By Heather Berry, Aseem Kaul and Narae Lee
The pollution haven effect—firms taking advantage of lax environmental standards in foreign countries by shifting their manufacturing activities there—has been extensively documented in both economics and management as governments and firms consider the interplay between environmental regulation, innovation and global competitiveness. However, nearly all of this prior work focuses only on the owned foreign manufacturing operations of firms. This is potentially misleading. On one hand, while firms may invest in countries with weak environmental standards to substitute for production elsewhere, they may also do so because they want to grow their presence in these local markets. In such a case, analyzing firms’ manufacturing investments in countries with weak environmental standards would overestimate the pollution haven effect. On the other hand, firms seeking to take advantage of weak environmental standards abroad do not have to build their own plants in such locations; they can choose to source from third party suppliers based in these countries instead. In that case, looking only at firms’ manufacturing investments would underestimate the pollution haven effect.
In a study recently published in the Strategic Management Journal, we try to correct for these problems by looking directly at the effect of foreign environmental standards on both the owned and unowned global sourcing choices of US manufacturing firms. Using data from the U.S. Census that tracks imports from 77 countries across 82 manufacturing industries from 2006 to 2016, we study how a change in the stringency of a country’s environmental standards changes the share of an industry’s foreign sourcing from that country. To account for unobserved factors that may influence both environmental standards and sourcing simultaneously, we use an instrumental variable approach. Specifically, we use the increase in environmental standards among signatories to the first stage of the Kyoto Protocol (after that agreement goes into effect) to estimate the subsequent change in the share of US manufacturing sourcing from those countries.
Our analyses produce three sets of results. First, we find that as countries raise their environmental standards, their overall share of total sourcing in US manufacturing imports falls. Based on our estimates, a one standard deviation increase in a country’s environmental stringency is followed by a decrease of over $200 million per year in imports for an average industry. This suggests that as countries increase their environmental standards, they become less attractive sourcing locations, other things being equal.
Second, we find that this decrease is driven by sourcing from both owned manufacturing facilities and third party suppliers abroad, with the proportional decrease in share being roughly equal in magnitude for both types of sourcing. This is an important finding because imports from third party foreign suppliers make up nearly half of all manufacturing imports into the United States, so the fact that such imports are equally impacted by foreign environmental standards potentially doubles the true extent of the pollution haven effect, compared to prior estimates. This finding is also significant because prior work on the pollution haven effect has tended to focus on the choices of multinational companies alone. Our findings imply that even domestic firms—those that have no direct foreign operations of their own—may indirectly contribute to the pollution haven effect by choosing to source from third party providers in countries with weak environmental standards.
Third, we find that it is not only firms in highly polluting industries that take advantage of lax environmental standards abroad. While firms in industries with high levels of toxic emissions may be somewhat more likely to locate their own production in pollution haven countries, we find no difference between high and low polluting industries in their tendency to source from third party suppliers abroad. We also find that firms in technologically intensive industries may find it harder to change their own location choices to adapt to changing environmental standards, though they may still be able to take advantage of such changes by outsourcing from pollution havens.
Overall, our paper suggests that by focusing on multinational location choice rather than global sourcing decisions prior research may have substantially underestimated the magnitude and prevalence of the pollution haven effect. Firms seeking to benefit from weak foreign institutions change the locations of both their owned and unowned global sourcing in response to increasing environmental standards, controlling for changes in other economic and institutional conditions in the country. At the same time, our results highlight the importance of coordinated, multilateral efforts across countries to address environmental sustainability and climate change. Not only do countries that try to address environmental issues on their own risk paying a price for their actions in terms of exports, but their environmental efforts may be undermined by firms shifting their sourcing to other country locations.
- For the original article, see Berry, H., Kaul, A., & Lee, N. (2021). Follow the smoke: The pollution haven effect on global sourcing. Strategic Management Journal, 1– 31.
Heather Berry is a Professor of International Business and International Affairs at the George Washington University School of Business. Her research examines how the strategic and organizational choices firms make across product and geographic markets impact their success in each of these markets.
Aseem Kaul is the Mosaic Company – Jim Prokopanko Professor for Corporate Responsibility and an Associate Professor at the Carlson School of Management, University of Minnesota. His research focuses on the antecedents and consequences of corporate scope choices, and more recently, on the social impact of firms’ market and nonmarket strategies.
Narae Lee is a PhD candidate in Strategy and Entrepreneurship at the Carlson School of Management, University of Minnesota. Her research interests relate to firms’ nonmarket strategies and various factors affecting firm environmental performance.