Institutions and Fuels Trade: a Quantitative Analysis

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I. ABSTRACT 
 
The thesis investigates whether there is a link between governance 
quality and fuels dependence, from the side of both exporting and importing 
countries. The underpinning argument consists in the fact that a more archaic 
institutional environment fosters trade in polluting energy sources while 
hindering renewables sector development.  
Institutional quality is measured employing the most widespread 
benchmark in literature, the World Governance Indicators: a subjective and 
composite index that measures governance along six dimensions. In order to 
interpret correctly thesis’ findings, it is important to highlight that, since the 
World Bank index has a subjective nature, results are referred to the perceived 
institutional framework, which it is likely not to fully mirror the actual one.  
The quantitative analysis exploits the panel feature of data, using the 
fixed-effects model with time dummy variables. Its main advantage is that not 
only it eliminates the effect of unobserved country characteristics but also the 
time related influence, resulting in more precise coefficients. Moreover, a 
series of control variables is inserted in order to capture main international 
trade determinants. The analysis is conducted on a twofold basis, keeping 
separate the exporting side from the importing, and draws different 
conclusions. 
The point the thesis wants to demonstrate is that improving national 
institutions constitutes an effective policy towards the reduction, on one hand,
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of the economic dependence from fuels for exporting countries and, on the 
other, of the energetic dependence for importing countries.
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Il presente lavoro investiga il legame tra qualità istituzionale e 
dipendenza da beni combustibili, dal punto di vista sia dei paesi esportatori che 
importatori. L’argomento che sottende l’intera tesi consta nel fatto che un 
ambiente istituzionale arcaico alimenta il commercio in prodotti energetici 
inquinanti mentre ostacola lo sviluppo del settore delle fonti rinnovabili. 
La qualità istituzionale è misurata attraverso il riferimento più diffuso 
in letteratura, gli World Governance Indicators: si tratta di un indice composito 
a carattere soggettivo che misura la governance lungo sei dimensioni. Al fine 
di intrepretare correttamente le conclusioni del presente lavoro, è importante 
non perdere di vista il fatto che, avendo l’indice della Banca Mondiale una 
natura soggettiva, i risultati si riferiscono unicamente alla percezione del 
quadro istituzionale, il quale non rispecchia perfettamente il concreto assetto 
istituzionale.  
L’indagine quantitativa trae vantaggio dalla struttura panel dei dati, 
facedo impiego del modello a effetti fissi con variabili dicotomiche temporali. 
Infatti, tale tecnica regressiva elimina gli effetti non solo delle caratteristiche 
nazionali non osservate ma anche degli eventi annuali, risultando in 
coefficienti più precisi. Inoltre, una serie di variabli di controllo viene inserita 
al fine di tenere in considerazione le determinanti classiche del commercio 
internazionale. L’analisi è condotta su due livelli separati ma paralleli, 
distinguendo tra importazioni ed esportazioni e giungendo così a conclusioni 
distinte. 
L’argomento che il presente lavoro intende dimostrare è che il 
miglioramento dell’assetto istituzionale costituisce una politica effettiva per la 
riduzione, da un lato, della dipendenza economica da fonti non rinnovabili per i 
paesi esportatori e, dall’altro, di quella energetica per paesi importatori.
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1. INTRODUCTION 
 
In social sciences, in particular in economics, the adoption of the term 
institution becomes widespread with the turn of the century, as a reflection of 
its growing importance in the academic domain. Nevertheless, even today a 
unanimous definition of the concept has not arisen. The most prominent 
scholar on the subject is Geoffrey Hodgson, Research Professor at the 
University of Hertfordshire and author of a number of books and studies about 
the role of institutions in modern economic theory. In one of his most known 
works, How economics forgot history, he states that “Essentially, institutions 
are durable systems of established and embedded social rules and conventions 
that structure social interactions” (Hodgson 2001). In other words, they may be 
referred to as the rules of the game to which every individual is subject in a 
defined environment. Their role is not only to constraint people’s behaviour by 
stating what the society allows and forbids, but also to enable the formation of 
expectations on future course of events. Examples of institutions may be 
language, table manners, law and all the kind of conventions people 
unconsciously agree upon within a culture. Institutions are not a static concept, 
but a rather dynamic one so that new conventions are established every day. 
As structures of social order, institutions are central in the social 
sciences, like political science, sociology and economics. Nevertheless, this 
study does not consider institutions as a whole but focuses on those which have 
a direct impact on economic activity. In particular, three macro areas are taken 
into consideration: first of all the country stability and the respect of civil 
rights, secondly the government ability to implement sound policies and the 
efficiency of the overall public administration and finally the rule of law and 
the pervasiveness of corruption.
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2. LITERATURE REVIEW 
 
The academic world acknowledges Governance as having a direct influence on a 
country’s economic performance. Good institutions are often associated with high income, 
consistent growth and significant FDI inflows. 
One of the first empirical evidences on the importance of the institutional 
environment is the work of La Porta, Lopez-de-Silane, Shleifer and Vishny (1997), where 
the authors focus on capital markets. Through the comparison of 49 countries, the study 
points out that nations with poorer investor protection also have smaller capital markets. 
This leads to a more concentrated ownership, which in turns makes it more difficult for 
entrepreneurs to raise money. The main conclusion is that bad institutions constraints a 
nation’s economic development. 
The idea that quality of institutions is the most important proxy for national wealth 
is supported by Rodrik, Subramanian and Trebbi (2004), who estimate the relevance of 
income determinants around the world. 
Kaufmann and Kraay (2002)nexplore more in detail the relationship between GDP 
and institutions. Generally speaking, GDP and the quality of governance are positively 
correlated, while the authors’ main contribution is to provide evidence on the negative 
causal effect running from income to Governance. It implies that improvements in 
institutions are unlikely to occur only as a consequence of economic development. “As 
countries become richer, it is important not to exaggerate the conventional wisdom that 
higher incomes lead to demands for better institutional quality” Kaufmann and Kraay 
(2002). From this point of view, this study aims to corroborate Kaufmann and Kraay’s 
hypothesis showing how low institutional quality may hinder energetic independence 
(measured as fossil fuels imports over GDP) for industrialized countries.
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In addition, Governance has a macroeconomic impact on trade. Canonical theory 
explains bilateral trade through a mix of country characteristics such as factors 
endowment, production technology and consumers preferences. A relatively recent branch 
of academic research, however, indicates that understanding the actual trade level requires 
the consideration of national institutions as well. 
One of the easiest way to assess institutional influence is to confront the volume of 
trade in differentiated goods, that is to say goods apt to assume several physical 
characteristics, with the volume of trade in commodities. The first to point out that 
institutional quality should foster international trade in complex goods was Douglass North 
in his book Institutions, Institutional Change and Economic Performance (1990). Ranjan 
and Lee (2007) test this reasoning for a particular aspect of institutions: enforcement of 
contracts. They derive estimating equations from a model where the degree of contract 
enforcement directly affects transaction costs, concluding that the degree of institutional 
quality positively affects the volume of trade in both types of goods, with increasing 
magnitude for differentiated goods. 
From a dynamic perspective, Schuler (2003) analyses the change in trade 
composition following an institutional worsening on a short-term basis. He focuses on the 
former soviet countries, highlighting that, after the USSR dissolution, exports in 
institutional intensive sectors fell relatively more. 
Far more comprehensive is Levchenko (2004)’s investigation, which models 
institutional differences using the Grossman-Hart-Moore framework of contract 
incompleteness. Better quality for developed countries means higher productivity in the 
institutionally dependent sectors, leading to full specialization in those goods. Emerging 
economies follow an opposite path resulting in the specialization in less desirable goods 
(i.e. goods that require the lessening of environmental or labour standards). Albeit in the 
short term some countries may not gain form trade, a further analysis with endogenous 
institutions shows that trade opening results in a race to the top with emerging countries 
gaining shares of more desirable sectors. This work confirms Levchenko (2004) main