Does environmental regulation matter? Determinants of the location of new manufacturing plants in India in 1994

____PSI / 1418 POLICY RESEARCH WORKING PAPER 1718 Does Environmental Regula- Thecostsattributableto complying with tion M atter? environmental regulation are Determinants of the Location of New not as important as other determinants of where Indian Manufacturing Plants in India in dtrinas of were Idan businesses locate new plants. 1-994 The level of existing business activity overwhelms all other factors affecting location Muthukumara Mani, Sheoli Pargal, decisions. and AlXinul Huq The World Bank Policy Research Department Infrastructure & Agriculture Division February 1997  POLICY RESEARCH WORKING PAPER 1718 Summary findings The cost of complying with environmental regulations After controlling for the impact of factor price has been cited as a major burden on businesses. Is it differentials, infrastructure, and agglomeration, they find enough of a burden to influence where businesses locate that the number of new plants commissioned in different new plants, which are not restricted in their choice of states of India in 1994 does not appear to be adversely location? affected by more stringent environmental enforcement at Mani, Pargal, and Huq examine a unique the state level. In other words, an environmental "race to establishment level dataset to find out whether the the bottom" is unlikely. stringency of environmental regulation affects where They find that the level of existing business activity firms locate new plants. Using a conditional logit model, overwhelms all other factors affecting location decisions. they estimate the importance of different variables in Reliable infrastructure and factors of production are also plant location choice. critical. This paper - a product of the Environment, Infrastructure & Agriculture Division, Policy Research Department - is part of a larger effort in the Department to study environmental regulation. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433-0001. Please contact Evelyn de Castro, room N10- 019x, telephone extension 89121, fax (202) 522-3230, internet address edecastro@worldbank.org (24 pages). The Policy Research Working Paper Series disseminates the findings of Cork in progress to encourage the excbange of ideas about development issues. An objective of the series is to get the findings outgquickly, even if the presentations are less than fully polisbed. The papers carry the names of the authtors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the autbors. They do not trecessarily represent the lviewo of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center  Does environmental regulation matter? Determinants of the location of new manufacturing plants in India in 1994 by Muthukumara Mani* Sheoli Pargal Mainul Huq The World Bank 1818 H Street. N.W. Washington DC 20433 * We thank Ken Chomitz. Koshv Mathai, Mead Over, I. J. Singh, and David Wheeler for helpful comrnments.   Introduction The cost of complying with environmental regulations has been cause for complaint by businesses the world over. At the same time. the view that jurisdictions would compete to attract new investment by lowering environmental standards has led to much anguish over a possible enviromnental "race to the bottom". If these regulations are indeed as onerous as industry alleges, we would expect to find significant differences in the observed volume of new business activity across locations which vary in environmental stringency, ceteris paribus. Since new firms are not restricted in their choice of location by sunk costs, an examination of new firmn location decisions would allow one to disentangle the impact of environrmental regulations from other factors affecting the decision. This paper uses a unique establishment level dataset from India to test this proposition. Following Schmenner's (1982) qualitative study of the factors motivating US businesses to locate where thev do, existing empirical work has found mixed evidence of a locational impact of environmental regulation when comparing new business location choices across US states. Among the recent establishment level studies. Bartik (1985), Schwab and McConnell (1990), and Levinson (1995) have all followed Carlton (1983) in using conditional logit models to estimate the impact of different variables on firm profits as reflected in firm location decisions. Schwab and McConnell. analysing the US motor vehicle industry, find that at the margin. firms tend to avoid so called "non-attainment" areas where environmental enforcement tends to be tightest. Levinson (1995) finds evidence that new branch plants of large multiplant firms locate in states with the least stringent environmental regulations. For developing countries. data has been sparse. For instance, a firm level study by Henderson and Kuncoro (1996) has analysed the centralization of manufacturing activity in Indonesia, but ignored the effects of regulation. In India the impact of environmental regulation on the spatial distribution of industry has not attracted much academic attention. Casual empiricism on state level competition for new investment has not been followed by rigorous studies of the phenomenon. Also, the focus of most work on 3  intergovernmental relations has been fiscal federalism rather than environmental performance, with Gupta (1996) being an important exception. Based on an inspection of secondary data, Gupta cannot conclude that states compete for investment by lowering environmental standards. He does not, however, preclude the possibility of states using environmental enforcement as a means of differentiation in order to attract new industry. This is one of the first analyses of the impact of environmental regulations on locational choice in a developing country. We have information on all new industrial projects over the size of Rs. 500 million commissioned in India in calendar 1994. The large size of these investments makes it reasonable to suppose that they are relatively footloose. Our establishment level data also allows us to avoid problems of plant closings and expansions that inevitably contaminate more aggregate measures of new business activity. Finally, having information on "greenfield" investment is as close to ideal as it gets. After controlling for the impact of factor price differentials. infrastructure, and agglomeration we find that the number of proposed new plants in different states of India is not affected by the stringency of environmental enforcement at the state level. Interestingly, plant location is significantly positively related to the level of environmental spending by the state govenmuent, which leads us to conjecture that this variable proxies other qualities of the state government rather than environmental stringency. Restricting our analvsis to five highly polluting manufacturing sectors'. we found a more significant but positive impact of environmental enforcement on location, and a very strong positive effect of environmental spending. We conclude from this that the stringency of enforcement of environmental regulations certainly does not have an adverse impact on the relative attractiveness of different sites for industrial location, and thus that it is not as important for investors as other attributes of potential sites. This paper is organized as follows. Section I briefly describes environmental regulation in India. Our basic model is described in section 2, and the factors affecting business location discussed in section 3. ' The five most polluting sectors identified here are chemicals, rubber. paper. metals and non-metallic mineral products. 4  Data sources and description are provided in section 4. Section 5 presents our results, with conclusions in section 6. 1. Industrial regulation in India There is a basic division of power between the centre and the states in India, reflecting the federal nature of the Indian Constitution. The mandate of the Central Pollution Control Board (CPCB) is to set environmental standards for all plants in India. lay down ambient standards, and coordinate the activities of the State Pollution Control Boards (SPCBs). The implementation of environmental laws and their enforcement. however. are decentralized. and are the responsibility of the SPCBs. Anecdotal evidence suggests w ide variations in enforcement across the states. In fact it has been argued (Gupta 1996) that although states cannot compete by lowering environmental standards. they can get around this by lax enforcement in order to attract new investment. From the mid 195 Os until 1991, when a major liberalization and economic reform program was launched. the central government effectively dictated the location and magnitude of private investment in India through the svstem of industrial licensing (Gupta 1996). Thus. although India has had stringent pollution regulation on the books for a couple of decades. and there is wide variation in the industrial climate across the country. firms may not have been able to factor these comparisons into their location decisions until fairly recentlv. After the removal of licensing controls. the pattern of new industrial investment reflects a rational response to expected profitability across states. To the extent that history and agglomeration effects matter. however, the inertia in the system may be insurmountable! The two main pollution control statutes in India are the Water (Prevention and Control of Pollution) Act of 1974., and the Air (Prevention and Control of Pollution) Act which came into being in 1981. Parliament passed the Environment (Protection) Act in 1986. This was designed to act as umbrella legislation for the environment. with responsibility for administering the new legislation falling on the 5  Central and State Boards. Before 1988 enforcement was only through criminal prosecutions initiated by the State Boards and by restraint injunctions. Boards can now, however, force closure of non compliant plants. as well as cut off their water and power by administrative fiat (Gupta 1996). II. Econometric specification Our basic premise is that new firms are free to locate anywhere in the country and that they are profit maximizers. Since they are rational, location choice is conditioned by expectations of where production is likely to be most profitable: firms are assumed to locate where revenues are perceived to be highest and costs loNvest. The restricted profit function of a representative new firm, i. located in state j, can be written as: -rZj(p,, w,; sj) = pj.y(pj)-C(wj,y;sj), where p is output price. w is a vector of factor prices, v is output, s is a vector of location specific fixed factors and C is the cost of production. As usual, an/ap>o, and Ianlw<0. For large plants, such as those being analysed here, there is a single nationwide market. So we ignore possible variations in output price and market size in our study, and focus on regulatory and factor price differences across states. Naturally, we look also at immobile factors that affect production costs by changing the productivitv and thus the effective price and availability of inputs across states. Letting x represent the vector of input prices and state characteristics, our reduced form model for profits of firm i in state j is Tr,, =F(xj). Following Carlton (1983), we assume a multiplicative specification for profits and fornulate the empirical model as: F(xj)= ym ln(xjm)Im where m refers to the mth characteristic of location j. Thus. trij = Em ln(xjm)1m + e1, with eij assumed independent of all Eik. kij. For each firm. i, the choice of state j is made s.t. irj 2Tik for all koj, i.e. ymln(xjm)1m + E;