Download

The question of whether ambitious carbon pricing policies encourage investments to relocate (or ‘leak’) to countries with lower carbon prices is important for climate change policymaking. The perceived threat of carbon leakage and competitive disadvantage associated with stringent environmental regulation is a major factor that curbs ambition in efforts to tackle climate change. This paper provides evidence to the long-standing debate on the impact of environmental regulation on the location of Foreign Direct Investments (FDI), making a number of advances both theoretically and empirically.

The results highlight the extent to which leakage concerns have been exaggerated. Upon deciding to invest, firms are indeed attracted towards acquiring assets in regions with lower energy prices, particularly those operating in energy-intensive sectors. However, other factors are more important in driving firms’ decisions around FDI location. Even a carbon price difference of US$50 per tonne of carbon dioxide between acquiring and target countries has a small impact on the number of cross-border deals. Hence compensation measures to prevent leakage should be used sparingly, and should target only sectors that are particularly energy-intensive and exposed to leakage.

Key points for decision-makers

  • This paper tests if more merger and acquisition (M&A) deals occur between countries with larger differences in industrial energy prices, to test if concerns around the adverse impacts of carbon pricing policies on cross-border investments are warranted.
  • It constructs a unique and comprehensive database of global bilateral cross-border investments in manufacturing sectors combining firm-level M&A data from Thomson Reuters with industrial energy prices. The data cover 41 countries over 20 years (1995–2014), including around 22,000 cross-border transactions.
  • Results show that energy price differences do indeed impact firms’ decisions on the location of FDI, but the magnitude of the effect is small.
  • A 10% increase in the industrial energy price differential between two countries is associated with a 3.2% increase in the number of acquisitions of firms or assets located in the countries where the energy price is lower.
  • This effect is four times larger for transactions targeting countries outside the Organisation for Economic Co-operation and Development (OECD) than for those targeting OECD countries.
  • The effect varies across sectors: it grows as sectoral energy intensity increases, i.e. as more energy is used per unit of output.
  • Even a carbon price difference of US$50 per tonne of carbon dioxide is expected to have limited negative impact on the attractiveness of economies as a destination for FDI.
Keep in touch with the Grantham Research Institute at LSE
Sign up to our newsletters and get the latest analysis, research, commentary and details of upcoming events.