The role of carbon risk in foreign direct investment: Evidence from China

This study examines how carbon risk affects firm foreign direct investment (FDI) under the carbon emissions trading system (ETS) in China. We leverage data on carbon emissions from more than 900 listed companies from 2007 to 2022. We explore how firm-specific carbon risk factors may impact FDI and show that carbon risk constrains firms’ FDI through increased carbon costs from regulations and earnings uncertainty. The findings hold across alternative measures of carbon emission intensity, various model specifications, and after considering potential endogeneity issues. We also show that carbon risk originates primarily from carbon emissions caused by the corporate combustion of fuels. For firms under mandatory governmental disclosure of environmental information, the negative effect of carbon risk on FDI is relatively modest. Heterogeneity analysis demonstrates that FDI is more adversely affected by carbon risk when invested in host countries with stringent environmental performance, industries with high-polluting, or state-owned enterprises. This study contributes to the literature by (1) providing a novel perspective of carbon risks to investigate their influence on FDI, (2) conducting micro firm-level analysis by manually collecting firm-level data, and (3) identifying two underlying mechanisms including increased carbon costs from regulations and earnings uncertainty.