Climate Risks and Investor Perceptions: Trade Agreements as an Environmental Seal of Approval

Recent studies show that foreign investors systematically avoid countries that are highly vulnerable to climate change. Investors are particularly wary of physical climate risks, which are growing as climate change leads to more frequent and intense weather events. Investors worry that these extreme weather events will damage key infrastructure in host countries, thereby jeopardizing their foreign direct investments (FDI). Thus, a negative relationship exists between climate risks and FDI inflows. However, this negative relationship may be moderated when host countries make strong commitments to managing climate change, which provides assurances to foreign companies that their investments will be protected. While these commitments could come in various forms, they may send an especially strong signal when they are embedded in preferential trade agreements (PTAs), since investors tend to use PTAs as proxies for safety and stability when judging potential risks to FDI. PTAs increasingly include environmental conditions, including legally binding standards that amplify existing multilateral environmental agreements, often making them more enforceable. Therefore, we expect PTAs that include environmental conditions to provide a credible commitment devise for high-risk countries that wish to attract FDI. We will test this expectation using PTA data from the TRade & ENvironment Database (TREND) and FDI data from the World Development Indicators and the International Trade Centre. Our study will contribute to the literature by elucidating how the trade and environmental regimes are intertwined in their impacts on both governments and private actors’ economic strategies as the world struggles to manage the impacts of climate change.