River Pollution: Combating Transboundary Externalities

Transboundary river pollution is a common problem worldwide and a major challenge for regulators to reduce water pollution, especially in developing countries. When polluters are located in the same administrative jurisdiction, local regulations may be sufficient to balance the associated benefits and costs. However, when an administrative boundary separates these groups, local regulators may fail to consider part of the harm that accrues to water users in downstream jurisdictions, resulting in overly lenient regulations. Because of this dynamic, firms may choose (or be encouraged) to locate near jurisdictional boundaries so that most of their pollution losses consist of such spillovers.

Existing policies have failed to address border effects, since almost all of these new regulatory instruments are implemented at the local level rather than at the firm level, when firms are sensitive to border effects. By strategically shifting pollutants toward downstream areas through differential regulation, local governments can improve their local environmental quality at the expense of downstream areas, for any given amount of pollution. This phenomenon is common in China (Cai et al. 2016, Zhang et al. 2018) and other countries (Gray and Shadbegian 2004, Helland and Whitford 2003), as well as between countries (Sigman 2002, Wolf 2007). Although the problem is widely understood, few effective solutions have been offered. Existing studies have provided investigations of China’s environmental regulations (e.g. Fan et al. 2020 on the impact of China’s enforced environmental policies since the 11th Five-Year Plan on industrial firms), but few studies have proposed effective solutions for border effects.

To improve water quality in the downstream reaches of the Xin’an River, in 2011 China established the first inter-jurisdictional environmental compensation system in the Xin’an River Basin, the Ecological Compensation Initiative (ECI), designed to facilitate upstream. -Downstream cooperation in water pollution control. A fund was established and jointly financed by the central government (contribution of 300 million RMB per year) and two provinces: Anhui Province (100 million RMB) and Zhejiang Province (100 million RMB). The two provinces reached an agreement on compensation for environmental services in Anhui Province for cleaning river water. As a base payment, 300 million RMB from the central government will be given to Anhui to support water conservation. If Anhui achieves agreed transboundary water quality targets based on pollution readings at the border – which exceed federally mandated standards – Zhejiang will pay Anhui 100 million RMB to compensate its inputs into water quality control; Otherwise, Anhui will pay Zhejiang 100 million RMB for environmental damage caused by failure to protect upstream water.

Figure 1 Reduction of Prefecture Wastewater Discharges Around the Jin’an River Basin After 2011

Comment: The red line shows the Xin’an River and the green dot marks the river boundary between Anhui Province and Zhejiang Province. Colors show percentage reduction in wastewater discharge in 2011–2013 compared to 2008–2010.

ECI has brought about favorable changes in water pollution levels in cities, as shown in Figure 1. Prefectures located near the Jin’an River have reduced their water pollution to a greater extent since the initiative was implemented. As target cities, upstream Anhui’s Huangshan Prefecture and Jixi County have larger proportional reductions than Hangzhou Prefecture, further downstream, while areas adjacent to target cities have shown no signs of pollution reduction. Significant reductions in contamination are also observed in solid data, as shown in Figure 2.

Figure 2 Water Pollutant Emissions of Anhui Companies Along the Jin’an River from 2007 to 2013

Based on these data, we develop a theoretical model to explain how ECI helps local governments take spillover effects into account and tighten regulation of entities near river boundaries. Following Lipscomb and Mobarak (2016), we model a river of single length divided into two parts governed by two jurisdictions, in which households and firms are distributed along the river with some density function. Local governments choose production at each point along the river within their jurisdiction to maximize social welfare, which includes the utility gain from river pollution caused during production and the utility loss during production based on the firms’ production function and emission functions.

In our model, we compared border pollution under the maximization option without ECI and pollution levels at the border after ECI was implemented. The point is that under the ECI, whether the upstream government can receive compensation funds depends on whether the level of pollution at the border satisfies the contract level, therefore involving the social welfare of the border pollution upstream and motivating the upstream government to make an optimum. Choice for the entire river basin. Border pollution determines spillover pollution downstream, which is not considered by the upstream government except ECI. ECI may induce upstream jurisdictions to internalize pollution externalities along the river into its maximization problem, thereby encouraging upstream governments to tighten riverbank regulation. From the model, we propose that there is a mutually acceptable compensation system under which both upstream welfare and downstream welfare increase relative to the no-contract case, and that the compensation system induces upstream jurisdictions to reduce pollution by reducing output.

Empirically, we find strong evidence of ECI’s effectiveness. We employ a difference-in-differences technique to study the impact of this watershed’s environmental compensation system using firm-level pollution data from annual environmental surveys of polluting firms. We find that China’s implementation of ECI is positively associated with an increased potential of upstream firms to reduce water pollution after 2011, and the effect can be explained by both scale effects and technology effects. For the underlying processes, we show that upstream firms have reduced total water and fresh water inputs, increased pollution treatment facilities, and reduced water pollution generated during the production process.

We then attempt to reveal the variation in policy effects due to uneven enforcement within an area of ​​pollution damage depending on proximity to the river. We examine heterogeneity across firms at different distances from river boundaries and river tributary banks due to potential variation due to geographic distance. We find that the effect of ECI is stronger for firms located near provincial borders and river tributaries

Next, we extend our discussion to further examine the implications of this new approach to addressing cross-border externalities. Because the ECI clearly focuses on specific target areas (such as Huangshan Prefecture and Jixi County in upstream Anhui Province), it is plausible that firms may respond by relocating to nearby, less-regulated areas. We find a significant increase in firm exit from the focal area and a significant increase in the entry of industrial firms into neighboring prefectures. These results indicate that firms leave ECI enforcement areas and move to neighboring areas with relatively more lenient regulations, which to a certain extent validates an ‘internal’ form of the pollutant harboring hypothesis. Consistent with this, we also find evidence of greater water pollution growth in regions with more firms entering.

Finally, to investigate whether this compensation system can be used elsewhere and to identify determinants that may account for its effectiveness in this region, we examine cross-provincial compensation schemes in nine other watersheds across China.1 We find that similar measures also effectively reduce water pollution from upstream prefectures, which confirms the wide applicability of similar measures in Jin’an ECI. ECI induces more firms to exit the downstream market and prevents firms from entering these markets. Moreover, these results are significantly driven by greater wealth in downstream prefectures than in upstream prefectures, possibly reflecting some arbitrage between differences in the marginal utility of income across locales. The economic structure of the region also affects the performance of the ECI: upstream prefectures with less reliance on industrial production and a greater proportion of tourism see a sharp reduction in water pollution.

An important takeaway from our study is that ECI as a quasi-market regulatory tool combines features of traditional command-and-control and market mechanisms, making it effective in managing transboundary spillover effects in situations where downstream stakeholders and upstream environmental service providers are vast and scattered. Our findings suggest that bilateral compensation for ecosystem services appears to successfully reduce pollution and that upstream jurisdictions are willing to reduce their net income (after subtracting output losses and adding ECI payments) in return for reduced pollution, as theory suggests. Although previous studies indicate that bargaining between upstream and downstream parties may be ineffective due to the large transaction costs associated with such bargaining (Diner 2006, Sigman 2002), our results indicate that ECI may be a promising model in cases where jurisdictions Boundaries are nested within a broader national judicial authority that can pull parties toward a Kosian solution


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1 China has promoted ECI to other pilot river basins since 2015, and by 2019, nine more interprovincial river basins have implemented this environmental plan between upstream and downstream provinces.

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