June, 2009

Trade Flow Consequences of the European Union’s Regionalization of Environmental Regulations

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Groups of countries in a region sometimes impose environmental regulations on themselves, particularly inside the European Union. Regional environmental regulations might affect trade flows to and from the regulated countries differently than unilaterally generated regulations for two reasons. The first we term the uneven competitiveness effect: A given increase in production costs across all countries is a higher percentage increase in production costs for countries that produce low-cost goods than for those that produce high-cost goods. The second reason we term the uneven burden of compliance: Because high-income countries are more likely than low-income countries to have relatively stringent environmental regulations in place prior to the creation of regional environmental regulations, the cost of compliance with a given regional environmental regulation might be lower for high income countries than for low-income countries.

Using the gravity equation, we test the effect on bilateral trade flows of increases in environmental regulation stringency ratings, taken from survey data, with a panel of 56 countries, controlling for European Union membership and income levels. We find significant differences in the effects on EU members' exports and non-EU members' exports' as well as across income levels of countries. An increase in environmental regulation stringency leads to a dramatic decrease in exports from low-income EU members; conversely, a similar change in environmental regulation stringency leads to an increase in exports from high income, EU-member countries. The results are consistent with the hypothesized uneven competitiveness effect and the uneven burden of compliance.