International Trade and the Environment - Research Paper Example

Running head: PUBLIC FINANCE ECONOMICS Public Finance Economics of the school] of the Introduction The analysis of environmental policy in the context of corporate strategy requires the use of ideas from fields as diverse as economics (especially trade theory), strategic management, law, politics and environmental studies. A new conceptual framework is proposed in which the emphasis is upon firm-level strategic decision-making rather than government policy making. The manager is the focus of attention. Today most firms engaged in international business not only need to be aware of environmental issues but, must also have in place a strategy to deal with environmental regulations. This requires that managers understand the political and legal process by which environmental regulations are drawn up and implemented, as well as the frequent interactive lobbying process between business, governments, bureaucracies, and environmental non-governmental organizations (ENGOs). Firms based in large home markets like the United States and the European Union (EU) should pay great attention to domestic environmental regulations. In contrast, firms from smaller countries like Canada (which is one-tenth the size of the United States), most Asian countries and all Latin American countries should focus primarily upon the environmental regulations of their major customers (usually the "triad" economies of the United States, the EU and Japan). Current paper develops a new conceptual framework which addresses this asymmetry by examining the interactions between government and the firm. In the following section of the paper I examine the relationship between environmental regulations and firms' responsiveness to them providing managerial perspective on compliance to international environmental policies. Paper particularly emphasizes the environmental side agreement of the North American Free Trade Agreement (NAFTA) linking Canada, Mexico and the United States. NAFTA is a major breakthrough since it is the first international trade agreement (other than internal EU regulations) to explicitly incorporate environmental issues, and to establish a bureaucracy to administer trade and environment interaction, primarily through the NAFTA Commission on Environmental Cooperation (CEC). NAFTA and the CEC can be seen as benchmarks for analysis of other international environmental organizations and agreements. Further, the discussion of a corporate strategy framework follows with which managers can determine the appropriate choice of strategy in response to both international and national environmental pressures. They can comply with new environmental regulations, but also develop green capabilities which may allow them to outperform competitors on environmental strategy grounds alone. Green strategies may focus on responding strongly to national regulations, international regulations or both simultaneously. In Section 4 we discuss the argument that firms can seek to avoid domestic environmental regulations by moving offshore; the Mexico pollution-haven case. 1. A MANAGERIAL PERSPECTIVE ON COMPLIANCE WITH INTERNATIONAL ENVIRONMENTAL POLICIES At the level of the firm targeted by international environmental policies, the corporate response in terms of compliance depends upon its expected economic benefits. These economic benefits can be high or low, as shown on the vertical axis of Figure 1. A second issue (on the horizontal axis) is whether these benefits are driven primarily by expected improvements in industrial performance (e.g., market share, profitability, growth, etc.) or by sanctions associated with non-compliance. In the latter case, it is mainly the strength of the administrative enforcement apparatus which determines compliance. For a discussion on the benefits of compliance, see Barrett (1992), Henriques and Sadorsky (1996), Nehrt (1998), Walley and Whitehead (1994). The four possible managerial responses are the following. In quadrant 1, performance driven compliance prevails. International environmental regulation is welcomed, for example, because it facilitates global benchmarking efforts irrespective of enforcement, which is viewed from a strategy perspective as a non-issue. This is the opposite situation to quadrant 3, where economic benefits consist primarily of avoiding costly sanctions, that is, compliance is enforcement driven. Figure 1 Quadrants 2 and 4 reflect cases for which compliance leads to low net economic benefits. In quadrant 2, administrative enforcement is not an issue as compared to the absence of any contribution to improving the firm's industrial performance, which leads to unconditional non-compliance. This occurs, for example, when international environmental regulation is viewed by firms as political lip service to environmental pressure groups, without any serious government commitment to implementation. In contrast, quadrant 4 reflects conditional non-compliance. This is the case of environmental regulations for which government shows a genuine interest in implementation, but the design or operationalization of an administrative enforcement apparatus is lagging because of a lack of resources or other implementation barriers. Once the administrative enforcement apparatus functions properly, a shift to enforcement driven compliance (quadrant 3) may occur. Several insights can be gained into the environmental policy literature by the use of this framework. We shall focus on two: first, an application to describe the types of international environmental agreements in place as viewed by firms; and second, a more specific application to corporate strategy. This is done in sections 4 and 5. The four types of compliance behavior that emerge from Figure 1 are induced by the characteristics of the environmental regimes faced by firms. Thus, in each of the four quadrants of Figure 1, we can place the major international environmentally related policies, regulations and environmental agreements on the basis of the firm responses that they have induced. In this way the agreements can be classified as follows: Quadrant 1: OECD non-binding environmental regulations, policies and principles. Quadrant 2: International agreements such as enforcement provisions, e.g. UNCED's Rio Declaration of 1992 and the Kyoto Conference of 1997. Quadrant 3: The environmental standards of the EU, and its "eco-labels." Multilateral Environmental Agreements (MEAs)with strong enforcement provisions, such as the Montreal Protocol. Quadrant 4: NAFTA and the CEC. GATT/WTO trade disciplines on environmental regulations. The positioning of these international agreements requires further explanation. In the remainder of this section we shall highlight the key provisions in each agreement which determine placement in the framework. It should be emphasized that the positioning of each agreement on the horizontal axis of Figure 1 is determined on the basis of the main driver of firm behavior (issue of contribution to industrial performance versus issue of administrative enforcement). A position on the left hand side of Figure 1 implies that firms fundamentally do not take into account enforcement issues. The environmental measures of the OECD are in quadrant 1 of Figure 1. The OECD does not enact binding environmental regulations on its members, yet its recommendations about environmental policy are extremely influential with firms who see the OECD as setting useful benchmarks for international business. Especially, multinational enterprises (MNEs) have been highly responsive to the OECD's investment codes (Safarian, 1993; Rugman and Gestrin, 1997). However, in quadrant 2 of Figure 1, firms do not adjust their behavior to respond to environmental regulations. This is because such regulations are not perceived as contributing positively to industrial performance. For example, although the United Nations Conference on Environment and Development (UNCED) has promoted international environmental concerns, as evidenced by the attendance of over 100 heads of state at the Rio Summit in 1992, it has not been taken seriously by most firms. Many firms viewed the Summit as a mere public relations exercise dominated by ENGOs with poor political commitment to actual realization. Similarly, while the Kyoto conference declaration of December 1997 requires states to adopt carbon emissions standards, most potentially affected firms fail to see any micro-level benefit potentially contributing to their industrial performance. They also assume that many states worrying about its costs will refuse to ratify the Kyoto declaration and so offset the ENGOs, except in the stronger advocacy areas such as the EU. NAFTA is largely in quadrant 4 of Figure 1, since its relatively strong environmental provisions have certainly captured the attention of most firms doing business in North America. However, only when the CEC becomes a credible bureaucracy, consistent with the intent of the three NAFTA signatories, with active dispute settlement procedures and active investigations to prevent trade-related environmental disputes (as its mandate permits), will NAFTA likely move from quadrant 4 to quadrant 3. To date, there is no evidence to support the placement of NAFTA in quadrant 3, since the CEC has not yet become active in seeking to investigate and mediate any of the current trade-related environmental disputes identified in Vogel and Rugman (1997), of which there have been over 20 between the United States and Canada in the last five years. In contrast to NAFTA, the EU has, through the actual enforcement by the European Commission, been able to make its environmental regulations widely applied by most EU companies, placing environmental regulations, such as the EU "eco-labels" in quadrant 3. The eco-labels (on fine paper for example) can even be used as a barrier to entry against foreign firms unable to comply with them (Rugman, 1995; Vogel, 1995). Similarly, MEAs such as the Montreal Protocol are also in quadrant 3, as the signing governments have taken measures to guarantee enforcement in the form of specific domestic legislation. Other MEAs with trade-related environmental measures (TREMs) which may be in quadrant 3 include the Basel Convention of Hazardous Wastes (1989), and the convention on the International Trade in Endangered Species (CITES) (1973). In all these cases the main driver of compliance is not related to any potential improvement of industrial performance, but rather the negative sanctions associated with non-compliance. 2. CORPORATE STRATEGY WITH INTERNATIONAL AND NATIONAL ENVIRONMENTAL PRESSURES The various compliance scenarios described in Figure 1 cannot capture at the micro-level the full range of strategic options open to firms faced with environmental regulations. In order to build a more realistic picture of corporate strategy that goes beyond firm compliance behavior, especially behavior in quadrants 1 and 3 of Figure 1, we need to relate the pressures of international environmental regulations to national pressures, and deduce a series of possible resource-based strategies for firms to follow as in Figure 2. Here, we make a conceptual distinction between national and international environmental regulations, although in practice many linkages may exist between them. In Figure 2, on the vertical axis, the resource-based perspective on international environmental regulations resulting from international agreements is captured. From the viewpoint of a senior manager, corporate strategy may need to take into account these pressures of international environmental policy. Here, a strong resource-based response implies that the firm aims to achieve benefits of integration by developing green capabilities that go beyond compliance to environmental standards resulting from an international agreement. These capabilities are shared across borders and create scope economies in MNEs. The horizontal axis of Figure 2 reflects the firm's responsiveness to national environmental pressures, again in terms of creating capabilities, weak or strong. Figure 2: Resource-based perspective on international environmental regulations Based on Figure 2, the four types of green corporate strategies that can be developed are discussed below. It is important to realize that in quadrants 1, 3 and 4 the firm actually develops a green capability consistent with the resource based management theory, Penrose (1959), Rumelt (1984), Barney (1991), and Conner (1991). On both axes of Figure 2 a "strong" resource-based response means going well beyond mere compliance with an environmental regulation. A strong response to an environmental obligation, in terms of the resource-based view, means developing strategic capabilities by which the firm can outperform the average competitor by being green alone. Such green capabilities are initiated by either national or international regulations, but are proprietary to the firm. The "weak" position in figure 2 means that the firm will be in compliance with the relevant environmental regulations, but is not able to develop a green capability. We assume that the enforcement mechanisms of environmental regimes are sufficiently transparent for a firm to invest in the development, or not, of green capabilities. Figure 2 represents a re-interpretation of the now conventional work on corporate strategy and globalization by Bartlett and Ghoshal (1989). It is a relatively simple resource based application of their integration-national responsiveness matrix, in which the strategic capabilities of MNEs can be analyzed. In their matrix, Bartlett and Ghoshal (1989) describe the tensions faced by managers of MNEs, between responding to pressures for integration (often leading to global scope economies) and pressures for national responsiveness (requiring global standards to be adapted to national requirements). With this in mind we shall now discuss the strategic environmental stance adopted by the firm in each quadrant of Figure 2. Quadrant 1: Strategies are directed towards developing capabilities as a response to environmental regulations resulting from international agreements, such as the OECD codes. Here, the firm merely complies with national environmental regulations, whereas it develops new green capabilities in the context of international regulation. This strategy is especially relevant to MNEs from smaller nations when operating in larger, foreign markets, e.g., a Canadian MNE in the United States or EU. Such a firm needs to comply with international, and thereby sometimes host country standards, especially within NAFTA (which does not yet provide international standards in most areas, but gives "national treatment" to a Canadian firm in the United States). The Canadian MNE will focus on meeting U.S. environmental performance benchmarks in order to achieve market access. In order to outperform domestic U.S. firms, the Canadian MNE may even need to develop green capabilities based on more far-reaching international regulations than those prevailing in the U.S. market. A similar argument, albeit at the macrolevel, has been advanced by Atik (1997). He also argues that small countries like Canada will need to gear their environmental standards to their large export markets, such as the United States. For individual industries, the question obviously arises whether Canadian regulations are, on average, more or less demanding than the U.S. ones. As Nehrt (1998) has argued, regulatory regimes prevailing in each country may be different (e.g., various command-and-control regimes versus incentive-based regulations). In addition, both countries have sometimes legislated different methodologies to measure pollution, even when the regulatory regimes are similar. It is therefore not possible to engage in simple comparisons of the relative strength of environmental regulations. Quadrant 2: Strategies are developed which do not aim at creating green capabilities as a source of sustainable competitive advantage. In this quadrant, we find firms preoccupied with conventional sources of competitive advantage. These firms merely comply with environmental regulations. The cost effects associated with a greening strategy are perceived to be higher than its potential benefits, Rugman and Verbeke (1998). Quadrant 3: The firm attempts to develop green capabilities (according to its administrative heritage) as a response to both national and international regulations. With both drivers for capabilities being strong, the firm has the greatest possible incentive to develop green strategies. The only problem is that there may be inconsistencies between the regulations, so that a choice must be made as to which ones should prevail. An example is EU firms having to choose between EU-wide environmental regulations and the health and safety regulations prevailing in individual member states, when the latter are more subject to capture by domestic producers seeking shelter. The concept of shelter was developed by Rugman and Verbeke (1990). They provide both theoretical and empirical evidence that some firms lacking in efficiency-based capabilities pursue a political strategy of seeking to capture, or influence, the administration of trade remedy laws (anti-dumping and countervailing duty laws) in order to erect an entry barrier against foreign rival producers. A more general statement of the nature of corporate strategy in the political arena can be found in Boddewyn and Brewer (1994). Examples of shelter practices occurred in the U.S. forestry sector from the early 1980s, with the use of several U.S. countervailing duty actions against the softwood lumber producers of Western Canada. Vogel and Rugman (1997) have applied the concept of shelter to the capture of environmental regulations and standards, again in a U.S.-Canadian context, but also involving Mexican agriculture cases under NAFTA. The entire set of NAFTA related environmental cases and their relationship to corporate strategy is explained by Rugman, Kirton and Soloway (1999). Quadrant 4: Strategies are primarily directed towards developing green capabilities as a response to home country national regulations. This is a rational strategy for firms from large triad economies, where the foreign market may represent a small share of their sales volume, e.g., U.S. or EU-based firms operating abroad, in Mexico, Canada or Asia outside of Japan. It is consistent with the policy advocated by Porter and van der Linde (1995). Having discussed the four quadrants, we now turn to two more generic issues. One significant firm-level response to the increase in international government regulation has been the development of ISO 14000. Flowing from the regulation of national governments and bodies like the OECD, this is a joint public-private sector initiative which seeks to rectify the increasing problems of disparate environmental standards. The International Organization for Standardization (ISO), in Geneva, with members from over 50 nations has developed a set of international environmental management voluntary standards for business (ISO 14000) (Benson, 1996). Firms which adopt ISO 14000 will be placed in either quadrant 1 or 3 of Figure 2, as they move beyond mere compliance with international environmental legislation toward a more proactive management of corporate environmental assets and liabilities. To manage for environmental quality, many companies are now applying the same quality management techniques used by manufacturers in the 1980s to improve competitiveness. Eco-labelling schemes identify for the consumer those products which are environmentally less harmful than other competing goods within the same product category, either because of their composition, the way in which they were made, or both (Staffin, 1996). Ecolabels can be mandatory or voluntary and can be implemented at the national or international level. There are ecolabels for products as diverse as washing machines, light bulbs, dishwashers, packaging, refrigerators, paper, batteries, detergents and shoes. In the EU, once an eco-label is official, manufacturers may apply for it in the EU country where the product is manufactured, first marketed or imported. For firms, an approved eco-labelled product in the host country market creates a competitive advantage when consumers are highly motivated to buy "green" products, placing eco-labels in either quadrant 3 or 4 of Figure 2. Eco-labelling schemes usually favor domestic production (Staffin, 1996), at the expense of imported products. 3. POLLUTION HAVENS AND MNE LOCATION BEHAVIOR Additional important issues of corporate strategy and environmental regulations can be explored using Figure 2. One of the most critical is the argument that countries with lax environmental standards can attract firms located in quadrant 2 (absence of a green strategy) away from countries with tight environmental standards. In the NAFTA context it has been alleged that Mexico is a "pollution haven" compared to Canada and the United States. The major industries in Mexico's border area are: automotive accessories, electrical equipment and electronics, and metal products. It is argued by some observers that there has been serious environmental damage along the border, especially in the maquiladora manufacturing region. Industry was allegedly attracted to maquiladoras because of the "hands-off attitude toward environmental protection and labor costs, and the fact that Mexico allows 100 percent foreign ownership of maquiladora plants" (Richardson, 1992). While Mexico has strict environment laws, enforcement has been a serious problem (Richardson, 1992), but has improved more recently. However, most MNEs operating in Mexico, whether from Canada or the United States, are positioned in quadrants 1, 3, or 4 in their home countries, and are therefore unlikely to move into quadrant 2 in order to operate in Mexico. When a green strategy is pursued, and capabilities are developed in this area, corporate behavior in quadrant 2 would be inconsistent with exploiting and further developing these capabilities. An in-depth discussion of the environmental practices and performance of MNEs is provided by Levy (1995), who demonstrates that a high degree of multinationality is associated with a better environmental performance, without, however, providing a definitive answer as to why this is the case. One effort at a transectorally comprehensive study of the impact of NAFTA on the United States and Mexico was a study released by the U.S. NGO Public Citizen in January 1996. It alleged, based on interviews and media reports, that NAFTA had directly increased the illegal dumping of industrial wastes and air pollution, which indirectly led to hepatitis and birth defects along the U.S.-Mexican border. The focus of concern was on increased infrastructural pressure due to growth in all industries, especially those which are pollution intensive, such as trucking and chemical/petrochemical production (Public Citizen, 1996). These findings can be contrasted with a more scientific study commissioned by the CEC on NAFTA's effects, which indicates that Mexico is not a pollution haven. In this, Kirton and Soloway (1996) found that most MNEs operating in Mexico have worldwide environmental mandates, often with suppliers, and use their best available environmental technology abroad, rather than out-of-date production processes. It was also found by Rugman, Kirton and Soloway (1999) that the pollution haven argument is further weakened by the environmental policy adjustments made in Mexico prior to its entry into NAFTA. International pressure and increased domestic activism led to the creation of the Mexican government's environmental institutions - Sedesol, Profepa, and INE - in response to new domestic ENGO activity and citizen concerns, as well as U.S. Congressional allegations. In 1992-93, the Mexican government launched a series of environmental inspections of foreign MNEs. Sedesol inspectors closed one of Ford's plants for a week, as well as a Kimberly Clark plant. This action led Ford to establish an environmental quality office and, along with other companies, develop an environmental plan. NAFTA thus helped produce a further greening of MNEs strategies in Mexico. NAFTA reinforced a trend begun in 1990 when Colgate Palmolive responded to multi-stakeholder pressures at home and abroad by starting to green itself (Rugman, Kirton and Soloway, 1999). Two empirical studies also tested the pollution haven hypothesis, and neither found evidence in support of it. Lucas et al. (1992) observed that when pollution-intensive industries have moved to developing countries, it is a function of industry expansion rather than displacement. Indeed, they find that toxic intensity of output declines as income rises because the share of manufacturing in total output declines beyond a certain level of income. Similarly, Low and Yeats (1992) found that while developing countries have more pollution-intensive industry than developed countries, there is no evidence to support the claim that location decisions are based on environmental considerations. Thus, the evidence indicates that an MNE normally operating in quadrant 1 in Canada, or in quadrant 4 in the United States, would not set up a subsidiary positioned in quadrant 2 of Figure 2 in order to operate in Mexico. It remains an empirical question whether certain industries would actually relocate to Mexico even if there are lower environmental standards, given the high sunk costs of physical capital. Finally, if, for example, a chemical (and related manufacturing) firm competes in quadrant 3 of Figure 2, the potential cost savings by relocating to Mexico into quadrant 2 would be inconsistent with its resource-based green strategy. THE PORTER HYPOTHESIS OF HOME-BASED ENVIRONMENTAL REGULATIONS The previous sections contrasted domestic (home country) and international environmental regulations. In this section, we focus on the specific case of two countries with strong trading relationships, in which one country has a much larger market size than the second one. It should be noted that there is no discussion here of the use of green strategies in relation to other market-based firm strategies, such as the three generic strategies of Porter (1980). Such work is attempted by Rugman and Verbeke (1998) and Shrivastava (1995). Porter and van der Linde (1995) argue that it is good policy for a government to pass strict environmental regulations. Then firms based in that country (e.g., the United States) will have to develop new core competencies in environmentally sensitive manufacturing. Eventually, these firms can go abroad and use their strong home base as a staging ground to outperform other less environmentally sensitive firms in global markets. This point has been endorsed by U.S. Vice President Al Gore (1992). The Porter hypothesis presumes that other countries will not "compete" by inconveniently raising their own domestic environmental regulations too soon (before the U.S.-based firms have developed innovations at home), and that the regional and multilateral organizations also follow along, rather than initiate new and diverging environmental regulations. Thus it is a matter of timing. If the U.S. government is a first mover, it can spur U.S.-based firms to be the first green MNEs, and their environmental credentials should help them outperform competitor firms on the world stage, once the world stage also becomes green. CONCLUSIONS In this paper I have produced a new conceptual framework which analyses the linkages between environmental regulations and corporate strategy. In the first component of the framework (represented in Figure 1), I positioned the various types of international environmental policy regimes in terms of firm level compliance behavior. In the second component (visualized in Figure 2) I assessed the significance of green strategic management through a resource based re-interpretation of the Bartlett and Ghoshal framework. Finally, the framework's third component allowed us to explore the Porter hypothesis, and found that while it could work for firms with triad-sized home bases, it would not be relevant for firms from smaller, open economies (such as Canada), which need access to a triad market. We conclude that this analysis of the dynamic tensions between environmental policy and firm behavior can provide valuable insights to managers responsible for corporate strategy. 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