Environmental Regulation Induced Foreign Direct Investment

The last decade has witnessed a renewed interest in the relationship between environmental regulations and international capital flows. However, empirical studies have so far failed to find conclusive evidence for this so-called pollution haven or race to the bottom effect where foreign direct investment (FDI) is assumed to be attracted to low regulation countries, regions or states. In this paper we present a simple theoretical framework to demonstrate that greater stringency in environmental standards can lead to a strategic increase in capital inflows which we refer to as environmental regulation induced FDI. Our result reveals a possible explanation for the mixed results in the empirical literature and provides an illustration of the conditions under which environmental regulations in the host country can affect the location decision of foreign firms.