Foreign Direct Investment (FDI) - investment by foreign companies in overseas subsidiaries or joint ventures - has a traditional reliance on natural resource use and extraction, particularly agriculture, mineral and fuel production. Though this balance has shifted in recent years, the poorest countries still receive a disproportionate amount of investment flows into their natural resource sectors.

The past decade has also seen all major trends of environmental degradation accelerate – for example, greenhouse gas emissions, deforestation, loss of biodiversity. Such patterns of environmental damage have been driven by increased economic activity, of which FDI is an increasingly significant contributor. Flows of natural resource-based commodities and investments are predicted to continue to rise faster than economic output. It is therefore critical to understand the environmental effects of FDI and identify appropriate responses.

Current debates on FDI and the Environment
Currently, much of the debate on FDI and the environment centres around the “pollution havens” hypothesis. This states that companies will move operations to developing countries to take advantage of less stringent environmental regulations. In addition, all countries may purposely undervalue their environment in order to attract new investment. Either way this leads to excessive levels of pollution and environmental degradation.

Generally, statistical studies show that this effect cannot be clearly identified at the level of aggregate investment flows. However, these studies have had serious flaws, and an excessive focus on site-specific environmental impacts and emissions of a few industrial pollutants. This report provides ample empirical evidence that resource and pollution intensive industries do have a locational preference for, and an influence in creating, areas of low environmental standards.

The report also argues that the pollution havens debate has produced policy stasis in this area by attempting to find simple empirical evidence to prove or disprove what is actually a complex and dynamic issue: how environmental regulation interacts with increasingly mobile production.

By asking the wrong question, and looking for the wrong evidence, the “pollution havens” debate has deflected discussion away from more important issues such as: the scale of economic activity relative to regulatory capacity and environmental limits; broad development/environment linkages; resource use and planning issues; and the complex policy and institutional failures linked to competition for FDI both between and inside regional trading areas.

As a result of this skewed debate, FDI is often glibly characterised as environmentally beneficial. Encouraging negotiators of economic agreements to argue against the need to introduce specific environmental clauses into international investment agreements. However, the economic growth produced by FDI is often fuelled at the expense of the natural and social environment, and the impact of FDI on host communities is often mixed in environmentally sensitive sectors.

The purpose of this report is to move beyond the pollution havens discussion, and examine the broad interactions between FDI and the environment. The main conclusions of the report are set out in two sections; the first summarising the analytical conclusions and the second outlining WWF’s policy proposals.

Analysis

Sustainable resource use is as important as the local environmental impacts of FDI
? A large proportion of FDI is concentrated in natural resource using sectors. In least developed countries this is the most important sector for FDI, even though current statistics underestimate its importance. Economic theories of sustainability show that economic growth and the proliferation of FDI will exacerbate existing unsustainable patterns of development unless matched by regulation. FDI must operate inside absolute sustainability constraints based on the need to preserve vital ecosystem functions.

? Given the inherent uncertainties and irreversibilities in making decisions about the environment, a precautionary approach to setting sustainability limits is necessary. Without limits in place even economically efficient use of resources is likely result in over-exploitation and over-pollution of the environment.

? When increased flows of trade and the investment exacerbate the existing inefficient use of scarce natural resources, economic benefits will be coupled with environmental and social costs; particularly to the most disadvantaged. Therefore the long term welfare implications of increased investment will be mixed in environmentally sensitive sectors.

? Attracting greater FDI in natural resource sectors is not an automatic route to  development. Strong regulatory systems are needed to ensure that rents from resource use are reinvested in productive capital, not wasted in luxury consumption. And that irreversible conversion of natural systems (e.g. forests, wetlands) is consistent with long-run sustainability and will give net societal benefits when all costs are accounted for.

? The transition to sustainability requires policies that often go against immediate economic incentives for higher resource exploitation and pollution. Institutional responses will always lag behind economic pressures in highly competitive global markets. It is important to act now to improve the environmental quality of FDI, and not wait for regulation in host countries to rise to adequate levels.
 

The sequencing of effective regulation, empowerment and liberalisation is vital
? The irreversibility of much environmental damage means that over-hasty liberalisation can result in long-run negative impacts if regulation in the host country cannot to respond to increased economic pressures. The sequencing of building regulatory capacity and liberalisation is vital, and a precautionary approach must be taken in sensitive areas. Where host country regulatory capacity is lacking, home countries have a responsibility to help improve this in advance of negotiations to open up new sectors to their investors.

? International financial institutions and export promotion agencies from source countries tend to operate in countries where all forms of governance are weak. They have a responsibility to review the investment they support for its direct and indirect environmental impacts, and reject or amend projects if necessary. The structure of current investment subsidies encourages capital intensive and damaging investment, and should be reformed to help promote more sustainable industries.

? The poor and marginalised groups disproportionately suffer any detrimental environmental impacts of investment. NGO’s and other civil society groups, from home and host countries, can play a vital role in articulating the interests of these groups. This role must be enabled by greater transparency in public and private processes surrounding investment decisions, and increased access to justice nationally and internationally.

? The scale, pace, and sectoral composition of FDI, coupled with the subsidies it receives, differentiates its impact on the environment from domestic investment in many countries. These differences argue for new policy mechanisms to lessen the environmental impact of FDI and strengthen host country regulatory capacity when needed.
 

Competition for FDI is clearly depressing and chilling environmental standards
? The effect of environmental costs on firm relocation must not be conveniently aggregated away as an insignificant determinant of total investment flows. There is clear evidence that, even though full environmental costs are not internalised, certain resource and pollution intensive industries have a preference for areas of low environmental standards. There is also evidence that host countries do not enforce standards in order to attract and retain investors, and that international investors have often encouraged such behaviour.

? In some sectors - particularly areas of high technology - there is support for the “pollution halos” hypothesis; where FDI raises environmental standards. However, for most industries factors such as age, size and community pressure are more important in raising standards than foreign involvement.

? The pollution havens and halos debate has not helped international policy move forward. It must be replaced by a more complex and policy relevant model of the factors determining investment location decisions, including choices between countries in the same trading region, and between different locations in the same country. Analysis of the effect of FDI on environmental regulation must also encompass both the competition for locating investment, and the credibility of threats to disinvest once established given available technologies, tariff barriers and market dynamics.

? The most significant effect of policy competition between, and within, countries may not be an overt “race to the bottom”, but the chilling effect on regulation and its enforcement. Currently, no country effectively internalises the environmental costs of economic activity. There are many clear examples of where competition for FDI has been cited as a reason for not introducing new environmental regulations or taxes.

Solutions

The “first best” solution to these problems is to increase host country capacity to regulate and construct international environmental standards. However, this is a long-run and uncertain process.  In the short to medium term the environmental quality of FDI should be raised by a set of attainable policy instruments. Higher quality FDI will support the development of host country regulation and improve the environmental performance of domestic industry, hopefully preventing any regulatory chilling by driving a race-to-the-top in regulation and performance.

Increased business responsibility is necessary for the transition to sustainability
? Business and industry must go beyond a position of basic “corporate responsibility”, and become “active corporate citizens” who help raise environmental standards inside the markets and communities they operate in.

? Ecolabelling is a powerful tool to promote more sustainable production practices in some consumer-sensitive natural resource sectors; such as forestry, fishing and tourism. However, binding minimum standards of environmental management and conduct across all sectors are also necessary to push standards upwards, and will help support high quality, economically sustainable ecolabelling schemes.
 

International economic agreements must not undermine environmental laws
? Environmental assessments of the draft OECD Multilateral Agreement on Investment (MAI) showed how international investment rules can conflict with both multilateral environmental agreements (MEAs) and national environmental laws. Any future international rules on investor protection must avoid such conflicts, and respect recognised principles of environmental law; such as the polluter-pays-principle, the precautionary principle and prior informed consent.

? The draft OECD-MAI undermined broader efforts to achieve sustainability by outlawing mandatory performance requirements on technology transfer, joint ownership and local content. Research shows these instruments can be powerful drivers for increasing the positive impact of FDI on the environmental performance of domestic businesses. WTO agreements on performance requirements must not repeat these mistakes .

? The draft OECD-MAI also conflicted with efforts to strengthen local control of resources, and reduced the ability of governments to gain fair benefits from natural resource use. Future investment agreements must support national and community sovereignty over natural resources, and give sufficient flexibility to national policy makers to maximise the benefits from sustainably developing their resource base.
 

New international regulation is needed to promote sustainable investment flows
? Voluntary, consumer or financial-sector driven initiatives can improve company behaviour – though experience is mixed and limited to date. However, a mandatory minimum floor to environmental conduct must be introduced to prevent the best firms being undermined by unscrupulous competitors. International rules should focus on environmental management processes, transparency and consultation. Such regulation, combined with incentives rewarding continuous improvement, will facilitate a “race-to-the-top” in environmental standards.

? Detailed binding regulation is needed in environmentally important non-consumer commodities. For example, minerals, fossil fuels, agricultural commodities and bulk chemicals. These industries have low profit margins and little opportunity to market improved environmental performance. Therefore, high standards of sectoral regulation - perhaps embedded in broad International Commodity Agreements - are needed.

? To support environmental best-practice by industry, governments must collaborate to eliminate costly competition based on lowering or freezing environmental standards. Fiscal incentives for FDI which distort incentives for efficient natural resource use should also be limited. Preventing such destructive competition requires international rules to limit financial, fiscal and regulatory incentives for FDI, and increased international assistance in building and maintaining regulatory capacity.

? However, top-down regulation by government is not sufficient to achieve sustainable and responsible investment. The role of local communities and civil society - in both home and host countries - must be strengthened to deter irresponsible corporate behaviour. This requires support for: investor transparency and reporting of environmental impacts; capacity building of civil society groups; and citizen’s access to justice against abuses by multinationals in the firm’s home country.

? Environmental sustainability can only be achieved inside a broader system that respects and enhances basic human and workers’ rights, and promotes good market structures. Priority should be placed on negotiating and strengthening international instruments to: promote fair competition; eliminate restrictive business practices; reduce bribery and corruption; and enforce core labour standards.
 

WWF's mission is to preserve biodiversity, reduce pollution and ensure the sustainable use of natural resources. The last decade has seen a rapid proliferation in FDI and related trade flows, but also unprecedented environmental destruction and depletion.

WWF believes international investment can bring substantial benefits, especially to developing countries, in terms of the transfer of resources (financial, technical and human). However, positive outcomes will only occur inside a international regulatory framework that promotes sustainable development and ensures environmental limits are preserved.

Earth Summit II in 2002, and the meetings of the UN General Assembly and Commission for Sustainable Development on trade and investment preceding it, present an opportunity to systematically examine the relationship between globalisation and sustainable development. This process provides an appropriate, legitimate and existing forum for negotiations on a broad framework for regulating international investment.

WWF believes that the most urgent areas for international negotiations on FDI are: binding standards for international corporate governance and behaviour; prevention of harmful forms of competition for FDI – including the lowering of environmental and core social standards; co-operation and co-ordination on market governance of FDI, including support for better regulation in developing countries; active promotion of appropriate forms of FDI to less developed countries.

Any negotiations on investment protection and liberalisation rules, either regionally or as proposed inside the WTO, should not proceed until this broader framework of principles, regulation and mechanisms has been determined and put in place. WWF does not believe that the WTO is an appropriate, legitimate or competent forum for developing such a framework.