Does FDI mitigate CO₂ emissions intensity? Not when institutional quality is weak

Foreign direct investment benefits developing countries. However, concerns have arisen that the influx of FDI potentially exacerbates environmental pollution. While this debate continues, growing attention has recently emerged on the role of institutions in mitigating FDI's potential damages, although the empirical findings remain inconclusive. This paper examines how institutional quality shapes the relationship between FDI and CO₂, both at the aggregate level and across different income groupings, using a reduced-form CO₂ emissions model, panel data from 2000 to 2018 and the IVGMM techniques. Three key conclusions emerge. First, the findings show that FDI reduces CO₂ emissions, but its magnitude depends on the measure used. Second, institutional quality is directly associated with higher emissions across income groups, suggesting current regulations inadequately ameliorate environmental pollution. Third, we find a positive interaction effect between CO₂ emissions and institutional quality. We argue that, for FDI to consistently curb CO₂ emissions, the quality of institutions must improve to better regulate foreign investors' activities, especially in low and high-income nations. Enhancing the quality of institutions will help translate FDI into improved environmental outcomes across income groups.