The pollution haven effect and investment leakage:The case of the EU-ETS

Are polluting firms more likely to invest in environmentally lax countries when confronted with increasingly stringent unilateral environmental policies at home? To answer this question, we explore the relationship between carbon inefficiency, regulatory pressure and the foreign direct investment (FDI) projects of multinational enterprises (MNEs) operating under the European Union Emission Trading Scheme (EU-ETS) during its third phase (2013–2020). Contrary to prior research on its initial and more lenient phases, we provide novel evidence on the existence of a pollution haven effect which enables both investment leakage as well as carbon leakage outside the EU-ETS's jurisdiction. These results highlight the dangers of implementing a stringent unilateral climate policy from both an economic and an environmental perspective.