fredriksson, P.G., E. Neumayer, R. Damania, S. Gates (2005), Environmentalism, democracy, and pollution control, Journal of Environmental Economics and Management 49, 343-365. Fredriksson, P.G. and J. Svensson (2003), Political instability, corruption and policy formation: the case of environmental policy, Journal of Public Economics 87, 1383-1405. Freedom House (2010), Freedom in the World, http://www.freedomhouse.org. Mani, M. and D. Wheeler (1999), In Search of Pollution Havens? Dirty Industry in the World Economy, 1960-1995, World Bank Discussion Paper 402: Trade, Global Policy, and the Environment, Washington, DC: World Bank. PRS Group (2010), International Country Risk Guide: Political Risk. Internet Posting: http://www.icrgonline.com/default.aspx. Schleich, J. (1999), Environmental quality with endogenous domestic and trade policies, European Journal of Political Economy 15, 53-71. World Bank (2010), World Development Indicators, Online access. World Economic Forum (2008), Global Competitiveness Report, http://www.weforum.org/en/initiatives/gcp/index.htm. 9

Appendix A: Definition of Variables and Data Sources Variable Definition Source EnvReg Stringency of environmental regulation, 1-7 World Economic Forum (2008) Openness Total imports and exports of goods (minus the ones in pollution World Bank (2010) intensive industries) divided by GDP Exppol Exports of dirty goods divided by total exports World Bank (2010) Imppol Imports of dirty goods divided by total imports World Bank (2010) GDP GDP per capita in constant US$, divided by 1000 World Bank (2010) Cor ICRG corruption measure, 0-6 PRS Group (2010) Polr Political rights, Freedom House, 1-7 Freedom House (2010) Urban Share of urban population World Bank (2010) Appendix B: Descriptive Statistics for the Total Sample and the Developing Countries Sample Total sample Variable Obs. Mean Std. Dev. Min Max EnvReg 433 4.44 0.59 2.33 6.8 Open 525 1.61 11.72 0.13 269.98 Exppol 529 0.11 0.09 0.005 0.44 Imppol 584 0.08 0.03 0.033 0.3 GDP 540 17.86 1.75 6.92 26.68 Cor 538 3.5 0.64 1 6 Polr 530 2.11 0.46 1 7 Urban 540 67.81 1.2 22.62 100 Developing countries sample EnvReg 218 3.68 0.39 2.33 5.4 Open 262 1.91 15.6 0.15 269.98 Exppol 266 0.11 0.096 0.006 0.43 Imppol 268 0.08 0.032 0.036 0.28 GDP 270 6.49 4.32 0.185 13.78 Cor 268 2.51 0.7 1 5 Polr 260 3.1 0.65 1 7 Urban 270 59.33 1.55 22.62 92.3 10

Appendix C: Country Sample (54 Countries) Argentina, Australia, Austria, Belgium, Bolivia, Brazil, Bulgaria, Canada, Chile, China, Colombia, Costa Rica, Czech Republic, Denmark, Ecuador, Egypt, El Salvador, Finland Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Luxembourg, Malaysia, Mauritius, Mexico, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, Singapore, Slovakia, South Africa, Spain, Sweden Switzerland, Taiwan, Thailand, Turkey, Ukraine, United Kingdom, United States, Venezuela, Vietnam, Zimbabwe Note: Countries in italics are developing countries 11