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 privately-

owned 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

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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”
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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
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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 under-

pricing 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
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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
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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.

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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 market-

oriented 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,

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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
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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.
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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.
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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.
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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.
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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-and-

control 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.
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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.
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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. Well-

educated 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
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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.