The past 15 years have seen an increasing debate over the linkages between trade and
environmental regulations. In part, this debate has reflected concerns in developed countries that
their competitive position would be eroded by environmental regulations that encourage
pollution-intensive industries to move to countries with lower standards (the so-called pollution
haven hypothesis). Environmentalists fear that increasing trade integration and the competition
for investment and jobs may lead to a “race to the bottom” on environmental regulations, as
national governments find it more difficult to internalize environmental and social costs in
prices. Hence, trade unions and environmentalists usually demand binding international
environmental standards, preferably within the framework of the World Trade Organisation
(WTO) to ensure a “level playing field” for all exporters (Grether and De Melo 2003).
Based on standard trade models, economic theory would predict that a comparative advantage in
pollution-intensive commodities would arise from relative factor endowments, that is, labor,
capital, natural resources, and the stringency of environmental regulations (Van Beers and Van
der Bergh 1996). It is well known that high-polluting industries, such as industrial chemicals or
iron and steel, are highly capital intensive and require less labor in comparison to other
manufacturing industries (Mani and Wheeler 1998). Environmental regulations, for instance, in a
high-income country, with considerable abatement costs (as a percentage of total costs) would
then lead to a relative cost disadvantage and a change in the relative comparative advantage in
the production of “dirty” commodities toward countries with lower standards. As these industries
move to lower-standards countries, not only the location of foreign direct investment (FDI) and
trade patterns would be affected, but also overall pollution levels would increase.

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