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Sustainable futures

COP26: securing a fairer global economy will help achieve our carbon targets

The climate crisis, the most complex and critical challenge of our time, must be tackled on many fronts. It requires coordinated, strategic and evidence-based action, yet working in harmony towards a shared goal is not always easy.

Such complexity is already seen in the global economy, where the strategic decisions by business on offshoring and foreign direct investment present challenges in establishing cross-border trade policies that are fair, effective and reduce environmental damage. Our research is helping policymakers to address this challenge.

To support sustainable economies that achieve higher welfare and lower environmental damage needs full coordination between government departments to ensure environmental, trade and investment policies are complementary.

For example, reducing environmental damage and increasing economic welfare may not go hand-in-hand. It is also important for policymakers to understand the implications of different types of pollution – consumption versus production, or domestic versus cross-border – when determining trade policies for polluting industries.

We studied the effects of environmental taxes on offshoring activities and foreign direct investment. In a recent paper, published in the Journal of Public Economic Theory, we show how firms may prefer offshoring and more specifically, the make-and-buy strategy to avoid environmental taxes.

Our analysis compares the effects of international harmonisation (where the countries set taxes to maximise global welfare) but the firm decides offshoring to maximise its profit with two other situations:

(1) where the countries set the taxes non-cooperatively

(2) where the offshoring decision as well as taxes are determined to maximise global welfare

Interestingly, when comparing international harmonisation and global welfare maximisation, we find that offshoring can be higher under international harmonisation but environmental damage can be higher under global welfare maximisation.

Hence, higher global welfare does not necessarily imply lower environmental damage. We also show that offshoring and environmental damage can be higher and global welfare can be lower under international harmonisation compared to non-cooperation.

When firms can choose offshoring strategically to influence environmental taxes, cooperating only on green taxes may neither increase global welfare nor minimise environmental damage.

"The complexity of the global economy and the ability of businesses to take strategic, cross-border actions underlines the challenges facing policymakers seeking to address environmental problems and achieve their carbon goals."
Professor Arijit Mukherjee

In a paper, published in Review of International Economics, we found that a foreign firm may want to relocate to a country with stricter environmental regulation, if foreign direct investment increases the environmental tax in the host country. This helps the foreign firm to seize significant market share from the host-country competitor, which is now facing significantly higher costs than that of the foreign firm due to the higher green taxes. We also show that this motive for foreign direct investment may reduce welfare in both the foreign firm’s home and host countries.

In a recent working paper, we show why countries concerned about controlling pollution from domestic industries, and wanting to maximise the welfare of its citizens, might encourage relatively unfettered import of ‘dirty’ goods. Harmonised tariffs aimed at achieving global fairness and wellbeing must take this into account.

The complexity of the global economy and the ability of businesses to take strategic, cross-border actions underlines the challenges facing policymakers seeking to address environmental problems and achieve their carbon goals. Securing higher global welfare may not create lower environmental damage; cooperation among governments on green taxes may not reduce environmental damage. Stricter environmental policies may not reduce investment by polluting firms and may not increase the welfare of our societies. Trade policies that seek to reduce the impact of pollution must meanwhile address diverse drivers of pollution - consumption versus production and domestic versus cross-border.

To overcome these challenges, we use game theory to model behaviour, factoring in the influence of strategic offshoring, foreign direct investment and export decisions and how these should determine effective, fair and sustainable environmental and trade policies.

Our research findings will also help policymakers understand the implications of different types of pollution – consumption versus production or domestic versus cross border – when determining trade policies for polluting industries.

Complementary policies may be required to achieve higher welfare and lower environmental damage, with coordination between government departments that are undertaking different environmental, trade and investment policies.

Arijit Mukherjee 

Arijit Mukherjee is Professor of Industrial Economics at the Nottingham University Business School

Further reading

COP26: the greatest challenge of our time

Journal of Public Economic Theory April 2020, Takeshi Iida, Arijit Mukherjee: Make and buy in a polluting industry

Review of International Economics July 2011, Arijit Mukherjee et al: Environmental Regulation: An Incentive for Foreign Direct Investment

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