Evaluating the environmental and economic implications of curbing transboundary pollution: Evidence from China

Mitigating transboundary pollution requires internalizing environmental externalities and coordinating inter-jurisdictional interests. This paper examines the environmental and economic consequences of China's watershed ecological compensation (WEC) policy, a government-led property rights allocation scheme that combines Coasean bargaining with state-contingent contracts. By exploiting the progressive roll-out of inter-provincial WEC schemes and employing a difference-in-difference-in-differences design with a novel county-level dataset containing long-term industrial water pollutant information, we find that upstream counties experience significant reductions in pollution emissions but slower economic growth relative to their adjacent downstream counties after policy implementation. Event study estimates further indicate that environmental governance entailing high economic costs is difficult to sustain over time, reflecting a potential misalignment between costs and benefits in environmental protection. These effects can be attributed to pollution-control-oriented policy measures adopted by upstream local governments and the resulting responses of firms and residents. We further show that upstream local governments' prioritization of environmental governance is shaped by both economic and political incentives. Our findings offer insights into institutional design for improving transboundary water quality in countries with decentralized environmental management systems.