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When regulated firms are offered compensation to prevent them from relocating, efficiency requires that payments be distributed across firms so as to equalize marginal relocation probabilities, weighted by the damage caused by relocation. We formalize this fundamental economic logic and apply it to analyzing compensation rules proposed under the EU Emissions Trading Scheme, where emission permits are allocated free of charge to carbon-intensive and trade-exposed industries. We show that this practice results in substantial overcompensation for given carbon leakage risk. Efficient permit allocation reduces the aggregate risk of job loss by more than half without increasing aggregate compensation. (JEL H23, Q52, Q53, Q54, Q58)

Does environmental regulation impair international competitiveness of pollutionintensive industries to the extent that they relocate to countries with less stringent regulation, turning those countries into"pollution havens"? We test this hypothesis using panel data on outward foreign direct investment (FDI) flows of various industries in the German manufacturing sector and account for several econometric issues that have been ignored in previous studies. Most importantly, we demonstrate that externalities associated with FDI agglomeration can bias estimates away from finding a pollution haven effect if omitted from the analysis. We include the stock of inward FDI as a proxy for agglomeration and employ a GMM estimator to control for endogenous, time-varying determinants of FDI flows. Furthermore, we propose a difference estimator based on the least polluting industry to break the possible correlation between environmental regulatory stringency and unobservable attributes of FDI recipients in the cross-section. When accounting for these issues we find robust evidence of a pollution haven effect for the chemical industry. (2003) is an exhaustive source of information on the subject of international environmental agreements. 2Electronic copy available at: http://ssrn.com/abstract=1138337 work that documents the importance of agglomeration effects for industrial location choice, the environmental economics literature has, by and large, ignored the implications of this finding for the study of pollution havens.We use longitudinal data on outward FDI flows of German manufacturing industries in 163 destination countries to test the pollution haven hypothesis conditional on industrial agglomeration -proxied by cumulative FDI -in the destination country. To this end, we develop a two-step estimator that explicitly accounts for the endogeneity of cumulative FDI and other country characteristics. Our method controls for unobserved heterogeneity at the country level and flexibly accommodates dynamic specifications of investment demand.Furthermore, our use of a survey measure of the stringency of environmental regulation is novel to the literature, as most existing research relies on measures of pollution abatement cost that may be endogenous to plant location decisions. We find that ignoring agglomeration externalities masks the pollution haven effect in the chemical industry.The paper is structured as follows. The next section reviews the literature on FDI and environmental regulation. Section 3 describes the econometric framework, and section 4 summarizes our data, along with explaining why Germany is a relevant country for such an analysis. In section 5 we report and discuss our results. Section 6 concludes.

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