Foreign direct investment and environmental policy. Have location factors been neglected?

This paper analyses the effect of asymmetric environmental policies on the international strategies of firms, when countries differ in terms of market size and barriers to trade and FDI have been removed. It contributes to the debate on the Pollution Heaven Hypothesis. A simple model with endogenous plant location is presented, considering both a symmetric and an asymmetric context. It is shown that, if countries have the same size and there are no other source of asymmetry, a more stringent pollution tax unilaterally adopted will always lead to some form of delocalisation. However, in an asymmetric context, if the more stringent environmental policy is introduced by the larger country, and unit transport cost is high as compared to the pollution tax, it is possible that the firm’s location choice will not change. The model suggests that environmental taxes should be industry specific, accounting for the geographical mobility of the industry. In addition, the analysis implies that environmental rules should not be uniform worldwide, but should take account of differences in countries’ market size and thus ability to attract production.