International Investment Rules and the Environment

Key Points

  • International competition for investment keeps environmental standards
    “stuck in the mud.”
  • With the right set of global rules, foreign direct investment could
    be a channel for ecologically sustainable economic development.
  • In the coming decade, U.S. policy will be decisive in shaping International
    investment rules.

The governance of international capital flows will be one of the key
environmental policy issues of the next decade. Along with labor, human
rights, and other social advocates, environmentalists are increasingly
demanding that international rules and corporate norms governing investment
explicitly embrace environmental and social performance goals.

The 1990s witnessed a sea change in the pattern of international capital
flows. In 1990, official sources accounted for more than half of international
capital flows to developing countries. By 1995, over three-quarters came
from private sources. The biggest story was the explosion in portfolio
(equity and debt) investment, which soared from $5 to $61 billion from

The growth of foreign direct investment (FDI) is equally dramatic. From
1990-95, the volume of FDI flows to developing countries nearly quadrupled.
Reflecting a strong “rich country bias,” the lion’s share of
FDI still flows between G-7 countries. Nonetheless, developing and transition
countries, especially China, have become important FDI recipients.

The surge in FDI has been propelled by global and national moves toward
trade and investment liberalization. According to a recent UNCTAD (UN
Conference on Trade and Development) report, 95% of the 599 changes in
laws and regulations governing FDI in developing countries between 1991
and 1996 were directed toward liberalization.

Given the lack of effective state regulation in many developing countries,
the explosion of FDI has triggered a hot debate about how to govern global
investment. The debate revolves around assessments of environmental and
social impacts of FDI in both home and host countries. The key question
is whether—and at what pace—globalization will induce standards
to harmonize upward or downward.

Environmentalists argue that, given the current lack of national and
global regulation, the gravitational pull is decidedly downward. Gaps
in standards either draw the dirtiest OECD (Organization for Economic
Cooperation and Development, composed of the world’s 29 wealthiest countries)
industries to developing countries or encourage foreign firms to pollute
once they get there. In either case, the effect is the creation of “pollution
havens”. In addition, local and/or national policymakers and communities
compete intensely to attract or retain FDI, especially by powerful transnational
corporations (TNCs), which are increasingly establishing global production
and supply networks. Less onerous or “more flexible” environmental
regulation is a locational bargaining chip. The result? A “race to
the bottom” in environmental standards, as OECD countries struggle
to keep TNC investment at home.

Proponents of free markets counter that FDI is good for the environment,
because it diffuses cleaner technology and best management practices,
thus creating “pollution halos.” Moreover, “green consumers”
in rich countries increasingly demand better environmental performance
from poorer countries. Free-marketeers thus contend that national policies
and global investment rules promoting maximum openness to FDI will drive
an upward process of harmonization, with developing-country standards
and performance racing toward higher OECD levels.

The problem with the “halo” perspective is that, even under
the most optimistic scenario, environmental progress is likely to be slow
and incremental—too slow to significantly alter clear trends toward
severe ecological degradation. Though they help to promote technological
innovation and diffusion, the relentless pressures of neoliberal international
competition mitigate against bold policy initiatives to significantly
move toward sustainable economic development paths. On the other hand,
it is likely that strong popular demands to maintain environmental quality
will remain politically and commercially salient in OECD countries. Environmental
standards may be pulled downward incrementally, but are not likely to
slide down dramatically or across the board.

Thus, rather than racing anywhere, the most likely pull of globalization
on environmental standards—under an investment regime guided by neoliberalism—is
toward sluggish and slow change. Environmental standards are “stuck
in the mud,” with policymakers and corporate managers alike looking
over their shoulders at what their competitors are doing. To get out of
this “prisoner’s dilemma” and move beyond incremental improvement,
international collective action will be required to lift environmental
standards for industry at a global level. This will entail establishing
global rules for investment—including for industrial sectors—that
explicitly embrace environmental performance goals.

Problems with Current U.S. Policy

Key Problems

  • The U.S. has pursued investment liberalization without considering
    environmental or social impacts either at home or overseas.
  • U.S. policy is based on two unproven tenets: that, on average, FDI
    is good for the environment and that voluntary self-regulation is the
    best way to raise corporate environmental performance.
  • The evidence shows that the environmental impacts of FDI are context-dependent
    and that effective regulation is key to corporate environmental performance.

Current U.S. policy rests squarely on neoliberalism—dismantling
national barriers to international trade and investment and creating global
commercial disciplines while leaving the social and environmental regulation
of markets to nations.

U.S. foreign policymakers, however, are not wholly insensitive to environmental
concerns. The Office of the U.S. Trade Representative has a section devoted
to natural resources and the environment. At the World Trade Organization,
the U.S. has been viewed as a leading environmental proponent—at
least when it suits U.S. commercial interests. In keeping with its overarching
commitments to neoliberalism, U.S. investment/ trade-environment policy
has two tenets: 1) liberalization is, on average, good for the environment;
and 2) the best way to increase TNC global environmental performance is
through voluntary corporate self-regulation.

What is the evidence that these tenets are valid? In a recent literature
review, the OECD found that FDI generates both positive and negative environmental
impacts at the micro (that is, plant or local) level. However, the OECD
identified a significant research gap on the ecosystem-wide scale or macro
effects of FDI, especially of FDI-induced increases in income. Free-marketeers
have made much of two studies by economists Gene Grossman and Alan Krueger
showing that environmental quality rises with income, once per capita
income reaches about $5,000-8,000. Richer consumers, for example, are
able to buy better cars, reducing air pollution.

These studies, however, utilize narrow indicators of local environmental
performance, e.g., measures of urban air and river pollution in Mexico.
They ignore a range of other environmental impacts that have been shown
to increase with affluence, including bioaccumulating toxic and hazardous
wastes, the loss of biodiversity/habitat, and atmospheric pollution. Raising
incomes in developing countries should be a central goal of global investment
rules, but it will not, of itself, put economic development on an ecologically
sustainable footing.

Moreover, foreign firms apparently do not consistently perform better
in developing countries. In some sectors, notably energy, foreign firms
are likely to have superior technology or close links to “green consumer”
markets. Both foreign and domestic firms seem to be incrementally improving
their environmental performance in many parts of the world, primarily
due to national regulation and/or local community pressure. For the most
part, foreign links, including export markets and plant ownership, seem
to make little difference to firm performance. Though FDI may offer benefits
in particular sectors in particular countries—for example, cleaner
energy technologies in China—there is no discernible, broad “pollution

There is some evidence that green consumers in Europe and North America
are using ecolabels to positive effect, especially concerning sensitive
resource-based products like timber and bananas. The improvements, however,
have been incremental. The “Eco OK” label, for Costa Rican bananas
allows European consumers to reward producers who reduce agrichemical
inputs and improve worker health and safety. However, it does not stem—and
may even promote—the widespread ecological damage caused by monocultural
banana production. Thus, even the halos that do exist are apparently pretty

On the other hand, there is little evidence to support the “pollution
haven” hypothesis, at least in terms of the industry-location variable.
Differences in environmental standards seem to have little influence on
where firms locate, probably because costs of compliance with environmental
regulations are low. However, there is substantial evidence of poor environmental
performance by foreign companies in developing countries. Indeed, in some
cases, FDI has generated egregious local and even national ecological
degradation with severe impacts on human health—oil exploration and
drilling in Nigeria and the Amazon, minerals extraction in Indonesia and
the Philippines, chemical plant explosions such as in Bhopal. Thus, although
foreign firms may not be drawn to relocate by lower standards, they may
perform like environmental renegades once they get there.

There is also substantial case-study evidence that local policymakers—from
Costa Rica to China to California—are sensitive to the potential
effects of higher environmental standards on TNC investors. They may not
weaken standards, but they may not enforce them either, and they certainly
hesitate to raise them.

This mix of demonstrated impacts mitigates against any overarching conclusion
about the effects of FDI “on average.” There is no average;
performance is context-dependent and other things are far more important
than ownership. If a goal of U.S. foreign policy is to promote ecologically
sustainable development on a global basis, then what is needed is effective
collective regulation of industry that addresses both the “micro”
and “macro” ecological impacts of international investment.

What about the efficacy of corporate self-regulation? As yet, there are
few in-depth studies, and research is hampered by the reluctance of companies
to disclose environmental performance data in either domestic or overseas
operations. Early evidence from the U.S., however, suggests that experiments
to give more regulatory flexibility to corporations, especially in the
high-tech sector, have fallen short of expectations. Without better company
disclosure and third-party monitoring, self-regulation will be doomed
to the realm of public relations-type claims—including by U.S. policymakers—that
lack credibility.

Toward a New Foreign Policy

Key Recommendations

  • The U.S. should articulate a clear set of goals for international
    investment policy via a widespread public policy debate.
  • U.S. policy should veer away from a single-minded focus on liberalization
    and be grounded in a policy framework that integrates environmental,
    social, and security objectives.
  • The U.S. should pursue domestic policy innovations in corporate governance,
    such as mandatory information disclosure and third-party verification,
    which increase the environmental and social accountability of U.S. TNCs.

The U.S. will play a decisive role in shaping the regulatory architecture
for international investment. To shoulder its global role responsibly,
Washington must first clearly define its policy goals. In the MAI (Multilateral
Agreement on Investment) process, which the U.S. initiated and led, environmental
and social concerns were initially not even on the radar screen. Even
after a storm of public criticism, environmental issues made only a minor
appearance. Yet the evidence shows that regulation—or the lack of
it—matters. Foreign investment, both direct and portfolio, could
act to promote ecological sustainability, which is—or should be—a
strategic U.S. foreign policy goal.

U.S. policy on international investment should thus not veer toward short-term
commercial gain via liberalization but should be based firmly on a wider
set of integrated economic and environmental, as well as security and
social, objectives. Policy goals should be clearly articulated—via
a process of wide public debate and consultation—and implemented
by all the relevant bureaucracies. How investment is governed globally
has impacts not only for business and for the environment but for international
peace, human rights, and social justice.

To promote sustainable development, U.S. policy should thus aim not only
to define and enforce environmental standards but to increase the flow
of economically beneficial foreign investment to developing countries,
especially the poorest. It should also aim to reduce beggar-thy-neighbor,
conflict-enhancing competition for FDI, and it should promote human rights.

The challenge, then, is how to channel investment toward sustainable
development. First, it is clear that regulation matters. Though local
and national regulation are important, there is a great need for an overarching
global framework to define and raise investor environmental responsibilities.
Located within a set of global or regional rules governing investment,
environmental norms would likely best be defined at the level of industrial

Global environmental rules for industry should embrace both process and
performance standards. Process standards include mandatory environmental
impact assessment and mitigation. International baseline performance standards,
such as those developed by the World Bank, set caps on specific pollutants.
Effective international standards should be minimum standards that countries
and companies can exceed if they wish, and they must be set high enough
to have a real impact. The formulation of such standards should include
widespread consultation among both developed and developing countries
as well as among environmental and other NGOs. Although the aim is to
achieve a high level of consensus, there will also likely need to be a
bargaining process between richer and poorer countries.

Second, the U.S. should help to build national-level environmental governance
capacities in developing countries via technical assistance, institutional
strengthening, and other foreign aid. Governments need help to establish
their broad development objectives and to subject FDI projects to preliminary
strategic environmental and social assessment. They also need technical
and financial help to develop their own capacities to regulate industry,
whether domestic or foreign. For many countries, the key issue is effective
enforcement of existing regulation.

Third, the U.S. needs to promote innovations in domestic corporate governance
that enhance the social and environmental accountability of U.S. TNCs.
Many TNCs have adopted voluntary, self-regulatory codes of conduct such
as ISO 14,000, the latest standards series put out by the International
Organization for Standardization that sets standards for consumer and
industrial products. Few codes, however, have any internal or external
compliance mechanisms. Increasing compliance requires, at minimum, that
companies measure environmental impacts and disclose information to regulators,
impacted communities, and the public. Useful internal governance tools
might include environmental auditing and reporting, environmental management
systems, and independent certification. Useful external governance tools
might include mandatory information disclosure and third-party certification.

Lyuba Zarsky is Codirector of the Berkeley-based Nautilus Institute
for Security and Sustainable Development and manages the Globalization
and Governance Program.