The Impacts of EnvironmentalRegulations on Competitiveness.docx

The Impacts of Environmental
Regulations on Competitiveness
Antoine Dechezleprêtre* and Misato Sato
†
Introduction
Ever since the first major environmental regulations were
enacted in the 1970s, there has been
much debate about their potential impacts on the
competitiveness of affected firms. Businesses
and policy makers fear that in a world that is increasingly
characterized by the integration of trade
and capital flows, large asymmetries in the stringency of
environmental policies could shift
pollution-intensive production capacity toward countries or
regions with less stringent regula-
tion, altering the spatial distribution of industrial production
and the subsequent international
trade flows. This has caused concern, particularly among
countries that are leading the action
against climate change, because their efforts to achieve deep
emission reductions could put their

own pollution-intensive producers at a competitive disadvantage
in the global economy.
There are two different views in the environmental economics
literature on the effects of
asymmetric policies on the performance of companies
competing in the same market: the
pollution haven hypothesis and the Porter hypothesis. The
pollution haven hypothesis, which
is based on trade theory, predicts that more stringent
environmental policies will increase
compliance costs and, over time, shift pollution-intensive
production toward low abatement
cost regions, creating pollution havens and causing policy-
induced pollution leakage
(e.g., Levinson and Taylor, 2008). This is a particularly
troubling problem for global pollutants
such as carbon dioxide, because it means that on top of the
economic impacts on domestic
firms, abatement efforts will be offset to some extent by
increasing emissions in other regions.
*Grantham Research Institute on Climate Change and the
Environment, London School of Economics,
Houghton Street, London WC2A 2AE, United Kingdom. Tel:þ44
(0)207 852 3626; e-mail: [email protected]
lse.ac.uk.
†

Grantham Research Institute on Climate Change and the
Environment, London School of Economics,
Houghton Street, London WC2A 2AE, United Kingdom. Tel:
þ44 (0)207 107 5412; e-mail: [email protected]
lse.ac.uk.
We would like to thank Milan Brahmbhatt, Raphael Calel,
Baran Doda, Damien Dussaux, Carolyn Fischer,
Matthieu Glachant, Colin McCormick, and Dimitri Zenghelis
for helpful comments on an earlier version of
this article. We are grateful to three anonymous referees for
very constructive comments and suggestions.
Financial support has come from the Global Green Growth
Institute, the Grantham Foundation for the
Protection of the Environment, the European Union Seventh
Framework Programme (FP7/2007-2013)
under grant agreement no. 308481 (ENTRACTE), and the UK
Economic and Social Research Council
through the Centre for Climate Change Economics and Policy.
Review of Environmental Economics and Policy, volume 11,
issue 2, Summer 2017, pp. 183–206
doi: 10.1093/reep/rex013
Advance Access Published on July 27, 2017
VC The Author 2017. Published by Oxford University Press on
behalf of the Association of Environmental and Resource
Economists. This is an Open Access article distributed under
the terms of the Creative Commons Attribution License (http://
creativecommons.org/licenses/by/4.0/), which permits
unrestricted reuse, distribution, and reproduction in any
medium,
provided the original work is properly cited.

183
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In contrast, the Porter hypothesis (Porter and van der Linde
1995b) argues that more
stringent environmental policies can actually have a net positive
effect on the competitiveness
of regulated firms because such policies promote cost-cutting
efficiency improvements, which
in turn reduce or completely offset regulatory costs, and foster
innovation in new technologies
that may help firms achieve international technological
leadership and expand market share.
This article reviews the recent empirical literature that attempts
to quantify the effects of
asymmetric environmental regulations on key aspects of firms’
competitiveness, including
trade, industry location, employment, productivity, and
innovation. The first major review
on this topic (Jaffe et al. 1995) concluded that there is relatively
little evidence that environ-

mental policies lead to large losses in competitiveness. Over the
last two decades, both the
growth in the number of environmental policies worldwide and
the availability of high-
quality data, especially at the firm and facility level, have
enabled researchers to improve
their empirical analyses of the economic effects of asymmetric
environmental policies. Our
aim is to critically assess this evidence to ascertain whether the
conclusions of Jaffe et al.
(1995) still hold or should be updated. By synthesizing the
evidence, we also hope to inform
the political debate concerning the economic impacts of
environmental regulations.
Competitiveness concerns stem largely from differences in
environmental regulations
across countries. Thus we focus primarily on studies that
empirically examine cross-
country differences in environmental stringency. We also
include some studies that examine
differences between smaller-scale jurisdictions (e.g., cross-
county differences in the United
States). Importantly, our review covers only ex post evaluation
studies, thus excluding ex ante

modeling studies, which have recently been reviewed by
Carbone and Rivers (2017). We also
focus on environmental regulations that affect the
manufacturing sector and target industrial
emissions, which are at the center of most competitiveness
debates.
1
The article is organized as follows. We start by explaining how
environmental regulation
causes competitiveness effects and how these effects are
measured. We then review the ex-
isting evidence, first discussing the impact of relative
environmental stringency on trade,
industry location, and employment, and then examining the
effects on productivity and
innovation, which could also impact firms’ competitiveness. We
conclude with a summary
and a discussion of priorities for future research.
How Does Environmental Regulation Affect Firms’
Competitiveness?
In the context of environmental policies, competitiveness
2
effects result from differences
or asymmetries in regulatory stringency

3
applied across entities (e.g., firms or sectors) that
1
We do not include regulations on fishing, agriculture, forestry,
mining, or waste, which are sometimes
directed explicitly at protecting the environment and human
health.
2
Competitiveness is a term that is often used but ill-defined. In
general, it refers to the ability of a firm or sector
to survive competition in the marketplace, grow, and be
profitable (Bristow 2005). Some concepts of
competitiveness discussed in the literature include the ability to
sell (which reflects the capacity to increase
market share), ability to earn (the capacity to increase profit),
ability to adjust, and ability to attract (see
e.g., Berger [2008] for an overview).
3
We use the term policy stringency here to describe a general
level of policy ambition. As we will discuss, in
practice, measuring relative policy stringency across different
forms of regulation and enforcement regimes
is far from straightforward.
184 A. Dechezleprêtre and M. Sato
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are competing in the same market. For example, some firms may
be regulated while
others are exempt, some sectors may face stricter pollution
standards than others, or
environmental stringency may vary across jurisdictions, as is
the case with climate change
mitigation policies, where different regions are expected to take
carbon mitigation action
at different speeds under the United Nations Framework
Convention on Climate Change
Paris agreement. If two competing firms face identical
regulation, then competitiveness
effects are not an issue.
4
Thus competitiveness effects can be distinguished from the
general effects of regulations on polluting firms’ economic
outcomes, which are caused
by the policy itself rather than by differences in environmental
policy faced by competing
polluting firms.
Asymmetric Environmental Regulations and Relative Production
Costs
Environmental regulations generally require polluting facilities

to undertake abatement
activities and may impose costs on businesses. Thus regulatory
differences across firms,
sectors, or jurisdictions can cause changes in relative
production costs. Such changes could
arise from differences in direct costs. For example, the
European Union Emissions Trading
System (EU ETS), which regulates carbon emissions of
approximately 12,000 installations
across Europe, is estimated to have increased average material
costs (including fuel) for
regulated firms in the power, cement, and iron and steel sectors
by 5 percent to 8 percent
(Chan, Li, and Zhang 2013).
5
Increases in relative costs could also result from higher indirect
costs caused by policy-induced changes to input costs. For
example, even if they are not
directly regulated by the EU ETS, European consumers of
electricity face higher electricity
costs due to the price on carbon emissions paid by electricity
producers. Differences in
environmental regulations can thus alter the competition
between firms by changing their

relative production costs.
Pasurka (2008) finds evidence that differences in environmental
stringency across coun-
tries induce important differences in pollution abatement costs.
Across nine countries in
Europe, North America, and Asia, the share of manufacturing
capital expenditure assigned to
pollution abatement in 2000 ranged from 1 percent (Taiwan) to
5 percent (Canada). In terms
of sectoral variation, abatement costs are typically higher for
pollution-intensive industries
such as pulp and paper, steel, and oil refining. In the United
States, for example, in 2005 each
of these sectors spent approximately 1 percent of their turnover
to comply with environmen-
tal regulations, while the average for all manufacturing plants
was 0.4 percent (Ferris and
McGartland 2014). Importantly, differences in relative costs
may arise not only from the
stringency of the regulation, but also from its nature and design
(Iraldo et al. 2011), in
4
Note, moreover, that if there are no regulatory differences
across companies, it is not possible to establish a

counterfactual scenario (i.e., what would have happened had the
policy not been implemented) against
which to evaluate the impact of a given regulation.
5
In addition to affecting marginal and average costs of
production, environmental regulations can affect
entry and investment costs for companies. Ryan (2012) finds
that the 1990 U.S. Clean Air Act Amendments
(CAAA) had no effect on the cement industry’s marginal
(variable) costs, but the average sunk costs of entry
increased, with the costs of building a new, greenfield facility
increasing by $5 million to $10 million due to
the rigorous environmental certification and testing
requirements of the CAAA.
Impacts of Environmental Regulations on Competitiveness 185
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particular because of the uncertainty associated with different
types of instruments (Goulder
and Parry 2008).

As illustrated in table 1, asymmetric environmental policies
induce changes to relative
production costs (the first-order effect) and trigger different
responses by firms. Firms may
respond through decisions concerning pricing, output, or
investment (second-order effects).
For example, in the case of pricing, firms may decide to absorb
the increase in production
costs or pass it through to consumers.
6
These firm responses in turn influence outcomes
along various economic, technological, international, and
environmental dimensions (third-
order effects). These effects are not uni-directional, rather there
are multiple linkages and
dynamic feedbacks. Changes to technology outcomes, for
example, may trigger cost impacts
or firm responses to change.
The Pollution Haven Hypothesis
There are two opposing views on the likely competitiveness
effects arising from asymmetric
environmental policies worldwide, as noted earlier. The
pollution haven hypothesis goes back

more than thirty years (e.g., McGuire 1982) and predicts that if
competing companies differ
only in terms of the environmental policy stringency they face,
then those facing relatively
stricter regulation will lose competitiveness.
Higher regulatory costs could, for example, crowd out
productive investment in in-
novation or efficiency improvements and slow down
productivity growth. If increased
regulatory costs are passed through to product prices in fiercely
competitive product
markets, distortions in trade could occur, as product prices will
increase more in coun-
tries with relatively strict regulation. Companies in countries
with higher costs will then
lose market share to competitors in countries producing
pollution-intensive exports
Table 1 Competitiveness Effects Due to Differences in the
Stringency of Environmental Regulations
First-order
effect
Second-order
effect

Third-order effects
Cost impacts Firm
responses
Economic
outcomes
Technology
outcomes
International
outcomes
Environmental
outcomes
Changes to
relative costs
(direct and
indirect
costs)
– Production
volume

– Product prices
– Productive
investments
– Investment in
abatement
– Profitability
– Employment
– Market share
– Product innovation
– Process innovation
– Input-saving
technologies
– Total factor
productivity
(TFP)
– Trade flows
– Investment
location

– Foreign direct
investment
(FDI)
– Pollution levels
and intensity
– Pollution
leakage
Source: Authors.
6
In order to drive a demand-side switch toward cleaner products,
it is both desirable and necessary to have
product prices reflect pollution abatement costs. How firms
respond to pricing has important distributional
consequences.
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more cheaply. If environmental regulatory differences are
expected to last, companies’
decisions regarding the location of new production facilities or
foreign direct investment
may also be affected, with pollution-intensive sectors, and thus

manufacturing employ-
ment, possibly gravitating toward countries with relatively lax
policies and creating pol-
lution havens.
The Porter Hypothesis
The Porter hypothesis takes the more dynamic perspective that
more stringent policies
should trigger greater investment in developing new pollution-
saving technologies. If these
technologies induce input (e.g., energy) savings that would not
have occurred without the
policy, they may offset part of the compliance costs. Porter and
van der Linde (1995b) go
further, arguing that environmental regulations can actually
“trigger innovation that may
more than fully offset the costs of complying with them,” i.e.,
lowering overall production
costs and boosting the competitiveness of firms.
7
This Porter hypothesis outcome may occur
if cleaner technologies lead to higher productivity, input
savings, and innovations, which over
time offset regulatory costs (dynamic feedback to the first-order

effect) and improve export
performance and market share. For example, the existence of
learning externalities might
prevent the replacement of an old polluting technology by a
new, cleaner and more produc-
tive technology because firms have a second-mover advantage if
they wait for someone else to
adopt. In this situation, the introduction of an environmental
regulation would induce firms
to switch to the new, cleaner technology, which improves
environmental quality and even-
tually increases productivity (Mohr 2002). An argument that is
related to the Porter hypoth-
esis postulates that a country can generate a first-mover
advantage to domestic companies by
regulating pollution sooner than other countries, which leads
domestic firms toward inter-
national leadership in clean technologies that are increasingly in
demand globally (Porter and
van der Linde 1995a).
Measuring Competitiveness Effects Empirically
Since Jaffe et al. (1995), empirical analyses of the
competitiveness effects of environmental

regulation have benefited from improvements in data
availability, empirical methodology,
and policy stringency measurement. There is yet no single
accepted test or measure of the
competitiveness effects of environmental regulation and the
literature continues to use a
variety of outcome measures linked to competitiveness
(summarized in table 1).
8
Estimates of
the effect of policies on these different outcomes are usually
derived using reduced form
rather than structural equations. Despite some progress being
made, there are still a number
7
See Ambec et al. (2013) for a discussion of the theoretical
justifications for the Porter hypothesis that have
been proposed in the literature.
8
Jaffe et al. (1995) argue that the ideal measure to study
competitiveness would be the effect of relative policies
on net exports. With aggregated sector-level data, this is a
theoretical measure because it is impossible to
measure the reduction in net exports “before” adjustments in the
exchange rates, holding real wages and
exchange rates constant. However, it is less of a problem when
using data at a disaggregated level, because
changes to trade of a single company are unlikely to affect

exchange rates.
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of challenges to conducting credible empirical analysis of the
competitiveness impacts of
Solving Endogeneity Concerns Through Disaggregated Data
The greater availability of detailed data, in particular at the firm
or facility level, over the last
couple of decades has been key to obtaining more robust
evidence on competitiveness im-
pacts. Using country- or sector-level data can be problematic
because it does not allow
researchers to distinguish between the production facilities that
are covered or exempt and
the particular policy being evaluated, leading to aggregation
bias (Levinson and Taylor 2008).
Moreover, an important challenge to empirically analyzing the

competitiveness impacts of
environmental regulation is that the policies could be
endogenous. This could be the case if
environmental policies are correlated with the unobserved
determinants of the outcome
variable of interest, such as trade (e.g., supply chain linkages,
other firm-specific factors,
political institutions, the stringency of other regulations).
Governments could also set strin-
gency levels strategically, for example, by exempting key
export sectors from environmental
regulations, suggesting the possibility of reverse causality when
using sectorally aggregated
data. The recent economic geography literature also suggests
the presence of bias if the
location of polluting firms is influenced by other firms in that
location (e.g., Zeng and
Zhao 2009). Firm-level panel datasets over long time periods
both before and after the
introduction of the policy and improved estimation methods can
overcome these problems
by controlling for unobserved heterogeneity across firms.
9
However, numerous policies, in

particular in developing countries, can still not be the subject of
rigorous evaluation, because
of the lack of high-quality data. Going forward, ensuring that
data collection is built into the
design of policies from the outset will enable researchers to
evaluate the impacts of the many
new environmental policies that are being implemented.
Measuring Environmental Stringency
To evaluate the impact of a given regulation, there needs to be
an accurate measure of envi-
ronmental stringency so that a control group can be constructed
that captures what happens in
the absence of a policy or in the event of a weaker policy. In
within-country analyses, variation
in environmental regulatory stringency can arise if a policy is
implemented in a random subset
of regions or if the rollout is staggered over time. For example,
in the U.S. context, the federal
designation of counties into “attainment” or “nonattainment”
status depends on local air
quality for various pollutants, thus providing a convenient
source of exogenous variation.
Counties with nonattainment status then face much stricter

environmental regulation.
10
In an international context, however, it is often the case that
different policies need to be
compared. This is a difficult task due to the complex nature of
9
Omitted variable bias can occur when firms’ unobserved
characteristics may be correlated with both
regulatory stringency and the outcome measure (e.g.,
productivity).
10
Being federally mandated, this status is unlikely to be related to
differences in tastes, geographic attributes,
or underlying economic conditions across counties. Moreover,
local pollution levels depend heavily on
weather patterns (in particular, wind and precipitation), which
are unlikely to be systematically related to
local manufacturing sector activity (Greenstone, List, and
Syverson 2012).
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Although the measurement of relative stringency is likely to be

fraught with measurement
error, a number of approaches have been used in the literature.
One popular option is to
proxy stringency using either the environmental outcome
(pollution level) or measures of
compliance costs as a share of value added. The latter option
has typically used data on
pollution abatement and control expenditures (PACE), which
has been collected for the
United States since the 1970s and for Europe and Asia–Pacific
countries since the 1990s.
However, PACE is far from an ideal proxy for stringency. First,
because the production level is
used as a denominator, it is unlikely to be exogenous. Second,
because it is based on survey
data, PACE is not readily comparable across countries since the
survey methodologies differ
across countries in terms of what should and should not be
considered as abatement expen-
ditures. Third, PACE data do not account for how compliance
costs may impact market
competition. Finally, PACE data are available only for
surviving firms. Thus impacts on firms
that exit because of the environmental regulation would not be

included in the measure.
Several alternative measures of stringency have been used in the
literature, including en-
vironmental or energy tax revenue, renewable energy capacity,
recycling rates, legislation
counts, and composite indicators. However, as discussed in
Brunel and Levinson (2013) and
Sato et al. (2015b), all of these have shortcomings. For
example, although price-based policies
such as emissions trading would appear to be easy to compare,
they are complicated by
differences in the setup of systems (e.g., sectoral coverage) and
exemption rules, such as
differences in free allowance allocation provisions, which not
only affect the level of policy
stringency, but also alter incentives and influence the behavior
of firms.
11
However, few
measures of stringency account for such provisions. Although
these shortcomings do not
prevent analysis of the impacts of environmental policies, it is
important to keep them in
mind when reviewing the available evidence, which we do in

the next two sections.
Empirical Evidence: Impacts on Trade, Industry Location, and
Employment
A central focus of the competitiveness debate has been the
potential impact of environmental
regulation on international trade and the location of production
and investment, as well as
the employment consequences of these effects.
12
In this section we examine the evidence
concerning these impacts.
Environmental Regulation and International Trade
Much of the early literature tested the pollution haven
hypothesis
13
by examining the overall
effect of international trade on the quality of the environment.
Grossman and Krueger
(1995), for example, asked how openness to trade affects the
environment through its effects
11
For example, see Branger et al. (2015) for an analysis of the
impact of the EU ETS free allocation rules on
operational, investment, and trade decisions.

12
Related to this are political economy concerns about
governments’ use of environmental policy as an
implicit trade barrier to circumvent international free-trade
agreements.
13
Some scholars also refer to a pollution haven effect, which
occurs if asymmetric environmental policies, at
the margin, influence firms’ trade and investment location
decisions. See Copeland and Taylor (2004) for a
detailed discussion of the pollution haven arguments.
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on the scale of economic activity, sector composition, and
technology adoption, and found
limited empirical evidence that trade made developing countries
dirtier.
14
In a study of 43
countries, Antweiler, Copeland, and Taylor (2001) find that
international trade is in fact
beneficial to the environment (as measured by sulfur dioxide
[SO2] concentration) be-

cause the increase in economic activity (scale effect) is offset
by changes in both technol-
ogy and the composition of output in the economy. One
explanation for this result is that
in low-income countries, the higher price of capital offsets their
“advantage” of having lax
environmental policies because pollution intensive industries
are also capital intensive.
Levinson (2010) instead examines the composition of U.S.
imports following the adoption
of environmental regulation. Taking account of intermediate
inputs, he finds that between
1972 and 2001, U.S. imports increasingly shifted away from
pollution-intensive goods.
This, he argues, does not contradict the pollution haven
hypothesis because the shift
toward less polluting imports may have been smaller without
However, he suggests that if there was indeed a pollution haven
effect, it was likely over-
whelmed by other forces such as availability and costs of raw
materials, skilled labour
availability, transport costs, market structure, and fixed plant
costs. Subsequent analyses

have found that international trade has a modest impact on
pollution (e.g., McAusland
and Millimet 2013).
Several studies have more directly assessed whether
environmental regulation causes
changes in trade flows. These studies use a variety of measures
of relative environmental
stringency, with PACE being a popular choice. For example,
Ederington and Minier (2003)
treat PACE as an endogenous variable
15
and, for a panel of U.S. manufacturing industries,
find that between 1978 and 1992, net imports rose with higher
PACE, suggesting that differ-
ences in environmental regulation impact trade flows. Using the
same data but taking ac-
count of factors that limit the geographic mobility of economic
activity (e.g., transportation
costs, fixed plant costs, and agglomeration economies of an
industry), Ederington, Levinson,
and Minier (2005) find that the pollution haven effect is
difficult to detect in capital-intensive
industries. They note that quantifying average effects on

competitiveness across all sectors
understates the effects of regulatory differences on “footloose”
(i.e., geographically mobile)
sectors. Levinson and Taylor (2008) use a panel for 1977–1986
and find that a 1 percent
increase in PACE in the United States is associated with an
increase in net imports of 0.4
percent from Mexico and 0.6 percent from Canada.
16
Levinson (2010), however, argues that
the result in Levinson and Taylor (2008) does not actually show
that higher levels of PACE
cause higher imports; rather, it shows that imports are rising in
sectors where the gap in the
stringency level across countries is increasing.
14
For a review of such earlier studies, see Jaffe et al. (1995) and
Copeland and Taylor (2004).
15
The authors use political economy variables and factor
intensities as instrumental variables for PACE. This
analysis also finds that PACE is endogenous and suggests that
policy stringency is determined strategically
by governments.
16

They use a fixed effects model that accounts for unobserved
sector characteristics that are correlated with
regulation and trade, unobserved foreign pollution regulation
levels, and aggregation bias in sectoral data
(due to changes in industry composition). Because they use data
from only one country, they can estimate
the effects of environmental regulation on trade only by
comparing sector-level net imports as a function of
industry characteristics. The variation in pollution abatement
expenditures across sectors may reflect
unobserved heterogeneity rather than relative stringency.
Deleted …
EC 230: Topics in Environmental Economics
Department of Economics, University of Vermont
Donna Ramirez Harrington
([email protected])
GUIDE QUESTIONS
Type your answers below the empty space provided (Your
answers can spillover to the next page of course) using BLUE
CALIBRI FONT: Then upload on designated portal on our
course Bb on the date indicated.
These two papers are related to each other and helps us loop
back to our Module 1 concepts. Jointly they deal with whether
and how environmental regulation affects firms’ economic
performance (competitiveness) directly or indirectly via
innovation. There is NO LAB for these readings. They are long
(a warning!) but easy reads. They are ripe for use as jumping

off points or potential references for your term paper in case
anyone wants to examine the topics of regulation, innovation
and competitiveness separately or examine / compare their
relationships for/across specific industries, countries or
pollutants.
Ambec et al deals with Porter Hypothesis (PH), while
Dechezleprêtre and Sato (DS) deal with Pollution Haven
Hypothesis (PHH). The PHH, in turn is related to the EKC
concept in the next module which looks at a the issue of a
country’s economic performance (growth) in relation to
environmental performance (pollution) from a macroeconomic
perspective and part of what determines their relationship is
regulation in an open economy (trade).
Note that the each paper has a distinct due date for submission.
You will also notice these readings cite a few
papers/authors/topics we have discussed earlier in the semester.
This is expected as these two readings deal with innovation and
regulation (policy instruments) which we spent a lot of time on.
You will be alerted to pay attention to these connections
through the guide questions below. So be on the lookout – all
our readings are related in some way.
Tips:
1. Read all the questions fort before you read the paper to give
you a better idea of the scope of each paper and the level of
detail I require.
2. Some questions are not chronological in terms of how they
appeared in the paper. Hence the answers may not be fully
clear or apparent until you finish reading the whole paper
(sometimes both papers).
I hope you enjoy these papers as much as I did. They are very
closely linked to our other papers and hopefully can give you an

affirmation of the key issues in the field of environmental
economics and policy.
AMBEC ET AL
Save and post your answers as:
YOURFAMILYNAME_Ambecetal.doc
Watch this video about Michael Porter’s main premise on
business strategy, so you would have an idea where his thinking
comes from in developing the “Porter hypothesis”
https://hbr.org/video/3590615226001/the-explainer-porters-five-
forces
1. Define the Porter hypothesis and define innovation offsets (p
4). How is the concept of innovation offsets related to the
Porter hypothesis? [ /5]
2. Describe how Porter hypothesis explains the relationship
between regulation innovation and competitiveness, i.e. the
mechanism(s) through which environmental regulation enhances
competitiveness via innovation.
[ /5]
(Hint: the next paper, DS also explains this quite well - pp 196-
200)

3. Define weak version, narrow version and strong version and
explain each one [ /15]
In doing so, make sure you identify which of these is related to
Milliman and Prince (our earlier reading on incentives for
innovation), which is the controversial or contentious one and
which is related to the induced innovation hypothesis
(Hint: footnote 4 of Ambec et al. and bottom of page 198 of DS)

4. Porter hypothesis has been so controversial but there have
been so many theoretical arguments proposed to explain it.
a. Summarize the behavioral argument for the Porter hypothesis
[ /5]
b. Summarize the market failure arguments for the Porter
hypothesis [ /15]
Make sure you discuss the concepts of (a) market power, (b)
asymmetric information and (b) RD spillovers. For each identify
and discuss concepts (and authors) we covered earlier this

semester can help explain the market failure argument for Porter
hypothesis (Hint: scarcity rents, VIBA, dual market failures)
c. Summarize the organizational failure arguments for the Porter
hypothesis [ /5]
5. NOT GRADED but make sure you can answer because these
relate to topics we covered earlier in the semester.
Summarize briefly empirical evidence for the narrow, weak and
strong versions (positive or negative effect on innovation or

competitiveness, short-term or long-term, large or small) and
the challenges of measurement ad doing empirical analysis
I doubt any of you will do an empirical paper on this topic
given the data, measurement and estimation challenges but it is
still useful to know which of the versions has robust and clear
empirical support and which doesn’t and why.
Explain briefly why older empirical evidence on Porter
hypothesis has been mixed but why more recent studies show
evidence to support it
Two of the four subsections of the section, “Designing Policies
to Enhance Innovation and Competitiveness” (specifically the
first and second subsections) are directly related two
topics/readings we have had earlier in the semester. Identify
what those concepts are and discuss briefly how they relate to
enhancing innovation and competitiveness

DECHEZLEPRÊTRE AND SATO (DS)
Save and post your answers as: YOURFAMILYNAME_DS.doc
1. Define the pollution haven hypothesis and the concept of
“race to the bottom”. Discuss how pollution haven hypothesis
creates a “race to the bottom” [ /5]
2. Following the question above, explain how the regulation -
competitiveness (economic impact) relationship under the
pollution haven hypothesis is different from that under Porter
hypothesis [
/10]

3. List and briefly describe briefly the first, second and third
order effects of regulation. Describe also the direct and indirect
costs of the first order effects. Which of these effects and how
do the relative magnitude of these effects help explain
controversial version Porter hypothesis?
[ /15]
4. Describe the mechanism through which environmental
regulation affects the following three metrics of
competitiveness, all giving rise to pollution haven hypothesis
and race to the bottom.
· Trade and trade flows (imports and exports)
[ /5]
(This is the section most related to the EKC, the next module,
(Cole reading) so be ready to relate this section to EKC later)

· Investment location – new plant births and FDI location
(inward and outward) [ /5]
· Employment [
/10]
Which theory of regulation (from Dion et al) does this
relationship capture?
Further, the article talks about the role of policy design in
achieving competitiveness (no or low adverse employment
impact). Which of our previous papers (before spring break)
was mentioned as an example to show how to design regulation
without adverse employment impacts?
Skip the section called Measuring Competitiveness Empirically
Summarize briefly the empirical evidence of regulation-
competitiveness relationship where competitiveness is captured
using various broad macroeconomic metrics; i.e. positive or

negative, short-term or long-term large or small.
I doubt any of you will do an empirical paper on this topic
given the data, measurement and estimation challenges but it is
still useful to know which of the macroeconomic measures of
competitiveness responds to regulation and in what direction
and why.
· Trade and trade flows
· Investment location
· Employment
Summarize empirical evidence for various measures of firm
level economic performance
Since this is firm level, this is essentially Porter hypothesis
except for the Productivity impact.
· Productivity
· Innovation
· Competitiveness
The Porter Hypothesis at 20: Can
Environmental Regulation Enhance
Innovation and Competitiveness?
Stefan Ambec*, Mark A. Cohen
y
, Stewart Elgie
z
, and
Paul Lanoie

§
Introduction
Some twenty years ago, Harvard Business School economist and
strategy professor Michael
Porter challenged the conventional wisdom about the impact of
environmental regulation on
business by arguing that well-designed regulation could actually
increase competitiveness:
“Strict environmental regulations do not inevitably hinder
competitive advantage against
rivals; indeed, they often enhance it” (Porter 1991, 168). Until
that time, the traditional view
of environmental regulation, held by virtually all economists,
was that requiring firms to reduce
an externality like pollution necessarily restricted their options
and thus by definition reduced
their profits. After all, if profitable opportunities existed to
reduce pollution, profit-maximizing
firms would already be taking advantage of them.
Over the past twenty years, much has been written about what
has since become known
simply as the Porter Hypothesis. Yet even today, we continue to
find conflicting evidence

concerning the Porter Hypothesis, alternative theories that
might explain the Porter
Hypothesis, and oftentimes a misunderstanding of what it does
and does not say.
This article reviews the key theoretical foundations and
empirical evidence to date concern-
ing the Porter Hypothesis and identifies research challenges and
opportunities concerning the
links between environmental regulation, innovation, and
competitiveness. Such a careful exam-
ination of both the theory and the empirical evidence can yield
some useful insights for the
*Senior researcher, Toulouse School of Economics (INRA-
LERNA), and visiting professor, University of
Gothenburg; e-mail: [email protected]
y
Professor of management and law, Vanderbilt University, and
university professor, Resources for the Future;
e-mail: [email protected]
z
Professor, Faculty of Law, University of Ottawa, and chair,
Sustainable Prosperity; e-mail:
[email protected]
§
Professor of economics, HEC Montreal; e-mail:
[email protected]
The authors thank Nick Johnstone, Leena Lankowski, David
Popp, and Marcus Wagner for helpful comments

on an earlier draft. All errors remain those of the authors. This
article was originally prepared as a background
paper for a symposium hosted by Sustainable Prosperity and
Resources for the Future.
2
Review of Environmental Economics and Policy, volume 7,
issue 1, winter 2013, pp. 2–22
doi:10.1093/reep/res016
� The Author 2013. Published by Oxford University Press on
behalf of the Association of Environmental and Resource
Economists. All rights reserved. For Permissions, please email:
[email protected]
design of regulatory instruments, as well as a rich research
agenda for the future aimed at
improving our understanding of the impact of environmental
regulations on innovation and
competitiveness.We start in the next section with a brief
overview of the Porter Hypothesis and
the variations on it that have been presented in the literature.
Next, we discuss the theoretical
arguments that have been proposed over the past twenty years to
explain the Porter Hypothesis.
Following the review of theory, we examine and evaluate the
empirical evidence concerning the

Porter Hypothesis and attempt to reconcile and explain some of
the conflicting evidence and
differing opinions on its validity. Next, we briefly discuss the
implications of these theoretical
and empirical findings for the design of policies aimed at
promoting innovation and competi-
tiveness. We conclude with an agenda for future research on
this important policy issue.
An Overview of the Porter Hypothesis
Historically, the conventional wisdom among economists,
policymakers, and business man-
agers concerning environmental protection was that it comes at
an additional cost to firms that
may erode their global competitiveness. According to this
traditional view, environmental
regulations such as technological standards, environmental
taxes, or tradable emissions forces
firms to allocate some inputs (labor, capital) to pollution
reduction, which is unproductive
from a business perspective even if it offers environmental or
health benefits to society.
Technological standards restrict the choice of technologies or
inputs in the production process.
Taxes and tradable permits charge firms for emitting pollutants,

a by-product of the production
process that was previously free. These fees necessarily divert
capital away from productive
investments.
About twenty years ago, this traditional paradigm was contested
by a number of economists,
notably Professors Michael Porter (Porter 1991) and Claas van
der Linde (Porter and van der
Linde 1995a). Relying primarily on case studies, these
researchers argue that pollution is often a
waste of resources and that a reduction in pollution may lead to
an improvement in the
productivity with which resources are used. They argue that
more stringent but properly de-
signed environmental regulations (in particular, market-based
instruments such as taxes or
cap-and-trade emissions allowances) can “trigger innovation
[broadly defined] that may par-
tially or [in some instances] more than fully offset the costs of
complying with them” (Porter
and van der Linde 1995a, 98).
Porter was not the first to question mainstream economic views
about the cost of environ-

mental regulation. Arguments that pollution controls can spur
the reduction of waste by
businesses date back to the 1800s (Desrochers and Haight
2012). By the 1980s, some researchers
had begun to examine whether environmental regulations could
boost technology innovation
without necessarily harming competiveness (Ashford 1993). But
it is Porter who, building on
this foundation, can be credited with bringing these ideas into
the mainstream business and
policy debate—and inspiring two decades of research into the
“Porter Hypothesis.”
Causal Links in the Porter Hypothesis
Figure 1 summarizes the main causal links involved in the
Porter Hypothesis. As Porter and van
der Linde (1995a) described this relationship, if properly
designed, environmental regulations
The Porter Hypothesis at 20 3
can lead to “innovation offsets” that will not only improve
environmental performance, but
also partially—and sometimes more than fully—offset the
additional cost of regulation.

Porter and van der Linde (1995a, 99–100) go on to explain that
there are at least five reasons
why properly crafted regulations may lead to these outcomes:
. “First, regulation signals companies about likely resource
inefficiencies and potential
technological improvements.”
. “Second, regulation focused on information gathering can
achieve major benefits by
raising corporate awareness.”
. “Third, regulation reduces the uncertainty that investments to
address the environment
will be valuable.”
. “Fourth, regulation creates pressure that motivates innovation
and progress.”
. “Fifth, regulation levels the transitional playing field. During
the transition period to
innovation-based solutions, regulation ensures that one
company cannot opportunistic-
ally gain position by avoiding environmental investments.”
Finally, they note, “We readily admit that innovation cannot
always completely offset the
cost of compliance, especially in the short term before learning
can reduce the cost of

innovation-based solutions” (Porter and van der Linde 1995a,
100).
Reactions to the Porter Hypothesis
The Porter Hypothesis has attracted widespread attention in the
political arena, especially in the
United States (Gore 1992), because it contradicts the widely
held view that environmental
protection is always detrimental to economic growth. In fact, a
summary of a conference
sponsored by the Environmental Protection Agency (EPA) in
1992 concluded that
“Complying with environmental requirements can lead to a net
cost savings for companies
[and] . . . improves the international competitiveness of those
companies and the U.S. economy
in general” (US EPA 1992, iii). The Porter Hypothesis has also
triggered extensive scholarly
debate and analysis, and Porter and van der Linde (1995a) has
become one of the most highly
cited articles in the interdisciplinary field of “business and the
environment.”
1
The Porter

Hypothesis has been invoked to persuade the business
community to accept environmental
Innova�on
Strict but Flexible
Environmental
Regula�ons
Environmental
Performance
Business
Performance
(some�mes)
Figure 1 Schematic representation of the Porter Hypothesis
1
Hoffman (2011) lists Porter and van der Linde (1995a) as the
number 5 most highly cited article, followed by a
companion piece, Porter and van der Linde (1995b), published
in the Harvard Business Review.
4 S. Ambec et al.
regulations as something that might ultimately benefit their
business or industry.
2
In a nutshell,

the argument is that well-designed environmental regulations
may lead to a Pareto improve-
ment (i.e., improving the environment while not reducing
business profits) or a “win–win”
situation in some cases, by not only protecting the environment,
but also enhancing profits and
competitiveness through the improvement of products or their
production processes.
The Porter Hypothesis was also criticized by Palmer, Oates, and
Portney (1995) and others
for being incompatible with the assumption that firms are profit
maximizing. In other words,
why would regulation be needed to encourage firms to adopt
profit-increasing innovations? In
fact, the Porter Hypothesis is based on the idea that firms often
ignore profitable opportunities.
Indeed, Porter (1991) directly questions the view that firms are
always profit-maximizing
entities: “The possibility that regulation might act as a spur to
innovation arises because the
world does not fit the Panglossian belief that firms always make
optimal choices.”
3
If systematically profitable business opportunities (“low-
hanging fruits”) are being missed,

then the question is whether environmental regulations can
change that reality. Are regulators
in a better position than managers to find these profitable
business opportunities? Porter argues
that environmental regulation may help firms identify
inefficient uses of costly resources. They
may also produce and disseminate new information (e.g., best-
practice technologies) and help
overcome organizational inertia.
Variations on the Porter Hypothesis
The literature contains conflicting accounts of what the Porter
Hypothesis actually says, and
different versions of the hypothesis have been proposed and
tested. As we noted earlier, the
Porter Hypothesis does not say that all regulations lead to
innovation—only that well-designed
regulations do. This is consistent with the growing trend toward
performance-based and/or
market-based environmental regulations. Second, it does not
state that this innovation always
offsets the cost of regulation. Instead, the Porter Hypothesis
claims that in many instances, these
innovations will more than offset the cost of regulation.

Researchers have generally disaggregated the Porter Hypothesis
into its component parts in
order to test the theory and the empirical evidence for the
hypothesis. Jaffe and Palmer (1997)
first distinguished among the “weak,” “narrow,” and “strong”
versions of the Porter Hypoth-
esis. First, properly designed environmental regulation may spur
innovation (as shown in the
first two boxes of Figure 1). This has often been called the
“weak” version of the Porter
Hypothesis because it does not indicate whether that innovation
is good or bad for firms. Of
course, the notion that regulation may spur technological
innovation is not a new idea in
economics and would not itself have led to the controversy
about the Porter Hypothesis.
4
The
2
Closely related to the Porter Hypothesis, in the early and mid
1990s, business and strategy leaders began to
argue that firms can enhance their bottom lines by voluntarily
reducing pollution beyond legal requirements (see
Elkington 1997; Esty and Porter 1998). Anecdotal evidence
cited by these authors as well as Porter and van der

Linde (1995a, 1995b) indicates that companies—often prodded
by government or nonprofits—that went
beyond legal requirements saved money and increased profits.
An examination of these voluntary actions is
beyond the scope of this article, but such actions have been
analyzed previously in this journal (see Portney 2008;
Reinhardt, Stavins, and Vietor 2008).
3
As discussed later, firms might not appear to be making optimal
choices for many reasons, such as imperfect
information or organizational or market failures.
4
In fact, the idea that regulation can spur technological
innovation is based on the concept of induced innov-
ation, which goes all the way back to Hicks (1932).
second part of the Porter Hypothesis (the lower right-hand side
of Figure 1) is that in many
cases this innovation more than offsets any additional
regulatory costs—in other words, en-
vironmental regulation can lead to an increase in firm
competitiveness. This has often been
called the “strong” version of the Porter Hypothesis. Finally, in
what has been called the
“narrow” version of the Porter Hypothesis, it is argued that
flexible regulatory policies give

firms greater incentives to innovate and thus are better than
prescriptive forms of regulation.
Indeed, Porter (1991) challenges regulators to examine the
likely impacts of their actions and to
choose those regulatory mechanisms, particularly economic
instruments, that will foster in-
novation and competitiveness. Thus the “narrow” version of the
Porter Hypothesis is largely a
restatement of the economist’s preference for performance-
based or market-based regulation
over command-and-control approaches.
The Theory Underlying the Porter Hypothesis
Over the last twenty years, this controversy over what the Porter
Hypothesis actually says and
means has given rise to a large economics literature on the
theoretical arguments underlying it.
Among the theoretical approaches taken to explain the Porter
Hypothesis are behavioral ar-
guments, market failures (market power, asymmetric
information, research and development
[R&D] spillovers), and organizational failure. This section
briefly reviews each of these
approaches.

Behavioral Arguments
One set of studies relies on the emerging behavioral economics
literature to depart from the
assumption of profit-maximizing firms. This literature argues
that the rationality of the firm is
driven by its manager, who has motivations and objectives other
than profit maximization.
More specifically, the manager may be risk averse (Kennedy
1994), resistant to any costly
change (Aghion, Dewatripont, and Rey 1997; Ambec and Barla
2007), or rationally bounded
(i.e., limited by information or cognitive ability to process
options and make good decisions)
(Gabel and Sinclair-Desgagné 1998). Thus the manager misses
good investment opportunities
(from the point of view of the firm’s profit) because they are
either too risky, too costly (for the
manager but not for the firm), or out of the manager’s habits
and routines. For example, in
Ambec and Barla (2006), the manager has present-biased
preferences that cause her or him to
put off investment in profitable but costly opportunities (“low-
hanging fruits”). Because the

cost of innovating occurs “now” but the benefit occurs “later,” a
present-biased manager tends
to postpone any investments in innovation. By making those
investments more profitable or
requiring them, environmental regulations help the manager
overcome this self-control prob-
lem, which enhances firm profits.
5
Thus this literature justifies the existence of “win–win”
opportunities based on the notion that regulation requires
certain behaviors that are ultimately
profit maximizing for the firm but might not otherwise be
chosen by the manager.
5
See also Chowdhury (2010) and Kriechel and Ziesemer (2009)
on timing issues.
6 S. Ambec et al.
Market Failures
A second set of studies reconciles the apparent contradiction
between the Porter Hypothesis
and profit maximization by assuming there is a “market failure”
in addition to the environ-

mental externality problem. Unlike the previous case, here firms
are assumed to seek profit
maximization; however, market failures prevent them from fully
realizing their profit poten-
tial—something that might be partially overcome through
regulation.
Market power
The first market failure assumption is market power. Simpson
and Bradford (1996) show that
when there is imperfect competition among firms, a government
may provide a strategic
advantage to its domestic industry by imposing a more stringent
This paper formalizes the popular idea that a firm or a country
can enjoy a first-mover advan-
tage by becoming “green” sooner than its competitors
(Lieberman and Montgomery 1988). As
noted by Barrett (1994), the environmental regulation may even
be too strong if it leads to more
pollution abatement than in the first-best case. In this way,
countries can use stringent envir-
onmental regulations as a strategic device to increase domestic
firms’ market share.
6

In a related
paper, Rege (2000) examines the role of government in
monitoring and regulating product
claims to ensure that consumers who want environmentally
friendly products will be able to
purchase them rather than buying products falsely claiming to
be green.
Mohr and Saha (2008) argue that when there are barriers to
entry, environmental regulations
may benefit existing firms by creating “scarcity rents.’’ That is,
prices will increase as firms
reduce production in reaction to limits or fees on pollution
emissions. For example, emissions
permits that are allocated freely to existing polluters will make
entry into the industry relatively
more costly as incumbent firms will have lower costs, thus
decreasing overall competition
among firms.
7
Finally, André, González, and Portiero (2009) show that with
imperfect com-
petition but differentiated products, a minimum standard for
environmental product quality
may benefit all firms by solving a coordination problem (i.e.,

allowing them to reach a
Pareto-improving equilibrium).
Asymmetric information
Asymmetric information in markets is another market failure
that might reconcile profit maxi-
mization with the Porter Hypothesis. As emphasized by Ambec
and Barla (2007), asymmetric
information about environmental quality creates a “market-for-
lemons” result where
only “brown” (i.e., dirty) products are supplied under fierce
competition among firms.
Environmental regulations such as green labels reveal
information that benefits firms supplying
high environmental quality products. These regulations may
also benefit firms specializing in
“brown” products by vertically differentiating products, thereby
reducing competition among
firms. In Constantatos and Herrmann (2011), the lag between
the time that firms invest in
green products and when consumers observe the environmental
quality of goods reduces the
6
As discussed in Ulph and Ulph (1994), this result depends on
many factors, including the nature of competition

(e.g., Cournot versus Bertrand—output versus price
competition), and how the R&D process impacts abate-
ment and production costs.
7
Note that unlike the Porter Hypothesis, the rent scarcity
argument does not require that innovation occur for
firms to benefit from environmental regulation.
profitability of producing a green product. Thus environmental
regulations that force firms to
produce green products help them reach a Pareto-improving
equilibrium where there is no
first-mover disadvantage from investing in this new innovation.
In Mohr and Saha (2008),
consumers’ willingness to pay for products increases with the
environmental performance of
the entire industry, not the environmental performance of
individual firms. Thus, with limited
entry, reducing the industry’s pollution raises prices, which
benefits all firms in the industry.
R&D spillovers
The public good nature of knowledge is another market failure
that lends support to the Porter

Hypothesis. Mohr (2002) models investment in R&D with
technological spillovers in a dy-
namic framework. Thus, in each period, firms learn about new
technologies implemented by
their competitors. Mohr (2002) finds that when the return on a
firm’s R&D investment is partly
captured by its competitors, firms underinvest in cleaner and
more productive technologies.
Thus an environmental regulation that forces adoption may
switch the industry from an
equilibrium with low investment in R&D to a Pareto-improving
equilibrium with higher
investments in R&D.
8
Greaker (2003) also cites technological spillovers as a market
failure
that provides a theoretical foundation for the Porter Hypothesis.
9
Some economists have argued that although environmental
regulations lead to investment in
innovation and technological change, thereby improving
productivity, this comes at a cost to
firms. Xepapadeas and Zeeuw (1999) analyze the impact of
environmental regulations on

capital and find that an emissions tax may lead to the retirement
of older vintage capital,
thereby increasing average productivity. However, they also
find that there is a negative
impact on profit. In contrast, Feichtinger et al. (2005) show that
an emissions tax may increase
the average age of capital. In a related article, Popp (2005)
argues that uncertain returns to R&D
can help explain why researchers observe individual firms or
industries for which the cost of
environmental regulation is completely offset, but economy-
wide studies typically find that
environmental regulation has a net cost. That is, because the
returns to R&D are highly skewed,
some innovations will result in significant cost savings even if
the average innovation does not.
Organizational Failure
A related approach uses the notion of “organizational failure” to
reconcile the Porter
Hypothesis with the assumption of a profit-maximizing firm.
This literature formalizes
Porter’s argument that environmental regulation may overcome
organizational inertia.

Ambec and Barla (2002) find that informational asymmetries
within the firm concerning
technologies might lend support to the Porter Hypothesis. For
example, if managers have
private information about the real costs of new technologies that
enhances both productivity
and environmental performance, they may use the information
opportunistically by exagger-
ating these costs, thereby extracting some rent from the firm. In
this situation, if the government
imposes an environmental regulation, the rent that managers
extract is lowered, thus benefiting
the firm. The regulation will be profitable for the firm if the
rent saved offsets the cost of
8
For a counterargument, see Gans (2010), who shows that more
stringent climate change policies will not
necessarily lead to more innovation. Indeed, it is demonstrated
that a tighter emissions cap will reduce the scale
of fossil fuel usage, which diminishes incentives to improve
fossil fuel efficiencies.
9
However, Greaker (2003) includes an upstream market for
innovation.
8 S. Ambec et al.

complying with the regulation. Thus the regulation may help the
head of the firm to increase
profits by fostering technological innovation at lower
organizational costs (i.e., by overcoming
some of the informational advantage of firm managers).
Empirical Evidence for the Porter Hypothesis
Numerous researchers have also tested the Porter Hypothesis
empirically. Generally, these
studies fall into three categories: those testing the “weak”
version, those testing a “strong”
version focused on firm-level performance, and those testing a
“strong” version focused on
country-level competitiveness. This section reviews the findings
of these three empirical
approaches.
Testing the “Weak” Version of the Porter Hypothesis
There is a large body of literature that analyzes the “weak”
version of the Porter Hypothesis—
that properly designed environmental regulation may spur
innovation (the link between the
first and second steps in the chain presented in Figure 1). In
practice, innovation is generally

assessed through R&D expenses (input) or through the number
of registered patents (the prod-
uct of R&D activity). However, as Porter and van der Linde
(1995a, 98) emphasize, innovation
is more than just technological change and can take various
forms including “a product’s or
service’s design, the segments it serves, how it is produced,
how it is marketed and how it is
supported.”
An example of the literature that assesses innovation through
R&D expenditures or patents is
Jaffe and Palmer (1997), who estimate the relationship between
pollution abatement costs
(a proxy for the stringency of environmental regulation) and
total R&D expenditures (or the
number of successful patent applications). They find a positive
link with R&D expenditures
(an increase of 0.15 percent in R&D expenditures for a
pollution abatement cost increase of 1
percent), but no statistically significant link with the number of
patents. However, examining
only environmentally related successful patent applications,
Lanjouw and Mody (1996),
Brunnermeier and Cohen (2003), Popp (2003, 2006), Arimura,

Hibiki, and Johnstone
(2007), Johnstone, Hascic, and Popp (2010), Lanoie et al.
(2011), and Lee, Veloso, and
Hounshell (2011) all find a positive relationship with
environmental regulation. Johnstone,
Hascic and Popp (2010) also find evidence that both the
stability and flexibility of environ-
mental regulations have distinct effects on innovation (i.e.,
impacts that are separate from those
due to the regulation’s stringency).
Concerning the relationship between environmental regulations
and the firm’s technological
choices, two older studies emphasize a negative relationship
between environmental regulations
and investment in capital. Nelson, Tietenberg, and Donihue
(1993) find that air pollution
regulations significantly increased the age of capital in US
electric utilities in the 1970s.
10
According to Gray and Shadbegian (1998), more stringent air
and water regulations had a
significant impact on paper mills’ technological choice in the
United States. However, their
10

However, as discussed later, this finding should not be
surprising given that US regulations imposed more
stringent requirements on new sources and are thus likely an
example of regulations that are not properly
designed to encourage innovation.
results suggest that such regulations tend to divert investment
from productivity to abatement,
which is consistent with the standard paradigm (i.e., that
regulation is costly).
To summarize, there is a relatively large literature that has
examined the link between en-
vironmental regulation (oftentimes measured as compliance
costs) and innovation (measured
as either R&D expenditures or patents). On balance, these
studies conclude that there is a
positive link between environmental regulation and innovation,
although the strength of the
link varies.
Testing a “Strong” Version of the Porter Hypothesis (Firm-
Level Performance)
The second empirical approach assesses the impact of
environmental regulation on the business

performance of the firm (the link between the first and last steps
in the chain presented in
Figure 1). However, this “strong” version of the Porter
Hypothesis, which is often measured by
the firm’s productivity, is tested without looking at the cause of
any variation in business
performance (i.e., whether it is linked to innovation or another
cause).
This second approach, which is reviewed in Jaffe et al. (1995),
has a long tradition in the
economics literature. Most of the studies reviewed in Jaffe et al.
(1995) find that environmental
regulation has a negative impact on productivity. For instance,
Gollop and Roberts (1983)
estimate that sulfur dioxide (SO2) regulations slowed down
productivity growth in the United
States in the 1970s by 43 percent. However, several more recent
studies find more positive
results. For example, Berman and Bui (2001) report that
refineries located in the Los Angeles
area enjoyed significantly higher productivity than other US
refineries despite the more strin-
gent air pollution regulation in Los Angeles. Similarly, Alpay,
Buccola, and Kerkvliet (2002) find

that the productivity of the Mexican food-processing industry is
increasing with the pressure of
environmental regulation, which leads them to conclude that
more stringent regulation is not
always detrimental to …

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