Are Foreign-owned Enterprises Disproportionately Harming The Environment In China?

Candace Williams Are Foreign-Owned Enterprises Disproportionately Harming the Environment in China? Introduction Over the past few decades, China has accomplished a level of industrialization and development that has taken other economies centuries to attain. The past 20 years, China’s GDP Per Capita has grown by over 3200% ($230 in 1975 and $7800 in 2007 by CIA estimates). With a growth rate of 11.5%, China is poised to surpass Germany as the third-largest economy by 2008. In 30 years, China has lifted hundreds of millions of its citizens out of poverty. China has accomplished these goals with state sector reform: state-owned enterprises (SOEs) are being replaced with collectively-owned and privatelyowned enterprises (COEs and POEs). Foreign Direct Investment (FDI) also accounts for China’s growth. In 2006, there were 41,485 FDI projects that were worth $69.47 billion dollars. Horrifying environmental woes mar China’s amazing economic achievements. In 2001, the World Bank reported that 16 out of the world’s 20 most-polluted cities are in China. In 2007, the World Bank announced that 760,000 people die prematurely each year because of air and water pollution, and that China loses 5.4% of its GDP ($160 billion) per year because of environmental degradation. The Chinese Ministry of Health says that cancer deaths in urban and rural areas have increased by 21% since 2005 as a result of air and water pollution. China’s State Environmental Protection Administration (SEPA) estimates that in 2000, industry accounted for 40% of China’s water pollution, and 80% of its air pollution. Consumption increases also present challenges. Communist Party of China General Secretary Hu Jintao spoke about the

Williams 2 environment at length during his October 2007 report to the 17 th National Congress of the Communist Party of China. For the first time, the report had a major focus on environmental protection via conservation and change of culture. The International Herald Tribune reports that during a ‘State of the Union’ style speech, Prime Minister Wen Jiabao referenced the “environment”, “pollution”, or “environmental protection” 48 times. In July 2007, Chinese authorities promised that the government would spend $175 billion over the next five years to cut pollution and improve air and water quality. These environmental goals exist alongside a national goal of quadrupling China’s 2000 GDP by 2020. Many experts say that China continues to sacrifice its environment for the economy. Historically, we have seen that countries exploit their resources during their development process and then use public funding to deal with environmental issues once they are affluent. We lack models for China’s current problem because China must deal with environmental issues while they are still relatively poor. Scholars, the media, and nongovernmental organizations question the role of FDI in China’s environmental issues. Some posit a “race to the bottom” scenario where foreign companies are attracted to places with few environmental regulations, and then create dangerous levels of pollution. Others say that foreign companies are efficient and have access to clean technologies. Furthermore, these companies may have the goal of reducing pollution since they do not want to waste raw materials. In this paper, I assert that FDIs are better than SOEs, POEs, or COEs at reducing pollution levels, and that the financial sector and citizens can provide an informal regulation system if there is a high level of transparency. First, I will analyze the costs of pollution to China’s economic and social well-being. Then, I will analyze literature that weighs the “race to the bottom”

Williams 3 hypothesis. Finally, I will explore new programs in China that capitalize on social capital and informal regulations. The Costs of Pollution Air Pollution Only 1% of China’s city 560 million city-dwellers breath air considered safe by the European Union (EU). The EU, United States, and international agencies say that between 40 and 50 micrograms of pollution per cubic meter of air is unsafe for human beings to breath daily. Last year, Beijing’s PM-10 level was 141 micrograms. Recent studies suggest that China has depressed its optimal crop yields by 30% because of rising temperatures and “brown clouds” that decrease the amount of sunlight that hits plants. Cancer is the leading cause of death in China’s urban areas. Air pollution in China is dangerous China’s economic growth. Premature death and poor health, declining food supplies, and forgone employment opportunities are issues that decrease China’s productivity and standard of life. China’s high levels of air pollution are driven by its reliance on coal and its transportation boom. The International Energy Agency says that China will be the world’s leading greenhouse gas producer while the Netherlands Environment Assessment Agency says that China is already the number one producer of greenhouse gases. China uses coal for over two-thirds of its energy needs and burns more of it than the United States, Europe, and Japan combined. Oil provides a quarter of its energy and ‘clean’ technologies such as wind and hydroelectric power provide less than 10% of its energy needs. Due to its heavy reliance on energy-intensive manufacturing industries and the under-pricing of coal and oil, China is six times more energy intensive per unit of national product than

Williams 4 the United States. Aside from the sheer number of coal-fired power plants and industrial furnaces, a major problem is that most of these facilities operate inefficiently with controls that the World Trade Organization, World Health Organization, the European Union, and the United States deem unhealthy. Many of these facilities were hastily constructed without adequate efficiency, safety, or health controls. China’s whole manufacturing process is very inefficient: to produce $10,000 worth of goods, China uses seven times the resources used by Japan, six times the resources used by the United States, and three times the resources used by India. This inefficiency is fueled by underpricing and subsidies given for fossil fuels and other goods and because China is still catching up in technological development and opening up innovation to market forces. China’s transportation boom is another source of air pollution: autos are the leading source of pollution in cities. Developers are working on over of over 57,200 miles of new highways to accommodate the 14,000 new (additional) cars that hit the roads each day (without official sanctions, Beijing has 3,000 new cars hit the roads each day). By 2020, China is projected to have 130 million cars on the road. As soon as 2040, China will have more cars than the United States. Most Chinese cars use low-grade gasoline and cars have not become more efficient over the past few decades. Water Pollution China has one-fifth of water per capita and five times the population of the United States. Water scarcity is already an issue without pollution. UNICEF says that 320 million people lack access to clean drinking water and half of the population has no access to sanitation. The north, home to half of China’s population, may become the world’s largest desert. Farmers and businesses have depleted aquifers and wells in an

Williams 5 attempt to irrigate. Increasing demand, pollution, inefficient use, and inefficient distribution of water resources have created a situation where 660 cities have less water than they need and 110 cities report severe water shortages. Some experts say that cities near Beijing and Tianjin could run out of water in five to seven years. The agricultural sector uses 66% of China’s water – it ends up wasting half of that and only contributing 13% to China’s GDP. China’s industries use 10 – 20% more water than similar industries in developed nations. Over 20% of all water is wasted due to leaky pipes. More than 75% of water that flows through faucets is deemed unsuitable for drinking or fishing and the government says that 30% of the water in rivers is unsuitable for agriculture or industry use. The World Bank finds that the Chinese government has failed to provide two-thirds of the rural population with water and that this is the leading cause of death among children under the age of five and is responsible for 11% of gastrointestinal cancer cases in China. Aside from inefficiency, failure to enforce restrictions means that individuals and industries dump waste into water supplies. Only 23% of factories treat sewage before dumping it. One-third of all industrial wastewater and two-thirds of household sewage remain untreated. The Yangtze and Yellow Rivers receive 40% of China’s sewage. Issues of water scarcity are exacerbated by climate change: reports on climate predict a 30% drop in precipitation. Political and Diplomatic Consequences Government officials and the public are aware of China’s environmental issues. Public unrest is a major political issue that destabilizes the government. Chinese officials say that there were over 51,000 environment-related protests in 2005 (over 1,000 protests

Williams 6 per week). Citizen complaint boards receive 30% more letters each year and complaints should top 450,000 per year in 2007. For example, in 2006, residents of six neighboring provinces in the Gansu Province protested zinc and iron smelters for many months because over half of the villagers had neurological problems from lead-related illnesses. Although many of these complaints and protests are peaceful, there have been episodes of violence and human rights abuses by the Chinese government. In 2005, 40,000 villagers from the Zhejiang Province torched cars and swarmed 13 chemical facilities. The government sent in 10,000 police officers and ordered the facilities to shut down. Environmental activists who tried to get the facilities to obey government orders were arrested. There is regional discontent. Provinces and cities are upset at the government. For example, politicians and residents of the Shanxi Province pays 11% of the province’s gross annual product while providing the country with coal. The city of Chongquing pays 4.3% of its gross annual product for health expenses related to water pollution. The worldwide impacts of China’s pollution devastating: 15% of sulfur deposits in South Korea and 50% of deposits in Japan are windblown from China. The Journal of Geophysical Research and the U.S. Environmental Protection Agency report that on some days, 25% particulate pollution in the atmosphere over Los Angeles originates in China. The World Wildlife Fund (WWF) says that China is the largest polluter of the Pacific Ocean. Many nongovernmental organizations say that Chinese multinational corporations are destroying the environments of other developing nations. The WWF says that China is the largest importer of illegally logged timber in the world (over 50% of its timber imports are illegal). Many politicians and scholars around the world are criticizing China’s role in global warming and climate change.

Williams 7 Overall Impact on Growth and Well-Being A key question to the debate about development and the environment is how much a nation should trade-off environmental health for development. Although China must exploit natural resources in order to develop, the costs of exploitation have reached a point of interference with goals of development. The well being of all Chinese citizens is impacted by environmental damage. Increasing health care costs, premature death, inefficient industries, increased natural disasters, and political instability lead to economic losses nearly as large as China’s trade surplus. China’s per capita GDP is still quite low and development has not reached every citizen: hundreds of millions of people lack a combination of clean water, sanitation, and food security. The opportunity cost of forgone development is extremely high. It is clear that industry and consumer behaviors have to be targets of policies. Privatization’s Impact on the Environment FDIs in China’s Ownership Structure China’s industrialization has included a shift from SOEs to POEs and COEs. The shift toward industrialization began in 1949 with the “Big Push” strategy of reducing consumption while giving high priority to heavy industrialization. In 1978, China began to shift away from Soviet-style central planning. This shift has continued over a series of 5-year plans. Decentralization and Interest Concessions gave more freedom and marketoriented structures to SOEs. In the late 1980s and the early 1990s, China moved to the Common Development of Multi-Economic Sectors. These reforms encouraged the development of the non-state economy. The Modern Enterprise System has encouraged the "marketization" of capital, labor, land, domestic trade, intermediary organizations,

Williams 8 and enterprises. The impact of these policies is apparent in China’s economic structure. Between 1978 and 2003, the contribution of agriculture decreased from 28.1% to 14.6%. Secondary industry (includes manufacturing and construction work) rose from 41.6% industry share to 52.2% industry share. The contribution of SOEs to the economy has dropped from 80% to less than 20%. POEs comprise 80% of China’s corporations, create 80% of all new products and 70% of all new technology innovation, and employ 70% of urban workers. Environmental policies must address how different types of enterprises contribute to pollution. The combined share of POEs and COEs increased from 0 to over 70%. FDIs are a type of POE. The number of FDI and joint-venture enterprises has increased significantly. In 2006, there were 41,485 FDI projects. Wholly-foreign owned enterprises accounted for three-fourths of the projects and most of the remaining ventures were equity-joint ventures. The value of these activities was $69.47 billion dollars. China has been the largest recipient of FDI in the developing world since 1990. Foreign Direct Investment and the Environment: Literature Review The “Race to the Bottom” The basis of the environmental “race to the bottom” theory comes from a situation in game theory, where the optimal outcome for the group is the result of cooperation amongst all members of a group, while the individual optimal outcome comes when one group does not cooperate while all others do. Applied to the environment, the argument is that although the world is better off if all countries try to decrease pollution, individual corporations will seek countries with no environmental regulations so that they have less operating costs and see more profit. Since the countries with no regulations are poor, the

Williams 9 corporations buy the consent of the developing country and exploit their natural resources. Extreme versions of this argument say that if this bottom-seeking behavior continues, the world will become full of pollution ghettos and as companies move out of developed nations with stricter regulations. In the United States, the model is espoused as a political objection to globalization and free trade. Political opponents of the World Trade Organization, the North American Free Trade Agreement, the General Agreement on Tariffs and Trade, and other globalization mechanisms are the primary asserts of the hypothesis. Academic literature from economics and political science tends to disagree with the theory. The Environmental Kuznets Curve The environmental Kuznets model says that pollution creates an inverted U-shape when compared to income. In the early stages of development, the level of pollution is low. As countries begin to develop, pollution levels steadily increase and peak. When countries reach a certain level of income, pollution levels drop. Although there is not strong statistical evidence that all environmental indicators take an inverted U-shape when compared to income, there is evidence that regulation increases with income. Hettige, Mani, and Wheeler (2000) study industrial water pollution using plant level data from 13 nations during the 1989 – 1995 time period.1 The researchers found that manufacturing share of output rises sharply through middle-income status and then slowly declines as nations reach affluence. The manufacturing share of output was the only measure that followed the Kuznets curve. The composition of sectors shifts to 1

The authors use OLS, fixed effects, and random effects to compare the impacts of income on manufacturing share of total output, sector-weighted pollution intensity, and EOP pollution intensity. Then, the authors use the results to simulate industrial pollution at different levels of economic development.

Williams 10 cleaner industries through middle-income status and then levels off. “End-of-pipe” (EOP) pollution intensities decline continuously with income. They found that EOP intensities decline continuously because higher wage levels and income are correlated with stricter regulations. Dasgupta, Mody, Roy, and Wheeler (1995) had similar findings about the correlation between regulation and income.2 The authors find a strong positive correlation between environmental regulations and income. The income elasticities of the indices were positive and highly significant. The income elasticities suggest that land and living space regulations precede water regulations, while air pollution regulations are the last to come about and income increases. Using data from complaint systems in China, Dasgupta and Wheeler (1996) estimate the incidence of complaints using data from The China Environment Yearbook (1987 – 1993) and China Statistical Yearbook (1987 – 1993). Using dependent variables the control for the amount of visible and invisible pollution, region, level of education, and income, they find that the incidence of complaints is positively related to the willingness-to-pay for environmental improvement, that people complain more as income rises (even when the opportunity cost of time rises with income), and that the education level of citizens is a major determinant of their propensity to complain. Increases in income seem to coincide with increases in formal and informal regulation. This study also complements findings about the high costs that companies face when there is informal regulation (complaints, rioting, etc).3

2

The authors used comparative indices created from a multidimensional survey of 31 nations (randomly selected). The researchers compared the scope of regulation (of air, water, and land pollution) to income, political economy, and institutional variables. 3 Pargal and Wheeler (1997) use plant-level data from Indonesia for 1989-1990 (this is the time before nationwide environmental regulation came into effect). They find that the costs of informal regulation are high when communities are educated, relatively affluent, and when plants are visible to the community.

Williams 11 The “Race to the Bottom” and Misinterpreted Incentives There is also evidence to suggest that the “race to the bottom” hypothesis does not capture the incentives that businesses have to adopt clean practices. Proponents of the “race to the bottom” hypothesis overestimate the costs of abatement to firms. Firms that are based in OECD companies seem to have low abatement costs and high costs when they

fail

to

follow

environmental

standards.

Governments,

nongovernmental

organizations, police companies from OECD countries and capital markets. Also, there are benefits associated with efficient use of raw materials and having a high internal standard that allows efficiency technologies to impact all levels of production. Dean, Lovely, and Wang (2005) studied Chinese FDIs and the “race to the bottom” hypothesis.4 They found that all joint venture projects are attracted to provinces with low levels of state ownership, high concentrations of foreign investment, abundant stocks of skilled workers, potential local suppliers, and special incentives. The only joint ventures that were attracted to provinces with low levels of environmental levies were highly polluting industries with partners from Hong Kong, Macao, and Taiwan. Joint ventures with partners from OECD sources were not attracted by low environmental levies (even if they were highly polluting industries. In a microeconomic analysis of abatement alternatives in China, Dasgupta, Wheeler, and Wang (1997) find that pollution control policies targeted on particulate and SO2 emissions are cheap. For example, their analysis of Zhengzhou found that abating one ton of SO2 would save .63% of a statistical life and 4

The authors studied 2,886 manufacturing joint venture projects with data from 1993 – 1996. Sub-samples were taken from joint ventures of Chinese origin and projects from foreign countries. A conditional logit was run with variables for industry type, source country, location, total levies collected, amount of skilled and unskilled labor, FDI value, technology and transportation level, state ownership level, and variables to proxy economic development.

Williams 12 yield a social benefit of $50. The cost of abating one ton at the current emissions level was $1.70. Abatement remains socially profitable until about 73% of current emissions are eliminated. Analysis of pollution charge programs in Columbia and Malaysia show that factory managers find that cleaning up is cheaper than paying low-level charges. Studies of Indonesian water pollution regulations found that 80% of multinational plants were fully compliant with standards compared to only 30% of domestic plants (Afsah and Vincent 1997). There is also evidence that the private status of FDIs influences their level of pollution. FDIs are not bogged by the inefficiency of SOEs. Wang and Jin (2002) collected extremely detailed plant-level data from the Danyang of Jiangsu Province, Liupanshui of Guizhou Province and Northern Tianjian Municipality. All major industrial cites were included in the sample. Output, material inputs, environmental complaints, pollution control efforts (from the state, community, and the firm itself), and other information was collected for the year 1999. The researchers found that SOEs have the worst environmental performance followed by domestic POEs. The best performers were FDIs. Domestic COEs performed better than SOEs and domestic POEs but did not match the performance of FDIs. Informal regulation from financial markets may explain OECD multinational compliance. A study by Dowell, Hart, and Yeung (2000) finds that 60% of US-based manufacturing and mining multinationals with branches in developing nations have internal pollution standards that reflect OECD norms.5 The study also found that these firms that follow OECD standards have a market value that is at least $10.4 billion higher 5

The study controls for the physical assets, capital structures, and other characteristics of plants.

Williams 13 than their counterparts. Gupta and Goldar (2003) find evidence that sock markets punish multinational polluters in India.6 Modeling abnormal returns after the announcement of ratings, the authors find that announcement of weak environmental performance leads to negative abnormal returns that are 30% lower than firms with average rankings. Positive abnormal returns are positively correlated with stock and environmental performance. Konar and Cohen (1997) and Dasgupta, Laplante, and Mamingi (1997) also find evidence that financial markets provide strong incentives for firms to follow environmental standards. Literature Review Summary The pollution-haven hypothesis does not hold in the literature for multiple reasons. First, pollution control is not a large cost for most private firms. Previous research shows that compliance costs for OECD industries are small even when there are command-andcontrol regulations that cause inefficiencies. Even big polluters create scale economies when it comes to pollution abatement: per unit of pollution control costs are low. Pollution control costs are so small that they alone they are not enough incentives to move to regions with low regulations. Another reason why the hypothesis is unrealistic is because it does not take community-level penalties into account. Informal controls create high costs for multinationals in communities with relatively high levels of education and income (precisely the communities that FDI projects are attracted to) and communities where plants are highly visible. Furthermore, OECD multinationals are policed by NGOs, the media, and capital markets. Abatement also reduces costs from informal regulation in the community. Pollutants are production residuals that are a result of inefficiencies. 6

The authors used NGO ratings from 31 large pulp and paper plants, 29 automobile manufacturers, and 25 chor alkali firms.

Williams 14 Firms do not want to waste raw materials. Discussion: What can we learn from the relative success of FDIs compared to SOEs, POEs, and COEs? It is clear that informal regulations can influence the decision-making of firms. Research about pollution complaints shows that citizens in communities that are relatively well-educated, out of poverty, and have firms that are visible in the community are more likely to utilize complaint systems. Wang and Di (2002) explore the determinants of government environmental performance at the level of townships (the lowest level of the government hierarchical structure). The authors find that show that public pressure is a large incentive for township governments to improve enforcement records, and increase the level of environmental services provided. 7 If a certain firm employs a many people in a township, there is a negative impact on regulatory enforcement, but a positive influence on the number of environmental services provided. Firms that offered higher wages to employees were subject to stronger environmental enforcement and received less environmental services. Citizens exert public pressure by making phone-calls to leaders, writing letters, and visiting government offices. The media also plays a significant role in pressuring local townships. Industries exert pressure over townships because many of them are collectively owned by the township itself or provide a township with substantial economic activity. Public pressure may outweigh industrial pressure when the social harms of pollution are so high that there is unrest and high costs. China has been developing the GreenWatch program. The GreenWatch program 7

The authors use information from 85 townships and 151 township government leaders in three provinces. The dependent variables include type of industry, current level of pollution, the level of privatization, and other characteristics of the firms and communities.

Williams 15 uses a five color rating system (green, blue, yellow, red and black) to rate the environmental performance of firms. The media shows these ratings to the public. China says that it will expand the program to every city by 2010 (it has been implemented in 22 municipalities so far). The creators of GreenWatch believe that ratings provide an incentive for improved environmental performance since firms value their public image. Firms may take initiative in regulating themselves if they feel that it will help them market their brand. The public expectation of ratings could also provide an incentive for regulatory institutions to keep accurately records and disseminate information in a timely matter. Also, other actors in the economy may exert pressure over firms. For example, bankers may not lend to firms that consistently receive low ratings out liability fears. Investors would have a tool to weigh the costs of regulatory penalties and liability settlements. The GreenWatch program also provides firms with an evaluation tool and decreases the costs of monitoring. The whole program rests on the idea that China has weak environmental regulation because citizens have insufficient access to information. This program is in line with studies like Dasgupta and Wheeler’s (1996) that find a positive correlation with level of education and the propensity to complain. Welleducated people may utilize complaint services more because they understand the negative impacts of pollution and have sources of information that uneducated people do not have. There have been generally positive results from GreenWatch and similar programs from other developing nations. Wang et al (2002) studied the impacts of GreenWatch on the Hohhot and Jiangsu Provinces. The researchers found that prior to the release of ratings, many firms tried to improve their performance. Even though Hohhot and Jiangsu

Williams 16 are at opposite levels of economic development, the researchers found that pollution was significantly reduced in both programs. In Zhenjiang (Jiangsu Province), firms improved their performance before the ratings were announced: the number of ‘superior performers’ doubled from 31% to 62%. In Hohhot, enterprises ranked “good or better” increased from 24% to 62%. GreenWatch is modeled off of the Program for Pollution Control, Evaluation, and Rating (PROPER) in Indonesia. A study of PROPER’s first run in 1995 shows that the lowest rating contracted by over 50% when the media announced negative environmental ratings (Wheeler 1999). China has to merge official regulations with pressures from communities, financial markets, and civil society. Public-sector agencies with the ability to measure pollution levels and report information are an important tool. These organizations must be built in ways that promote transparency and provide services to both manufacturers and communities. Any trade and aid sanctions from foreign countries must assess the pollution levels of individual firms and assess penalties accordingly. These forms of sanctions seem problematic since FDIs, the only companies with an international stake, are the least-problematic enterprises.