Good for the environment, good for business: Foreign acquisitions and energy intensity

Arlan Brucal, Beata Javorcik, Inessa Love 16 August 2019

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According to the 2018 report of the UN Intergovernmental Panel on Climate Change (IPCC), exceeding the global threshold of 1.5°C above the pre-industrial temperature level will mean increased risk of extreme drought, wildfires, floods, and food shortages for hundreds of millions of people. Keeping emissions below the crucial threshold would require widespread changes in energy, industry, buildings, transportation, and cities. Can multinationals be part of the solution? Can flows of foreign direct investment (FDI) help put a brake on emissions? Or would they exacerbate the already worsening global climate condition?

Environmentalists argue that highly polluting multinationals relocate to countries with weaker environmental standards to circumvent costly regulations in their home country (Hanna 2010, Millimet and Roy 2015, Cai et al. 2016). In this way, they increase pollution levels not only in host countries but also globally. 

In contrast, supporters of globalisation point out that FDI has a positive effect on the natural environment because multinationals tend to use more efficient and cleaner technologies than their domestic counterparts. With the spectacular growth in FDI flows and the increasing importance of developing nations as host countries, the potential effect of FDI on the natural environment remains controversial (Kellenberg 2009, Cole et al. 2017).

In a forthcoming paper (Brucal et al. 2019), we contribute to this discussion by examining the impact of foreign acquisitions on energy consumption and CO2 emissions of acquired plants. The study is based on plant-level data from the Indonesian Manufacturing Census, covering the period 1983-2001. The data contains detailed information on plant-level use of various energy inputs (both in value and physical units) and thus can be used to calculate the expected CO2 emissions using standard conversion factors specific to each type of energy. We then compare the changes in these variables in the acquired plants and a carefully selected group of domestic plants that had not changed ownership.1

Why would we expect acquired plants to improve energy efficiency?

There are several reasons why foreign acquisitions may improve energy efficiency. First, foreign acquisitions tend to increase production volume by boosting productivity and facilitating access to foreign markets through the foreign parent’s distribution network (Arnold and Javorcik 2009). This makes investments in improving energy efficiency more worthwhile as the sales base becomes large enough to cover the fixed cost of investment.

Second, multinationals based in countries with strict environmental standards (such as the OECD countries) may employ more energy-efficient and cleaner technologies to comply with the domestic regulations. The use of these energy-efficient technologies and management practices may be passed on to affiliates in developing countries to maintain production standards and meet the requirements of environmentally conscious export markets. 

Third, investment in energy efficiency fundamentally involves decisions on higher initial capital costs and uncertain lower future energy costs at present values (Gillingham et al. 2009). Consequently, firm-level characteristics can be crucial in determining a firm's propensity to invest in improving energy efficiency (DeCanio and Watkins 1998). Some domestic firms may underinvest in energy-efficient technologies due to capital constraints or financial issues (Anderson and Newell 2004). Information problems may also force locally owned firms to resort to suboptimal alternatives. These issues are less serious for foreign affiliates, as they generally dominate locally-owned firms in terms of investment (Arnold and Javorcik 2009) and in international training and experience of decision makers within the firm (Cole et al. 2008).

Fourth, superior management practices are widely believed to be a characteristic of multinational companies. With better management practices, it makes it easier for multinationals to introduce low-cost efficiency improvements.

What do we learn from the Indonesian data?

Four lessons emerge from the analysis. First, while foreign ownership increases the overall energy usage due to an expansion of output, it decreases the plant's energy and emission intensities, which implies that each additional unit of output is produced with lower energy and CO2 content. Specifically, compared to plants that remain domestic, acquired plants reduce energy and emission intensities by about 30% two years after acquisition (see Figures 1 and 2). Observed increases in capital intensity and investment in machinery, coupled with improvement in energy efficiency – even when the effect of changes in the production mix and contemporaneous output is considered – strengthen the argument that the within-plant decline in energy intensity and emission intensity cannot be fully accounted for by economies of scale from expanding production.

Figure 1 Trajectory of energy intensity of matched acquired and domestic plants

Notes:  The figure illustrates the average value of the variable of interest in a given time period for the acquired and the domestic groups. The horizontal axis indicates the year relative to the period t when treated plants are acquired.

Figure 2 Trajectory of CO2 emission intensity of matched acquired and domestic plants

Notes: The figure illustrates the average value of the variable of interest in a given time period for the acquired and the domestic groups. The horizontal axis indicates the year relative to the period t when treated plants are acquired.

Second, foreign divestments appear to have the opposite effect, namely, losing a foreign owner is associated with a reduction in a plant’s output and an increase in its energy intensity. The increase in energy use relative to output is quite substantial, reaching 29% two years after the ownership change. The effect also persists years after the divestment. 

Third, plants with different initial energy intensity benefit from acquisition differently. In particular, plants with higher energy intensity (possibly smaller and less efficient plants) tend to reduce their energy and emission intensities more than those that were already less energy intensive. This finding might explain why previous literature on the relationship between foreign ownership and plant-level energy intensity produced mixed results.

Fourth, energy and emission intensities in Indonesian manufacturing as a whole improved by 31% from 1983 to 2001 (Figure 3). The industry-level data indicate that the decline in the aggregate weighted energy intensity is positively associated with the increased presence of foreign affiliates. The improvement seems to be driven by both within-plant reduction in energy intensity as well as the reallocation of market shares towards more energy-efficient producers.

Figure 3 Aggregate energy intensity, its components and the number of foreign affiliates in the Indonesian manufacturing industry, 1983-2001

Notes: Aggregate energy intensity figures are relative to 1983 levels.
Sources: No. of foreign affiliates—Indonesian Census of Manufacturing; aggregate energy intensity measures—authors' calculation; net FDI inflows—The World Bank.

Concluding remarks

The results presented here challenge the view that the economic growth brought about by FDI is attained at the expense of the natural environment and that an increase in FDI will worsen the existing unsustainable use of natural resources and increase the carbon content of products. On the contrary, they suggest that FDI may serve as a channel for the international transfer of environmentally friendly technologies and practices, thus directly contributing to environmental progress.

References

Anderson, S T, and R G Newell (2004), “Information programs for technology adoption: The case of energy-efficiency audits”, Resource and Energy Economics 26(1): 27-50.

Arnold, J M, and B S Javorcik (2009), “Gifted kids or pushy parents? Foreign direct investment and plant productivity in Indonesia”, Journal of International Economics 79(1): 42-53.

Brucal, A, B Javorcik and I Love (2019), “Good for the environment, good for business: Foreign acquisitions and energy intensity”, Journal of International Economics, forthcoming.

Cai, X, Y Lu, M Wu and L Yu (2016), “Does environmental regulation drive away inbound foreign direct investment? Evidence from a quasi-natural experiment in China”, Journal of Development Economics 123: 73-85.

Cole, M A, R J Elliott and E Strobl (2008), “The environmental performance of firms: The role of foreign ownership, training, and experience”, Ecological Economics 65(3): 538-546.

Cole, M A, R J Elliott and L Zhang (2017), “Foreign direct investment and the environment”, Annual Review of Environment and Resources 42: 465-487.

DeCanio, S J, and W E Watkins (1998), “Investment in energy efficiency: do the characteristics of firms matter?”, The Review of Economics and Statistics 80(1): 95-107.

Hanna, R (2010), “US environmental regulation and FDI: Evidence from a panel of US-based multinational firms”, American Economic Journal: Applied Economics 2(3): 158-89.

Kellenberg, D K (2009), “An empirical investigation of the pollution haven effect with strategic environment and trade policy”, Journal of International Economics 78(2): 242-255.

Millimet, D, and J Roy (2015), “Empirical tests of the pollution haven hypothesis when environmental regulation is endogenous”, Journal of Applied Econometrics 31(4): 652-677.

Gillingham, K, R G Newell and K Palmer (2009), “Energy efficiency economics and policy”, Annual Review of Resource Economics 1(1): 597-620.

Endnotes

[1] More specifically, the analysis combines propensity score matching with a difference-in-differences approach. Matching is done within industry-year cells.

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Topics:  Development Energy Environment

Tags:  energy, FDI, energy efficiency, Indonesia, technology transfer, climate change, environment, multinationals, emissions

Research Officer, Grantham Research Institute on Climate Change and the Environment, LSE

Professor of Economics, University of Oxford; and ITRE Programme Director, CEPR

Associate Professor in the Economics Department, University of Hawaii at Manoa

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