Financial development and environmental quality in UAE: Cointegration with structural breaks

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Abstract

This study extends the recent work of Shahbaz et al. (2014) by implementing recent unit root tests with multiple structural breaks and regime-switching cointegration techniques considering for one and two unknown regime shifts to investigate the relationship between carbon dioxide emissions, electricity consumption, economic growth, financial development, trade openness and urbanization for the UAE over the period spanning from 1975 to 2011. Our results confirm the existence of Environmental Kuznets Curve (EKC). Moreover, we find an inverted U-shaped relationship between financial development and CO2 emissions. We also find that electricity consumption, urbanization and trade openness contribute to improve environmental quality.

Introduction

Concentrations of carbon dioxide and other greenhouse gases (GHG) in the atmosphere have increased since the beginning of the industrial era1. Almost all of this increase is attributable to human activities, largely by burning fossil fuels to generate electricity, heat and cool buildings, and power vehicles. According to the United States Environmental Protection Agency [2], worldwide GHG emissions from human activities increased by 35% from 1990 to 2010. The majority of the world׳s emissions in 2011 result from the use of energy (83%), which is followed by agriculture (8%), industrial processes not related to energy (6%), and waste (3%). The awareness in the GHG emissions and its impact on climate change and global warming has been grown enormously in recent decades. In fact, climate changes that disrupt the functioning of ecosystems may create air pollution problems and more extreme climate events. As a result, environmental degradation displays potential to undermine conditions necessary for well-being of humans. Although there is acutely conscious of increased greenhouse gases emission, this is grudgingly accepted as the necessary cost of rapid economic development. Therefore, to reduce the GHG emissions without any loss of economic growth, it is important to better understand the inter-temporal links in the environment-income nexus.

The relationship between economic growth and environmental degradation, first established by Kuznets [3], has attracted many researchers since the pioneering study by Grossman and Krueger [4]. The EKC hypothesis postulates that the relationship between economic growth and environmental degradation is inverted-U shaped. It implies that initially economic growth increases environmental degradation and then declines it after a threshold point of income per capita. More specifically, at initial level of economic growth, an increase in income is linked with an increase in energy consumption that raises environmental degradation. After reaching a critical level of income, the spending on environment protection is increased, and hence environmental damage tends to decrease.

The EKC hypothesis has been a subject of considerable academic scrutiny on different countries and regions including Asia [5], [6], [7], [8], America [9], [10], [11], [12], Europe [13], [14], [15], [16], [17], Africa [18], [19], [20], and on countries in different regions [21], [22], [23]. The findings of these studies, however, are mixed. The EKC has been estimated for a variety of environmental indicators including air pollution and ecological footprint [23], [24]. Different pollutant emissions have been considered such as sulfur dioxide (SO2), nitrous oxide (N2O), methane (CH4) and total suspended particulate [9], [22], [25], [26]. In this paper, we use carbon dioxide (CO2) emission as an indicator of environmental pollution because it is the foremost GHG contributor to threatening global warming and therefore it plays a central role in the current debate on the environment protection, climate change abatement and sustainable development [27]. Moreover, CO2 emission has been used by most of the previous empirical studies.

Our study extends the recent work of Shahbaz et al. [1] for the UAE by further taking into account financial development into the relationship between economic growth, electricity consumption, urbanization, trade openness and CO2 emissions as a means to circumvent omitted variable bias. Moreover, we examine whether the relationship between CO2 emissions and financial development is inverted U-shaped. Second, compared to the work of Shahbaz et al. [1] employing the autoregressive distributed lag (ARDL) bounds testing approach to cointegration developed by Pesaran et al. [28] in the presence of structural breaks, we use a more recent and more robust empirical methodology when determining the exact breaks dates. While Shahbaz et al. [1] use the break date obtained from the Zivot and Andrews [29] unit root test as a date of shift in the cointegration vector, we use in this paper the Gregory and Hansen [31] and Hatemi-J [32] approaches for testing for cointegration with structural breaks. These two latter approaches are more appropriate for testing for cointegration with one and two unknown regime shifts in the cointegration vector compared to Zivot and Andrews [29] test which is designed by construction to test for unit root with one structural break and not for shifts in the cointegration vector. Moreover, our empirical methodology allows for determining the breaks dates endogenously rather than exogenously like in the study of Shahbaz et al. [1].

The remainder of the paper is organized as follows. Section 2 presents a brief literature review. Section 3 presents an overview of the UAE economy. Section 4 describes the data and models. Section 5 presents and discusses empirical results. Finally, Section 6 concludes and presents policy implications.

Section snippets

Literature review

Beginning with the seminal work of Grossman and Krueger [4], academic researchers have increasingly focused on the EKC hypothesis for many countries and regions using different types of pollutants. The EKC hypothesis postulates an inverted-U-shaped relationship between environmental quality and per capita income. That is, environmental degradation first increases up to a certain level of income, and after that it decreases. Since last decades, the EKC hypothesis has been widely tested, and a

Overview of the UAE economy

Since its federation in 1971, the UAE6 has developed rapidly during the last four decades. Table 2 below reports a summarize of the evolution of some selected UAE׳s indicators and their growth rates. The average annual income growth was about 5% between 1975 and 2012. The GDP per capita increased from 27631.898 (current USD) in 1975 to 41691.695 in 2012.

Econometric models

Since the seminal paper of Grossman and Krueger [4] introducing the EKC hypothesis, several empirical studies have investigated this hypothesis by adding some variables to the basic EKC equation. Following these studies, we propose to consider three different augmented versions of this equation. As additional variables to real GDP per capita, we propose to include in the right hand the electricity consumption, the financial development, the urbanization and the trade openness variables.

Data and descriptive statistics

The data used in this paper are collected from the World Development Indicators (WDI) of World Bank. The data covers the period spanning from 1975Q1 to 2010Q4. We convert the annual data to quarter data using quadratic match sum method13

Summary and policy implications

In this paper, we investigate the relationship between carbon emissions, economic growth, electricity consumption, financial development, urbanization and trade openness for the UAE during the period 1975–2011. The use of Kapetanios [30] unit root test with multiple structural breaks and Gregory and Hansen [31] and Hatemi-J [32] cointegration approaches with one and two unknown regime shifts approaches to investigate the EKC hypothesis in case of UAE represents the main innovative contribution

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