Foreign direct investment, institutional development, and environmental externalities: Evidence from China Danny T. Wang a , Wendy Y. Chen b, * a Department of Marketing, School of Business, Hong Kong Baptist University, KowloonTong, Hong Kong b Department Geography, The University of Hong Kong, Pokfulam, Hong Kong article info Article history: Received 23 April 2013 Received in revised form 24 October 2013 Accepted 9 January 2014 Available online Keywords: Foreign direct investment Institutional development Environmental externalities Industrial sulfur dioxide emission China abstract The question of how foreign direct investment (FDI) affects a host country’s natural environment has generated much debate but little consensus. Building on an institution-based theory, this article ex- amines how the institutional development of a host setting affects the degree of FDI-related environ- mental externalities in China (specifically, industrial sulfur dioxide emissions). With a panel data set of 287 Chinese cities, over the period 2002e2009, this study reveals that FDI in general induces negative environmental externalities. Investments from OECD countries increase sulfur dioxide emissions, whereas FDI from Hong Kong, Macau, and Taiwan shows no significant effect. Institutional development reduces the impacts of FDI across the board. By focusing on the moderating role of institutions, this study sheds new light on the long-debated relationships among FDI, institutions, and the environments of the host countries. Ó 2014 Elsevier Ltd. All rights reserved. 1. Introduction Based on the common belief that foreign direct investment (FDI) benefits its host economies, governments of emerging economies such as China have granted FDI a high priority on their develop- ment agenda. Often they offer a wide array of incentivesdincluding subsidies, lower taxes, duty exemptions, and local market access (UNCTAD, 2001)dwith the expectation that any FDI they attract will contribute positively to the local economy due to technology transfer, management know-how, global market access, and in- dustrial competitiveness (Blomström and Kokko, 1998; Javorcik, 2004). However, the potential effects of FDI on host countries’ natural environments remain controversial (Meyer, 2004). This question holds great importance, especially considering expanding worldwide initiatives to address environmental concerns. Researchers offer competing hypotheses about FDI’s environ- mental externalities. For example, one stream of literature suggests a possible asymmetry between foreign and local environmental standards that attracts dirty industries to developing countries, because multinational companies are motivated to reduce the pollution abatement costs associated with their operations. This perspective represents the “pollution haven hypothesis,” according to which FDI aggravates pollution (Mani and Wheeler, 1998; Bommer, 1999; Cole, 2003, 2004; List et al., 2003; Levinson and Taylor, 2008; Lan et al., 2012). In contrast, some researchers claim that FDI diffuses best management practices and advanced envi- ronmental technologies, creating “pollution halos” in developing countries and thereby reducing pollution (Christmann and Taylor, 2001; Eskeland and Harrison, 2003). These conflicting views cite evidence in support of each direction, and to date, little consensus has been achieved. The unsettled question results in part from the lack of a well- defined framework to explicate the institutional contexts for FDI’s environmental externalities. Existing economics literature largely focuses on empirical examinations of the processes by which FDI exerts an impact on environments, namely, through changes in economic scale, industrial composition, and techniques (Grossman and Krueger, 1995; He, 2006). This approach is similar to the one economists have used to explore the dynamics by which economic development (Grossman and Krueger, 1995) and trade liberaliza- tion (Antweiler et al., 2001; Copeland and Taylor, 2004) influence the environment. Although this process-oriented approach docu- ments various environmental externalities due to the inflow of FDI, it largely ignores the role of local institutions in the FDIeenviron- ment relationship, despite increasing evidence that institutions are critical influences on FDI-related strategic choices (Dunning and Lundan, 2008; Cantwell et al., 2010). In this realm, previous research on FDI fruitfully explores how institutional factors, such as * Corresponding author. Tel.: þ852 3917 5459; fax: þ852 2559 8994. E-mail addresses: dtwang@hkbu.edu.hk (D.T. Wang), wychen@hku.hk (W. Y. Chen). Contents lists available at ScienceDirect Journal of Environmental Management journal homepage: www.elsevier.com/locate/jenvman 0301-4797/$ e see front matter Ó 2014 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.jenvman.2014.01.013 Journal of Environmental Management 135 (2014) 81e90