The last decade has witnessed a six-fold increase in Foreign Direct Investment (FDI) - investment by foreign companies in overseas subsidiaries or joint ventures. With all major trends of environmental degradation accelerating over the same period – be it greenhouse gas emissions, deforestation, loss of biodiversity – it is vital that the links between FDI and the environment are clearly understood.

Research by WWF shows that the interactions are complex: they can be both positive and negative. In many cases FDI has had large negative impacts; especially in natural resource sectors that form the largest proportion of investment flows to least-developed countries. WWF recognizes that FDI can bring substantial benefits, particularly in developing countries. However, such positive outcomes only occur inside an international regulatory framework that actively promotes sustainable development.

Efforts have failed, most notably through the Multilateral Agreement on Investment, to promote FDI by limiting the ability of sovereign governments to discriminate against, or limit the actions of incoming investors. The OECD-MAI collapsed because the major extensions of investor protection intruded into many areas of national decision-making. Any agreement on investment must recognise the necessary limits to liberalisation in a systematic and coherent manner, which subordinates investor rights to legitimate national sovereignty and the achievement of sustainable development.

Actual FDI flows are highly liberalised in most countries. Problems arise because FDI is under-regulated and countries are damaging themselves to attract new investment. WWF believes that the most urgent areas for international negotiations on FDI are: binding standards for MNC behaviour; prevention of harmful competition for FDI – including lowering environmental and core labour standards; co-operation on market governance of FDI; and active promotion of appropriate FDI to less-developed countries.

Earth Summit 2002, and the meeting of the UN Commission for Sustainable Development on investment in 2000, present a real opportunity to examine the relationship between FDI and sustainable development. These discussions should agree a broad framework for regulating FDI, and decide priorities for negotiations inside the UN system. Any negotiations on investment liberalization, rules should not proceed until these priorities have been determined and regulation put in place.
 

1. Foreign Direct Investment and Sustainable Development

The last decade has seen Foreign Direct Investment (FDI) increase over six-fold, but also an unprecedented increase in environmental destruction and depletion. WWF has carried out extensive research on the impacts of FDI on a country’s prospects for sustainable development that forms the basis of this paper. This is published in a new report: FDI and the Environment: from pollution havens to sustainable development; available at www.wwf-uk.org. The research shows that the links between FDI flows and the environment are highly complex.

Current policy ‘’consensus’’ often portrays FDI as a springboard for economic growth in developing countries through boosting their productive capacity, enhancing their competitiveness and creating positive “spill-over effects” from the transfer of technology, knowledge and skills into domestic firms. However, the positive impacts depend on a number of national factors, including strong domestic regulation. There are a number of examples where investment has taken place at such a scale and pace - in the maquiladro zone in Mexico, the mining sector in South East Asia - that it has overwhelmed host country regulatory capacity, resulting in inefficient and irreversible environmental destruction, and a potential decline in overall welfare [1].

The impact of FDI on a country’s prospects for sustainable development will also depends on the sector where the investment is taking place. Less developed countries still receive a disproportionate amount of investment flows from their natural resource sectors. For example, 52% of FDI flows to Africa from France are in the primary sector, and the figure is 53% for the United States. FDI in the primary sectors do not provide the host country with the same benefits as manufacturing or services; and indirect spill-over effects in particular may be negligible. In addition these sectors are prone to rent-seeking activities with potentially pernicious, irreversible impacts on the local social and natural environment.

The link between FDI in these sectors and balanced development is not clear, as Joseph Stiglitz, chief economist of the World Bank, stated of the transition economies:

“Let us be clear: it is not hard for a country rich in natural resources to find investors abroad willing to exploit those resources, especially if the price is right. Far more difficult, however, is creating an industrial or service based economy. In 1994, foreign investment in manufacturing was a mere 7 per cent, compared with 57 percent in natural resources. By 1997, non-natural resource investment dropped to a mere 3 percent.”  ABCDE Conference, Valdivia; June 24, 1999

Much of the debate on FDI and the environment has focused on the ‘’pollution havens’’ hypothesis, and the search for evidence that industries from industrialized countries move to countries with lower standards. Though aggregate studies do not seem to show regulation is a primary cause of relocation, detailed studies in key sectors show clear examples of this effect; for example, in the tanning industry in Brazil; phosphate manufacturers in North Africa [2].

However, the most pronounced effect of competition between countries to attract FDI is the ‘’chilling’’ of the development of environmental regulation. Countries fear taking unilateral action to raise environmental standards and risk losing a competitive edge to rival firms in other, less regulated countries. Threats of industrial location have defeated or weakened proposals on energy taxation in the UK, US, EU and Australia. To lure foreign investors countries are offering ‘’financial incentives’’ that often have negative environmental impacts.

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

2. Reforming International Investment agreements: Removing Barriers to Sustainable Development

Most binding investment agreements at the international level are instruments for investor protection (compensation for expropriation), investor treatment (national treatment, outlawing performance requirements) or increasing the access of foreign investors to certain sectors (sectoral liberalisation, removal of technical barriers).

Outside regional economic agreements such as NAFTA and the European Union, the primary instruments for achieving these deregulatory objectives have been Bilateral Investment Treaties (BITs) signed between two sovereign states. In 1997 there were 1,517 BITs, up from around 500 in 1989. Several areas of investment liberalisation and investor treatment are also dealt with in the General Agreement on Trade in Services (GATS) and the Trade Related Investment Measures agreement (TRIMs), administered by the WTO.

The proposed OECD Multilateral Agreement on Investment (MAI) would have combined the most “investor-friendly” parts of previous agreements, inside a framework aimed at total liberalization with direct investor-state dispute settlement. A similar, if less far-reaching, agreement has been proposed in the next round of WTO negotiations. These instruments aim to promote greater FDI by limiting the ability of sovereign governments to discriminate against, or limit the actions of, incoming investors, and by providing more investment protection than is available in national courts. The lowering of risks to investors should then stimulate greater overall investment flows.

However, most empirical evidence gives little support for a causal linkage between countries signing strong international investment rules and increased FDI flows. The destination of FDI is mainly driven by market growth and access to cheap factor inputs. China receives 40% of FDI going to developing countries, despite having restrictions on foreign ownership, performance requirements and an unreliable legal system.

Over the last decade many economies have opened up to foreign investors. Over 90% of recent unilateral changes in investment laws – mainly in developing and transition economies - have been liberalising, not restrictive. The main ‘’value added’’ of further liberalization to capital exporters would be to lock in these liberalisation measures, and to progressively roll-back other restrictions.

The form of existing investment promotion agreements sets a framework of legal parity (national treatment) where foreign investors cannot be treated less well than domestic ones, but may be treated better. There is no attempt to assess the economic parity between foreign and domestic investors, or whether competition would be “fair” based on factors such as capitalisation, size, technology, brand name, etc.

In order to accommodate issues of economic imbalance, or to preserve other national policy goals – for example, to assist cultural, community or fledgling industries - investment agreements allow “flexibility” in their provisions. This may be achieved in different ways, such as explicitly nominating those sectors to which the agreement applies, or specifying exceptions from its provisions.

However, the relative bargaining power of the countries in the negotiations decides the extent of flexibility that can be agreed. There is no rational framework for comparison, though general exceptions for national security are usually included. The OECD-MAI negotiations collapsed because these conflicts between liberalization and national policy flexibility could not be resolved.

Both theory and practice show that the extent of liberalisation must necessarily be limited by other policy goals, especially in the absence of adequate international and domestic regulation. Each sphere of sustainable development – economic, social and environmental – requires international markets to be limited to some extent. The needs of development, competition and human rights justify limits in the economic arena; maintenance of local cultural diversity and community economic control may necessitate limits in the social arena; potential irreversible impacts and maintenance of communal-use rights provide a rationale for limits in the environmental sphere.

Investor protection and liberalisation agreements must recognise the necessary limits to liberalisation in a systematic and coherent manner, which subordinates investor rights to legitimate national sovereignty and to the achievement of sustainable development.
 

3. Setting a New Agenda: Priorities for International Rules on Investment

Any problems with FDI do not come from over-protection and over-regulation, actual FDI flows are highly liberalised in most countries. Problems arise because FDI is under-regulated and countries are damaging themselves to attract new investment. The “first best” solution to these problems is to increase host country capacity to regulate and construct international environmental standards. Due to economic imparity between between developed and less developed countries, the former have a responsibility to increase official assistance to build such regulatory capacity. This support could be directly linked to rising investment flows and commitments under existing or new international investment agreements.

However, this is a long-run and uncertain process. In the short to medium term the environmental quality of FDI can be raised, and prospects for sustainable development improved through a set of attainable policy instruments. These include,

Mechanisms to divert appropriate investment to least-developed countries:

? The bulk of FDI flowing into developing countries is in natural resource or pollution intensive industries. Greater efforts must be made to divert foreign capital into the manufacturing and services sectors. This could include discounted investment guarantees to LDCs in non-natural resource sectors, removing tariff-escalation on processed products and the promotion of ethical investment funds.

? Investor agreements must recognise the necessary limits to liberalisation that subordinates investor rights to legitimate national sovereignty and to a country’s achievement of sustainable development. Given that domestic firms are often at a competitive disadvantage to foreign investors host countries must be given greater policy flexibility to build fledgling industries or to protect community based or small-scale initiatives in line with their development priorities.

? The benefits host countries receive from performance requirements placed on incoming investors - for example joint ventures, hiring of local personnel and mandatory technology transfer provisions - must not be eroded by further liberalization; for example as would have happened with the OECD MAI proposals. To ensure that countries receive a fair rent on their natural resources investors must be required to pass at least part of these rents to the sovereign authorities.

Increased business responsibility:
 
? Large multinational companies (MNCs) carry out the bulk of FDI, and are at the very core of global environmental concerns. With the knowledge and resources to operate to high environmental standards 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 for promoting more sustainable production practices in some consumer-sensitive natural resource sectors, such as forestry, fishing and tourism. Lessons learnt from the Forest Stewardship Council highlight the importance of demand side measures in purchasing countries - supplier agreements, education, public policies, information packs – in producing sufficient demand to make a real impact on mainstream corporate behaviour.

New international regulation:

? Initiatives driven by the voluntary, consumer or financial sectors 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 of 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.

? 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.

Broader economic and social governance:

? Environmental sustainability can only be achieved inside a broader system that respects and enhances basic human and workers’ rights, promotes good market structures and compatible with existing national and international strategies for sustainability. 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.

The implementation of such a framework will occur at different levels - multilateral, regional, and national and through many different institutions; for example new international agreements, changes to existing regional and bilateral treaties; or through complimentary actions in home and host countries. However, to be effective they will have to be coordinated to avoid some countries attempting to free-ride on the actions of others, or the competitiveness argument being used as a reason for inaction.

Therefore, an overall strategic approach is needed which identifies appropriate actions at different levels of governance, identifies any existing gaps, and sets timetables and deliverables for implementing agreed common goals (in a similar way to the OECD Bribery Convention). The only forum with the breadth of competence to take this work forward is the United Nations system.

Earth Summit III 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. In such a fora all countries have an adequate opportunity to consider their priorities in this area and decide the scope, composition and timing of any new negotiations and related initiatives.

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. WWF does not believe that the WTO is an appropriate, legitimate or competent forum for developing such a framework.
 
 

The recommendations of this paper are based on research carried out by WWF-UK. The paper entitled: FDI and the Environment: from pollution havens to sustainable development, can be found on the WWF webite www.wwf-uk.org

For queries on this paper please contact: Richard McNally
WWF-UK Weyside Park, Catteshall Lane, Godalming, Surrey GU7 1XR

References:

[1] MPI - Mining Policy Institute (1998), Trade Liberalisation, Mining Investment and the Impacts on the Environment and Related Social Issues, Sydney, MPI

[2] Demandt, I. (1999), The World Phosphate Fertiliser Industry, A Research Project for the EU on Environmental Regulation, Globalisation of Production and Technological Change, United Nations University, Institute for New Technologies, Brussels.
Knutsen, H.G. (1999), “Leather tanning, environmental regulations and competitiveness in Europe: A comparative study of Germany, Italy and Portugal”, F.I.L Working Papers, No 17, University of Oslo, Oslo.