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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: stefan.ambec@tse-fr.eu.

y
Professor of management and law, Vanderbilt University, and university professor, Resources for the Future;

e-mail: mark.cohen@owen.vanderbilt.edu.

z
Professor, Faculty of Law, University of Ottawa, and chair, Sustainable Prosperity; e-mail:

stewart.elgie@uottawa.ca.

§
Professor of economics, HEC Montreal; e-mail: paul_lanoie@hec.ca.

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
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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).

The Porter Hypothesis at 20 5

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

environmental regulation.

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.

The Porter Hypothesis at 20 7

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.

The Porter Hypothesis at 20 9

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 productivity.

Testing Both the “Weak” and “Strong” Versions of the Porter Hypothesis

Lanoie et al. (2011) examine both the weak and strong versions of the Porter Hypothesis, for

the first time assessing the whole Porter causality chain. The data come from a unique

Organisation for Economic Co-operation and Development (OECD) survey of more than

four thousand companies located in seven industrialized countries.
11

Lanoie et al. (2011) con-

duct a regression analysis of three equations,
12

using the three dependent variables from Figure

1: environmental innovation, environmental performance, and business performance. The

results indicate a positive and significant link between the perceived stringency of environmen-

tal regulations and environmental innovation, which is consistent with the weak version of the

Porter Hypothesis. Furthermore, the “predicted” environmental innovation from the first

regression has a positive and significant impact on business performance. This provides evi-

dence of the causal link suggested by the strong form of the Porter Hypothesis—that regulation

spurs innovation, which further enhances business performance. However, Lanoie et al. (2011)

also find that environmental regulation has a direct negative effect on business performance.

They conclude that the net effect is negative—that is, the positive effect of innovation on

11
Details of the OECD survey are available at www.oecd.org/env/cpe/firms.

12
The equations are estimated using two-stage least squares.

10 S. Ambec et al.

www.oecd.org/env/cpe/firms

business performance does not outweigh the negative effect of the regulation itself. These results

suggest that environmental regulation is costly, but less so than if one was to consider only the

direct costs of the regulation itself.

Static versus Dynamic Tests of the Porter Hypothesis

It is important to note that most previous studies have not adequately accounted for the

dynamic dimensions of the Porter Hypothesis. Porter argues that more stringent environmental

policies will lead to innovations to reduce inefficiencies, which, in turn, will eventually reduce

costs. However, this process may take some time. Most previous studies of the determinants of

productivity have regressed productivity at time 0 on proxies of the stringency of environmental

regulation at time 0 as well, which does not allow time for the innovation process to occur. In

contrast to earlier studies, by introducing lags of three or four years between changes in the

stringency of environmental regulations and any resulting changes in productivity, Lanoie,

Patry, and Lajeunesse (2008) find that stricter regulations led to modest long-term gains in

productivity in a sample of seventeen Quebec manufacturing sectors.
13

They show that this

effect is more important in industries that are highly exposed to outside competition. Future

research should focus more on these dynamic impacts.

Summary of Empirical Findings on Business Performance (“Strong” Version)

To summarize, the empirical evidence on the impact of environmental regulation on business

performance (generally measured as firm- or industry-level productivity) suggests a negative

relationship, contrary to the strong version of the Porter Hypothesis. However, these studies are

generally cross-sectional or two-period models. The only study to date that attempts to measure

this relationship over long time periods (Lanoie et al. 2008) produces results that support the

strong version of the Porter Hypothesis (i.e., that there is a positive relationship between

environmental regulation and firm-level performance). Further research is clearly needed in

this area.

Testing a “Strong” Version (Country-Level Competitiveness)

A third empirical approach to evaluating the Porter Hypothesis is to examine competition

among nations, which returns to the original hypothesis (Porter 1991) that environmental

regulation will enhance a country’s competitiveness. Much of the empirical literature on this

issue turns the Porter Hypothesis on its head by examining the “pollution haven” hypothesis—

that stringent environmental regulation will induce firms to leave the country for less strict

(and hence less expensive) regulatory regimes. Of course, firms might move polluting facilities

abroad for reasons other than to avoid environmental regulation, such as access to markets or

differences in the cost of labor, land, transportation, and other inputs.

Much of the early literature on the pollution haven hypothesis (e.g., Jaffe et al. 1995) found

evidence that is consistent with the Porter Hypothesis—that industries with more stringent

regulations (generally proxied by higher pollution abatement costs) have lower net trade flows,

13
More specifically, they find that stricter regulations reduced productivity in year 1 had a slightly positive effect

in year 2, and resulted in even more positive outcomes in years 3 and 4, more than offsetting the first year’s loss.

The Porter Hypothesis at 20 11

consistent with the Porter Hypothesis. However, as Copeland and Taylor (2004) and

Brunnermeier and Levinson (2004) note in their literature reviews, both endogeneity and

unobserved variables that are correlated with regulation may explain these results. Indeed,

citing more recent literature, these authors conclude that while much work still needs to be

done, the weight of the evidence supports the pollution haven hypothesis. Nevertheless, the

magnitude of the effect of environmental regulation does not appear to be “strong enough to be

the primary determinant of the direction of trade or investment flows” (Copeland and Taylor

2004, 48). Perhaps more important from the perspective of the Porter Hypothesis, few of the

pollution haven hypothesis studies have distinguished among the types of regulatory mechan-

isms employed (e.g., countries that use command-and-control versus more market-based

standards). Instead, they generally use pollution control costs or emissions levels (see, e.g.,

Quiroga, Persson, and Sterner 2009) as proxies for regulatory stringency. Although these vari-

ables may be reasonable measures of stringency, they do not provide information about

whether countries with more stringent policies are using “good” (e.g., market-based) or

“bad” (e.g., command-and-control) forms of environmental regulation.

To summarize the empirical findings concerning environmental regulation and

country-level competitiveness, although more recent evidence suggests that countries with

more stringent environmental regulations (generally measured as pollution abatement costs)

become less competitive (which contradicts the Porter Hypothesis), this finding of a “pollution

haven” is not the primary driver of trade flows. More importantly, to date, empirical studies

have not been able to distinguish between “good” and “bad” regulation. Thus additional

studies are needed that compare the competitiveness of nations based on their approach to

environmental regulation.

Designing Policies to Enhance Innovation and
Competitiveness

It is clear from both Porter’s original writings and the empirical evidence that the impact of

environmental regulation on innovation and competitiveness depends critically on the type of

environmental policies that are implemented. The Porter Hypothesis is premised on flexible

market-based environmental regulation, not rigid command-and-control regulation. Thus if

the competitiveness or innovation benefits promised by Porter are to be realized, it is important

that the right type of regulations be implemented (e.g., flexible, market based). However,

government policies other than environmental regulations can also have an impact on the

relationship between environmental policies and innovation or productivity. In this section, we

briefly examine how the type of environmental (and nonenvironmental) policies can affect

innovation and competitiveness.

Environmental Policies

Porter (1991) noted that the type of regulatory instrument is an important premise for the

Porter Hypothesis. More specifically, Porter and van der Linde (1995a, 110) argue:

If environmental standards are to foster the innovation offsets that arise from new

technologies and approaches to production, they should adhere to three principles.

12 S. Ambec et al.

First, they must create the maximum opportunity for innovation, leaving the

approach to innovation to industry and not the standard-setting agency. Second,

regulations should foster continuous improvement, rather than locking in any

particular technology. Third, the regulatory process should leave as little room as

possible for uncertainty at every stage.

Market-based and flexible instruments such as emissions taxes. tradable allowances, or per-

formance standards are more conducive to innovation than technological standards because

they leave more freedom to firms to find a technological solution to minimize compliance costs.

Some researchers (e.g., Jaffe and Palmer 1997) call this the narrow version of the Porter

Hypothesis. However, as noted earlier, this is not the main contribution of Porter because

economists have long advocated market-based and flexible instruments. Nevertheless, there has

been much research in this area that provides support/evidence for this “narrow” version of the

Porter Hypothesis. For example, Burtraw (2000) finds evidence that the switch in US envir-

onmental regulations for SO2 emissions in 1990 from a technological standard with emissions

caps to an allowance trading program considerably reduced compliance costs (40 to 140 per-

cent lower than projected), although the net effect was still a net cost. However, Burtraw (2000)

also concludes that the switch from a command-and-control approach to a more flexible

emissions trading program enhanced innovation and fostered organizational change and com-

petition in the upstream input market. That is, the program gave firms the flexibility to select

the best strategy for reducing emissions including a switch to coal with lower sulfur content.

The industry also experienced innovation in fuel blending and in the scrubber market.
14

In

addition, the switch from technological standard to tradable emissions allowances transferred

responsibility for compliance from engineers or chemists, typically in charge of environmental

issues, to top executives such as financial vice presidents, who are trained to treat SO2 emissions

allowances as financial assets. Thus market-based approaches appear to have spurred innov-

ation in both technology as well as organizational processes.

Along the same lines, Hoglund Isaksson (2005) examines the impact of Sweden’s decision in

1992 to impose a charge on nitrogen oxides (NOx) emissions. Looking at the impact on the

abatement cost functions of 114 combustion plants during the 1990–96 period, she finds that

extensive emissions reductions occurred at zero or very low cost, primarily due to learning and

technological developments that occurred during the period analyzed.

Lanoie et al. (2011) also provide indirect evidence on this issue, showing that performance

standards are leading to more innovation than more prescriptive technological standards.

Driesen (2005, 303) reviews the literature and concludes:

Pollution taxes have a greater potential to promote innovation than either emis-

sions trading (at least when permits are given away, rather than sold) or traditional

regulation. Both emissions trading and performance standards produce incentives

only to attain the standards government sets, rather than to go further. While

trading does provide incentives for low cost sources to produce some “extra”

credits, it does so only to the extent that high cost sources need credits to meet

their limits. Once the high cost sources have purchased enough credits to attain

14
The previous command-and-control regulation did not provide incentives to increase SO2 removal by scrub-

bers. However, the new program provided incentives to upgrade existing scrubbers.

The Porter Hypothesis at 20 13

their limits, no further incentive to go beyond compliance exists. Pollution taxes,

however, provide a continuous incentive for polluters to deploy innovations cost-

ing less than the marginal tax rate.

Moreover, if market-based instruments generate revenues (e.g., from taxes or permit auc-

tioning), then the efficient recycling of those revenues can improve competitiveness outcomes.

For example, Andersen et al. (2007) analyze environmental tax revenues in seven European

Union countries that are recycled into other tax cuts (labor or income) and find a neutral or

slightly positive net impact on gross domestic product.

Finally, Lankoski (2010, 6) reviews the empirical evidence to date on the impact of the type of

policy instrument on competitiveness and reaches conclusions that are similar to those in

Porter and van der Linde (1995a), that regulatory “policy should strive to be win–win com-

patible. This speaks in favour of policies that provide incentives to innovation, are stable and

predictable, make use of suitable transition periods, focus on end results rather than means, and

economic policy instruments.”
15

Industrial and Patent Policies

Industrial and patent policies may complement environmental regulation to protect the en-

vironment at the lowest cost to firms. For example, well-defined property rights for innovations

can help reduce R&D spillovers that benefit all innovating firms while slowing diffusion.

Mandatory licenses may also foster technological adoption—but at the risk of reducing the

incentive to invest in R&D. Subsidies and tax credits for R&D spending may make technological

change aimed at environmental compliance a more attractive strategy. Popp (2006) provides

evidence that the timing of the introduction of more stringent environmental regulations has an

impact on the number of patents issued for pollution abatement technology. More precisely, he

finds that the introduction of stringent SO2 and NOx standards in the United States, Germany,

and Japan has led to a large increase in the number of patents issued on related abatement

technologies in each of the three countries. Interestingly, the transfer of technologies occurs

across countries, although indirectly: earlier patents issued in other countries are cited in the

new patent applications. Lee et al. (2011) found similar evidence that stringent automobile

emissions standards implemented in the United States induced domestic firms to increase their

patenting activities relative to foreign competitors. In the same vein, Dechezlepêtre, Glachant,

and Ménière (2011) examine the international transfer of technologies related to climate change

mitigation policies, such as wind and solar power, and find that more stringent intellectual

property rights in a country seem to encourage the diffusion of green power technologies.
16

Training

Under the Porter Hypothesis, improved productivity or competitiveness depends heavily on

the possibility of low-hanging fruit, although new technological innovations are also important.

Because busy managers, especially in small and medium enterprises (SMEs), may not always

have the time and the technical expertise to identify these profitable opportunities, training

15
See also the discussion in Wagner (2006).

16
Maskus (2010) provides a discussion of intellectual property rights for environmental and climate

technologies.

14 S. Ambec et al.

programs may be helpful. Rochon-Fabien and Lanoie (2011) investigate the benefits of a unique

Canadian training program, the Enviroclub initiative, which was developed to help SMEs

improve their profitability and competitiveness through enhanced environmental perform-

ance. An Enviroclub consists of a group of ten to fifteen SMEs, each of which is required to carry

out one profitable pollution prevention project. Support is provided to the SMEs through

workshops on various themes related to environmental performance and consultant services.

The consultant analyzes the operations of the firm and recommends specific measures to

prevent pollution and enhance business performance. The participating firm must then

adopt at least one of these recommendations. Rochon-Fabien and Lanoie (2011) examined

the first 187 projects produced through this program and conclude that all of them were

profitable for the participating firms (i.e., they reduced both costs and pollution). Lyon and

van Hoof (2009) find similar results for Mexico.

Organizational or Governance Issues

As noted earlier, Porter (1991) argues that organizational inertia may provide an explanation

for firms missing profitable opportunities to both reduce pollution and increase profits. This is

more likely to occur in firms with deficient governance structures including asymmetric infor-

mation and misaligned incentives between firm owners and managers. Such organizational or

governance failures either constrain the ability of managers to pursue profit-maximizing ob-

jectives or otherwise distort incentives within the firm. Environmental regulations may help

firms overcome this organizational inertia by forcing them to review the organization of pro-

duction and their business model. For example, based on the results of three case studies,

Arjalies and Ponssard (2010) argue that the potential benefits envisioned by Porter were

more likely to be realized in firms that viewed the treatment of environmental issues as an

opportunity, and thus incorporated environmental management into their organizational

processes and management system, than in firms that viewed environmental issues as a

compliance-oriented task. Similarly, Burtraw (2000) argues that firms were more likely to

take advantage of cost-reducing opportunities available to them under the US SO2 trading

program once responsibility for trading was shifted from environmental managers to financial

officers. These examples illustrate the impact that organizational design can have on a firm’s

ability to reap some of the benefits of the well-designed regulations envisioned by Porter.

Recent efforts to increase corporate transparency and reporting (e.g., the Carbon Disclosure

Project
17

and Global Reporting Initiative
18

), provide training on sustainability issues, hire

corporate responsibility officers who often report directly to the board of directors, and appoint

individuals with sustainability experience to firms’ boards of directors all reflect actions that

might further reduce organizational inertia, thus moving firms toward more strategic oppor-

tunities that might reduce costs or increase profits.

17
The Carbon Disclosure Project is an investor-led organization that annually requests, reports, and widely

circulates detailed information from the largest global companies concerning their carbon emissions and water
use. See www.cdproject.net.
18

The Global Reporting Initiative is a nonprofit international multi-stakeholder organization that sets guidelines
for reporting on economic, environmental, social, and governance issues. As more firms use the common GRI
framework for sustainability reporting, both internal and external stakeholders are better able to compare
nonfinancial performance across firms. See www.globalreporting.org.

The Porter Hypothesis at 20 15

www.cdproject.net

www.globalreporting.org

Conclusions and Directions for Future Research

More than twenty years ago, Michael Porter generated enormous interest among scholars,

policymakers, businesses, and interest groups in the idea that well-designed regulation could

actually enhance competitiveness. Indeed, much has been written since then about what has

become known as the Porter Hypothesis. This article has provided an overview of the theor-

etical and empirical literature on the Porter Hypothesis. First, we find that the theoretical

arguments for the Porter Hypothesis appear to be more solid now than when they were first

discussed as part of the heated debate in the Journal of Economic Perspectives in 1995 (see Palmer

et al. 1995). On the empirical side, the evidence for the “weak” version of the Porter Hypothesis

(that stricter environmental regulation leads to more innovation) is fairly clear and well estab-

lished. However, the empirical evidence on the strong version of the Porter Hypothesis (that

stricter regulation enhances business performance) is mixed, but with more recent studies

providing clearer support.
19

Porter’s suggestion that more stringent environmental protection may lead to “win–win”

outcomes for society overall has stimulated extensive academic research and policy debates over

the last twenty years and has no doubt contributed to significant environmental and economic

improvements through better designed regulation. We owe Porter great thanks for this. The

Porter Hypothesis continues to raise important issues and questions for both researchers and

policymakers about how to design and implement policies that will induce environmental

innovation and how to protect and diffuse these innovations among firms. We conclude

with a discussion of the research challenges and opportunities concerning the relationship

between environmental regulations, innovation, and competitiveness, which we have divided

into four major categories.

Data and Methodological Issues

Much of the existing literature necessarily uses proxies for the key variables of interest. For

example, in studies of innovation, environmental regulations are often proxied by environ-

mental compliance costs. Yet the Porter Hypothesis does not argue that higher abatement costs

will lead to innovation. Indeed, higher compliance costs might simply be attributable to older

plants, for example, rather than more stringent regulatory standards. In fact, the Porter

Hypothesis suggests that more stringent environmental standards lead to investment in R&D

(or changes in processes, organizations, and so on), which in turn leads to innovation. The

challenge for researchers is to find appropriate data that can be used to help us more fully

understand and test the mechanisms by which regulation leads to innovation, and, ultimately,

determine when these innovations increase or decrease costs.

One explanation for the conflicting empirical results concerning the Porter Hypothesis is

that firm, industry, or environmental characteristics may affect the extent to which innovation

offsets and productivity or competitiveness enhancements occur. What is it about manufactur-

ing industries in Canada between 1985 and 1994 (Lanoie et al. 2008) or the US petroleum

industry between 1987 and 1995 (Berman and Bui 2001) that caused them to increase their

19
Brännlund and Lundgren (2009) reach similar conclusions about the more recent evidence on the strong

version of the Porter Hypothesis.

16 S. Ambec et al.

productivity when faced with stricter environmental standards while just the opposite occurred

among US paper mills between 1979 and 1990 (Gray and Shadbegian 2003)?

These types of inconsistencies and challenges abound in the literature on the Porter

Hypothesis. Lankoski (2010) provides a helpful summary of these issues and notes that previous

studies have identified fifty or more methodological or measurement problems that make it

difficult to compare results across firms, industries, countries, time periods, and so on, and thus

to draw conclusions. Future research is needed to refine and address these issues. In addition, an

extensive meta-analysis might help uncover some of the underlying effects and thus shed more

light on these issues.

Nonregulatory Policies

As noted earlier, there is some evidence that training programs can provide helpful information

to environmental managers about more productive (and perhaps even profitable) approaches

to environmental protection. Related to direct training on better compliance approaches are the

growing number of voluntary programs such as the 33/50 and ENERGY STAR programs in the

United States.
20

Although these programs are generally designed to provide companies with

information and/or incentives that encourage them to go beyond compliance—either to reduce

costs or to increase demand for their products—they may have the significant ancillary benefits

of increasing compliance with existing regulations.

There is also growing evidence that mandatory disclosure programs have resulted in im-

provements in environmental performance. For example, although Hamilton (1995) finds that

on average, firms lost market value on the day that the first Toxic Release Inventory (TRI)
21

numbers were made public in the United States, Konar and Cohen (1997) find that firms with

the largest stock price declines have subsequently reduced their emissions the most. More

importantly, Konar and Cohen (2001) find that subsequent reductions in TRI numbers have

increased the intangible asset value of firms. These and other similar findings raise the inter-

esting question of whether the net impacts of indirect forms of regulation such as mandatory

disclosure are positive or negative.

There are other actors besides the government whose policies might interact with the

regulation-innovation-competitiveness links. As mentioned earlier, the trend toward increased

transparency, whether through voluntary corporate reporting, quasi-mandatory requirements

from stock exchanges or other agencies, or third-party reporting such as the Carbon Disclosure

Project or www.scorecard.org, might reduce organizational inertia. This would also appear to

be a fruitful area for future research.

Longitudinal Studies

As noted earlier, one reason for the mixed empirical results concerning the link between

environmental regulation and competitiveness is the inability of previous studies to adequately

20
The 33/50 program was designed by the US EPA to encourage firms to reduce their toxic emissions voluntarily

by 33 percent in 1992 and 50 percent in1995. See http://www.epa.gov/oppt/3350/. The ENERGY STAR program
(a joint program of EPA and the US Department of Energy) provides product labels to manufacturers that meet
energy efficiency guidelines. See www.energystar.gov.
21

The TRI program requires facilities to disclose to the EPA (and ultimately to the public) their disposal
practices and emissions of hundreds of toxic chemicals. See www.epa.gov/TRI.

The Porter Hypothesis at 20 17

www.scorecard.org

http://www.epa.gov/oppt/3350/

www.energystar.gov

www.epa.gov/TRI

capture the lag structure of innovation. Although Brunnermeier and Cohen (2003) find a

positive relationship between lagged compliance costs and innovation and Lanoie et al.

(2008) find a positive relationship between lagged regulatory stringency and productivity,

most previous studies have relied on contemporaneous comparisons. Because innovations

may take several years to develop, and capital expenditures are often delayed for a few years

through normal budgetary cycles and building lags, future studies that carefully examine the

dynamic nature of the relationship between regulation, innovation, productivity, and competi-

tiveness would be helpful.

Lankoski (2010) suggests that this difference in treating lag structures is one reason why

earlier studies were more likely to reject the Porter Hypothesis; recent studies have been more

favorable. However, another possible explanation for more recent studies finding empirical

support for the Porter Hypothesis is simply that the world has changed over time. We now have

more experience with market-based regulation of the form advocated by Porter. There is also a

heightened social consciousness around sustainability, in the form of both green products and

corporate social responsibility. Thus the “value” of improving environmental performance

may have increased over time, which means that firms are more able to profit from their

environmental initiatives than in the past, and that the Porter Hypothesis may be more relevant

today. Although capturing these effects in a longitudinal study would be a challenge, it could

provide important and more current policy-relevant results and help reconcile some of the

conflicting evidence from previous studies.

Global Studies

As data sets become more global and our ability to make cross-country comparisons with

meaningful detailed data increases, future research should also focus on competitiveness across

nations. As mentioned earlier, there is growing (but still not conclusive) evidence that countries

with more stringent environmental regulations are less competitive in those regulated sectors

(see the reviews in Esty [2001] and Ederington [2010]). Future research might distinguish

among command-and-control, performance-based, and market-based instruments to deter-

mine whether the form of regulation has an impact on these findings.

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22 S. Ambec et al.

Copyright of Review of Environmental Economics & Policy is the property of Oxford University Press / USA

and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright

holder’s express written permission. However, users may print, download, or email articles for individual use.

EC 230: Topics in Environmental Economics

Department of Economics, University of Vermont

Donna Ramirez Harrington

(djramire@uvm.edu)

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

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.

6. NOT GRADED but make sure you can answer because these relate to topics we covered earlier in the semester.

Explain briefly why older empirical evidence on Porter hypothesis has been mixed but why more recent studies show evidence to support it

7. NOT GRADED but make sure you can answer because these relate to topics we covered earlier in the semester.

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

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

5. NOT GRADED but make sure you can answer because these relate to topics we covered earlier in the semester.

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
6. NOT GRADED but make sure you can answer because these relate to topics we covered earlier in the semester.

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 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: A.Dechezlepretre@
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: m.sato1@
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.

186 A. Dechezleprêtre and M. Sato

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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.

Impacts of Environmental Regulations on Competitiveness 187

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of challenges to conducting credible empirical analysis of the competitiveness impacts of

environmental regulations.

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 environmental regulation.

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).

188 A. Dechezleprêtre and M. Sato

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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.

Impacts of Environmental Regulations on Competitiveness 189

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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 environmental regulations.

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.

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While carbon pricing policies are relatively new and coverage is limited, a number of recent

studies conduct ex post analysis on their trade impacts.
17

Branger, Quirion, and Chevallier

(2016) examine the impact of the EU ETS—to date the world’s largest carbon market—using

a time-series analysis for the period 2004–2012. They test whether carbon prices increased net

EU imports of cement and steel, but they find limited evidence. Two studies use an alternative

approach—exploiting the historic variation in energy prices to estimate the effect of carbon

price differences on trade—thus taking advantage of the fact that carbon prices essentially

work by increasing energy prices. In the first study, Aldy and Pizer (2015) use U.S. state-level

variation in industrial energy prices and fuel composition to estimate how production and

net imports changed in response to energy prices between 1974 and 2005.
18

When averaging

across all sectors, they find that the effect of energy price on net imports is statistically

indistinguishable from zero. However, they find evidence that both net imports and produc-

tion are more sensitive to energy prices in more energy-intensive sectors, including iron and

steel, chemicals, paper, aluminum, cement, and bulk glass, but that the magnitude of the

effect is small (a 0.1–0.8 percent increase in net imports from a hypothetical $15 per ton CO2
price). In the second study, Sato and Dechezleprêtre (2015) examine the influence of an

energy price gap between two trading partners on bilateral trade flows for 42 countries and 62

manufacturing sectors between 1996 and 2011. On average, they find that a 10 percent in-

crease in the energy price gap increases bilateral imports by 0.2 percent and that overall,

energy price differences explain 0.01 percent of the variation in trade flows.
19

To summarize, the recent evidence appears to offer broad support for the existence of a

pollution haven effect, with imports of pollution- or energy-intensive goods increasing in

response to tighter regulation. However, the effects tend to be small and concentrated in a few

sectors. Overall, the effect of relative stringency on trade flows is overwhelmed by other

determinants of trade.

Environmental Regulation and Production and Investment Location

Addressing concerns that trade liberalization is creating a “race to the bottom,” in which

governments competing for FDI are strategically undercutting each others’ environmental

standards, another active area of empirical investigation has been exploration of the effects of

environmental regulation on investment location as evidence of pollution havens.

This literature broadly examines two distinct questions: first, whether relatively lax policies

are a pull factor in attracting incoming manufacturing investments and second, whether

stringent policies are a push factor that influences the decision on outward investment flows

or relocation decisions.

17
There is a substantial literature on carbon leakage that explores the potential environmental consequences
of the trade effects of regulatory differences (see Branger and Quirion [2014] for a review). However, this
literature mostly uses ex ante modeling and is thus excluded from our review. The carbon leakage literature
can be distinguished from the literature on trade-embodied carbon (e.g., Peters et al. 2011), which includes
all embodied emissions in trade regardless of whether they are induced by asymmetric policies or other
underlying economic factors that influence trade patterns.

18
They use a detailed panel of state-level manufacturing production data covering 450 sectors.

19
The more recent time frame of these two studies means we can interpret the results in the post-2000
context, which saw rapid growth in global trade, particularly between industrialized countries and emerg-
ing economies such as China, as well as an increase in competitiveness concerns.

Impacts of Environmental Regulations on Competitiveness 191

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Location choice of new and relocating domestic firms

A number of studies use the variation in environmental standards across U.S. states and counties

to examine its effect on manufacturing plant location. Using establishment-level data for 1982

from the Census of Manufacturers and six different measures of environmental stringency,

Levinson (1996) finds that interstate differences in environmental regulations do not system-

atically influence the location choice of new manufacturing plants. Using the Levinson index of

environmental regulatory stringency,
20

Henderson and Millimet (2005) examine the impact of

environmental policy between 1977 and 1986 and find no effect on state-level aggregate output.

In contrast, studies that used more disaggregated data for New York State find that between 1980

and 1990, county-level differences in the regulatory status of the 1997 Clean Air Act

Amendments (CAAA) had very large statistically significant effects. More specifically, relative

to an “attainment” county, being a strictly regulated “nonattainment” county decreases the

inflow of relocating plants by nearly 63 percent (List et al. 2003) and decreases the expected

inflow of new dirty plants by 44–61 percent or 150–600 percent, depending on the estimator

used (List, McHone, and Millimet 2004). A comparison of these inter- and intrastate studies of

the United States suggests that studies with a smaller geographic scope tend to find stronger

effects, possibly because smaller areas tend to have less variation in the other determinants of

production location. Indeed, also using the dataset for New York State, Millimet and List (2004)

finds that the effect of stricter regulation is spatially heterogeneous and varies systematically with

location-specific attributes such as unemployment levels.

Impacts on inward FDI location

A number of studies use the within-country variation in environmental stringency and find incon-

clusive evidence on its impact on inward FDI location. List, McHone, and Millimet (2004)

use U.S. data and find that environmental stringency has very strong effects on new plant

births for domestic companies’ plants, but no effect on locational choice for foreign-owned

pollution-intensive plants. Dean, Lovely, and Wang (2009) examine inward FDI in China

between 1993 and 1996 and find that equity joint ventures in polluting industries are gen-

erally not attracted by weak environmental standards. In contrast, using U.S. state-level data,

Keller and Levinson (2002) find that between 1977 and 1994, a 10 percent increase in relative

manufacturing pollution abatement cost is associated with a 0.79 percent decrease in

manufacturing FDI and, more specifically, a 1.98 percent decrease in FDI in the chemical

industry. Fredriksson, List, and Millimet (2003) and Millimet and Roy (2016) also find that

environmental regulation plays a role in the location outcome of FDI into the United States,

and both studies highlight the importance of treating environmental regulation as endoge-

nous, because the influx of FDI can lead to a change in environmental regulation.

With international studies, determining whether countries use environmental regulation

strategically to attract FDI faces the major challenge of accurately measuring relative envi-

ronmental stringency across countries. Xing and Kolstad (2002) studied 22 countries

between 1985 and 1990 using SO2 emissions.
21

The authors find a significant effect for

20
This is a state- and year-level industry-adjusted index of environmental stringency based on pollution
abatement costs.

21
This approach captures only one component of environmental stringency, namely the regulation of coal
combustion, which likely biases estimates towards energy-intensive industries.

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two of the six sectors studied – with a 1 percent decrease in SO2 emissions associated with

0.27 and 0.20 million dollar increases, respectively, in new investments from U.S. multina-

tional companies in the chemicals and primary metals sectors. However, this effect is small

relative to the total outflow of U.S. FDI (e.g., $4 billion in 1991 in the chemicals sector).

Wagner and Timmins (2009) use the World Economic Forum (WEF) index of environ-

mental stringency and enforcement, which is based on interviews with business executives,

to study the effect of relative environmental stringency on German FDI destinations across

163 countries and 23 industrial sectors. They find that in the chemicals sector, if a country

reduces its environmental stringency by one standard deviation,
22

German FDI to that

country would increase by e122,000 per year, which corresponds to almost two-thirds of

the standard deviation of annual investment flows in the chemical industry. However, they

find no effects for other sectors. Kellenberg (2009) also uses the WEF index and finds strong

evidence that countries with lax environmental policy enforcement (rather than lax strin-

gency) attracted more U.S. multinational firms’ production.
23

In contrast, although

Raspiller and Riedinger (2008) and Ben-Kheder and Zugravu (2012) experiment with a

number of different measures of stringency, they find no systematic evidence concerning

French firms’ FDI location choice.

Impacts on outward FDI location

Whether stringent environmental policies encourage firms to increase foreign assets also

remains empirically unresolved. Using energy intensity as a proxy, Eskeland and Harrison

(2003) find little evidence that stringent regulation in the United States encourages outbound

investment to Mexico, Cote d’Ivoire, Morocco, and Venezuela. Manderson and Kneller

(2012) use UK firm-level data to explicitly account for heterogeneous firm behavior, and

also find no evidence that firms with high environmental compliance costs are more likely to

establish foreign subsidiaries than those with low environmental compliance costs. Hanna

(2010) also uses firm-level data to examine whether exogenous changes in regulatory status

under the CAAA caused U.S. multinational firms to increase their foreign assets and foreign

output in the 1980s and 1990s.
24

She finds that for “nonattainment” counties, their resident

multinational firms increased their foreign assets by 5.3 percent and their foreign output by 9

percent.

Overall, the empirical evidence suggests that the existence of a pollution haven effect for

foreign investment remains unclear. In a meta-analysis of eleven studies on the impact of

environmental regulations on new plant location, Jeppesen, List, and Folmer (2002) find that

the estimates are highly sensitive to the empirical specification, the data, the definition of the

regulatory variable, the control variables, and geographic coverage. Our updated review of the

new plant and FDI location literature here suggests that this conclusion still holds.

22
To give an idea of magnitude, this is exemplified by the difference in environmental stringency between
Austria and neighbouring Slovakia.

23
More specifically, they find that for countries in the top twentieth percentile in terms of the value added of
U.S. multinational affiliates from 1999 to 2003, 8.6 percent of the value added growth was attributed to
lower environmental policy stringency.

24
The use of disaggregated data allows Hanna (2010) to avoid reverse causality issues, control for unobserved
heterogeneity at the firm level, and industry trends, thus going a long way toward avoiding the problem of
omitted variable bias.

Impacts of Environmental Regulations on Competitiveness 193

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Environmental Regulation and Employment

Given that the offshoring of pollution-intensive production corresponds to the offshoring of

pollution-intensive jobs, debates about the impacts of environmental regulations on com-

petitiveness are often framed in terms of “jobs versus the environment” (Morgenstern, Pizer,

and Shih 2002), particularly in regions where declining manufacturing employment has

become a contentious political issue.
25

Hafstead and Williams (2016) show that at the mac-

roeconomic level, in the long run, environmental regulations might simply induce a substi-

tution between polluting and nonpolluting activities, with the impact on net employment

impossible to determine a priori but likely small because of general equilibrium effects.

However, at the microeconomic level and in the short-run, the available evidence shows

that the effects of environmental regulations on employment in energy- and pollution-

intensive sectors are small but statistically significant.

Unfortunately, the evidence to date is based exclusively on within-country differences in

environmental stringency across subnational jurisdictions. This suggests that if relocation

barriers are assumed to be higher across than within countries, then it is reasonable to con-

sider the results we will present here as being upper bounds on the likely effect of an equivalent

cross-border difference in environmental stringency.

Sectoral studies

Using PACE as a proxy for environmental stringency, Morgenstern, Pizer, and Shih (2002)

find that stricter environmental regulation generally does not have a statistically significant

effect on employment. In fact, they even find statistically significant and positive employment

effects in two industries (plastics and petroleum), although the total number of affected jobs

remains quite small. More specifically, they find that environmental regulation accounted for

at most 2 percent of the observed decline in employment from 1984 to 1994. Similarly, in one

of the very few non-U.S. studies, Cole and Elliott (2007) find no evidence that environmental

regulations reduced employment in 27 industries in the UK.

Plant- and firm-level studies

Studies using sector-level data cannot capture job reallocation within firms, industries, or

regions. However, a few studies have used plant- or firm-level data and can thus account for

these impacts. For example, Berman and Bui (2001a) compare petroleum refineries in the Los

Angeles area, which are subject to some of the strictest air pollution regulations in the United

States, to all other refineries in the country. They find no evidence that environmental reg-

ulation decreased labor demand, even when allowing for induced plant exit and discouraged

plant entry. They actually find weak evidence that the strict environmental regulations in Los

Angeles may have resulted in a small net increase in employment, possibly because more labor

is required for pollution control activities. This finding is similar to Morgenstern, Pizer, and

Shih (2002), with the lower bound of the Berman and Bui (2001a) estimates implying that

25
For example, in the United States, aggregate manufacturing jobs declined by 35 percent between 1998 and
2009, while total manufacturing sector production grew by 21 percent (Kahn and Mansur 2013).

194 A. Dechezleprêtre and M. Sato

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over a 12-year period, fewer than 3,500 jobs were lost due to regulation (and the upper bound

implying 11,700 jobs were gained).

By combining large micro datasets with long panels, Kahn (1997) and Greenstone (2002)

are able to provide the most compelling evidence to date on the impact of the U.S. CAAA on

employment. Kahn (1997) finds that the growth rate in manufacturing employment over the

1982–1988 period is 9 percent lower in nonattainment counties that have more stringent air

pollution regulations than in attainment counties. However, the magnitude of this effect

differs across sectors, with the impact of differences in relative stringency ranging from not

statistically significant (but negative) in half of the sectors examined to more than a 10 percent

slower growth rate in the chemicals, primary metals, industrial machinery, and instruments

sectors. Interestingly, plants in nonattainment areas are less likely to close but, conditional on

staying open, grow more slowly than their counterparts in attainment counties. A possible

explanation for this finding is that strict environmental regulation of new sources in these

counties conveys some monopoly power to the incumbents. Using a longer panel of plant-

level data (1972–1987), Greenstone (2002) estimates that the CAAA of the 1970s resulted in a

loss of around 590,000 jobs in nonattainment counties. This represents 3.4 percent of

manufacturing employment in the United States and less than 0.5 percent of total employ-

ment. However, Greenstone (2002) cannot reject the hypothesis (even at the 10 percent level)

that the pollutant regulation effects are equal across industries. Clearly, part of the lost activity

in nonattainment counties may have simply moved to attainment counties. This suggests that

the net national effect of the CAAA on employment is likely to be smaller, but from a cross-

country perspective, and assuming the same effects of environmental regulation, the jobs

would have been lost to foreign competitors. In a study of the employment effects of phase I of

the Title IV cap-and-trade program for SO2 emissions implemented under the 1990 CAAA,

Ferris and McGartland (2014) provide evidence suggesting that the impact of environmental

regulations on employment may be only temporary. Using a small panel dataset of 61 reg-

ulated and 109 unregulated plants, they find that employment is significantly lower in reg-

ulated plants than in nonregulated plants, but only in the first year of compliance.

Walker (2013) finds that the labor transition costs associated with reallocating workers to

other sectors because of the CAAA are large, estimating that the average worker in a regulated

sector experienced a total earnings loss equivalent to 20 percent of the worker’s preregulatory

earnings. In aggregate, workers in newly regulated plants experienced more than $5.4 billion

in forgone earnings for the years after the change in policy, with almost all of the estimated

earnings losses driven by unemployment.
26

Impacts of energy price levels

A few recent studies have examined the impact of differences in energy price levels on

employment, providing insights into the effect of carbon tax differentials on jobs. Using

within-state variation in electricity prices in the United States, Deschenes (2011) finds that

employment rates are weakly related to electricity prices: a 1 percent increase in electricity

prices leads to a change in full-time equivalent employment that ranges from �0.16 percent
to �0.10 percent. Kahn and Mansur (2013) examine variations in energy prices and

26
However, earnings losses also depend on the strength of the local labor market, suggesting that policy-
induced labor market reallocation may be more costly in periods of high unemployment.

Impacts of Environmental Regulations on Competitiveness 195

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environmental regulations among adjacent counties from 1998 to 2009 and find evidence

that energy-intensive sectors tend to locate in low electricity price areas and that polluting

sectors seek out low regulation areas, thus reducing employment in high regulation areas.

Although the effects are modest and only weakly significant for the typical manufacturing

industry, the most electricity-intensive industry—primary metals—has an implied price

elasticity of employment of�1.65, which means that a 10 percent increase in the price of
electricity leads to a 16.5 percent decrease in employment in that sector. Based on these

estimation results, Kahn and Mansur (2013) predict that the employment effect of a hypo-

thetical $15 per ton carbon tax would affect employment very differently across states, ac-

cording to the carbon intensity of electricity production and the energy intensity of the

industry, ranging from a 3.8 percent decline in employment in Ohio to a 0.3 percent decline

in California.

Role of policy design

Importantly, the effects of relative environmental stringency on employment levels and dis-

tribution depend on the policy design. In an econometric analysis of the impact of British

Columbia’s unilateral revenue-neutral carbon tax, Yamazaki (2017) finds that the carbon tax

generated a small but statistically significant 2 percent increase in employment in British

Columbia relative to other (free of carbon taxes) provinces over the 2007–2013 period, but

that the magnitude of the effect differs according to the sector’s carbon intensity and trade

exposure. For example, with a carbon tax of CAD10 per tonne of CO2 equivalent, the basic

chemical manufacturing sector, one of the most emissions-intensive and trade-exposed in-

dustries, experiences the largest decline in employment (30 percent),
27

while the health care

industry experiences a 16 percent increase in employment, which the author attributes to the

positive demand shock induced by the redistribution of tax revenues to residents of British

Columbia. Thus Yamazaki (2017) finds that while there are clearly winners and losers, a

revenue-neutral carbon tax may not adversely affect aggregate employment.

In summary, the most rigorous studies that use installation or county-level data from the

United States and long panels provide evidence of a pollution haven effect within the United

States. More specifically, they find that environmental regulations have negative effects on

employment in pollution-intensive sectors. This suggests that—in the United States at

least—differences in environmental regulations between states or counties have led to small

negative effects on employment in polluting sectors. However, it is important to keep in mind

that employment effects might be larger within national boundaries (where relocation bar-

riers are lower) than across countries.

Empirical Evidence: Impacts on Productivity, Innovation, and
Competitiveness

Environmental regulation may also alter firms’ decisions concerning the volume, type, or

timing of their investments, whether in adopting cleaner technologies through plant refur-

bishment or replacement or in the development of innovative production technologies or

27
The 95% confidence interval ranges from -15 percent to -48 percent.

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products. Environmental policies can thus affect firms’ long-term competitiveness through

these channels.

Environmental Regulations and Productivity

By lowering firms’ marginal production costs (and hence product prices in competitive

markets), increased productivity can enhance the competitiveness of firms that operate in

international markets, thus boosting exports and market share.
28

However, because invest-

ment in pollution control diverts resources away from production, economic theory suggests

that environmental regulation will hamper productivity growth.

Evidence that environmental regulation hampers productivity

Early studies of the relationship between environmental regulation and productivity did find

empirical evidence to support this theory, at least for some sectors of the economy. For

example, Gollop and Roberts (1983) found that SO2 regulations in the United States reduced

productivity growth in 56 fossil-fuelled electricity utilities by an estimated 44 percent during

the 1973–1979 period. More recently, Gray and Shadbegian (2003) found a link between

higher pollution-abatement operating costs and lower productivity in 116 pulp and paper

plants. However, most of these early studies used small samples.

Thus far, Greenstone, List, and Syverson (2012) have conducted the largest plant-level

study, with 1.2 million plant observations from the 1972–1993 Annual Survey of

Manufacturers. This large data set allows them to control for many confounding factors

that may affect both productivity and regulation. Specifically, Greenstone, List, and

Syverson (2012) investigate the economic costs of the 1970 CAAA using nonattainment

designation as a measure of regulation. They find that total factor productivity (TFP) declines

by 4.8 percent for polluting plants in strictly regulated counties relative to weakly or unregu-

lated counties. Almost all of the effect occurs in the first year of nonattainment status, sug-

gesting that capital investments in pollution abatement have only a short-term impact on

productivity.

Variation across pollutants and industries

The evidence also suggests that the impacts of the relative stringency of environmental reg-

ulations on productivity vary across pollutants and industries and can sometimes be positive.

For example, Greenstone, List, and Syverson (2012) find that while nonattainment of ozone

concentrations negatively affects productivity, nonattainment of carbon monoxide concen-

trations leads to statistically significant increases in productivity. However, the authors do not

discuss reasons for these differences in outcomes across pollutants. Similarly, Alpay,

Kerkvliet, and Buccola (2002) find that the productivity of the Mexican food processing

industry increased with more stringent local environmental regulation and that pollution

28
See the seminal article by Melitz (2003), who shows that only firms that are sufficiently productive can
become exporters (as being more productive allows firms to secure a market share that is large enough to
cover the fixed cost of exporting) and that trade increases average productivity by forcing the least pro-
ductive firms to exit. See Balistreri and Rutherford (2012) for a discussion of the consequences of using the
Melitz model for competitiveness in a computable general equilibrium (CGE) setting.

Impacts of Environmental Regulations on Competitiveness 197

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regulations in the United States had no negative impact on the profitability or productivity of

its domestic food manufacturing industry.

Short-term impacts

Berman and Bui (2001b) find that although refineries located in the Los Angeles (South Coast)

Air Basin area experience a short-run decrease in productivity due to increased regulatory

stringency between 1979 and 1992, this effect appears to be temporary; after a few years they

enjoy significantly higher productivity than other refineries in the United States despite the

more stringent air pollution regulations. Similarly, Lanoie, Patry, and Lajeunesse (2008) find

that the negative short-run effects of regulation on the Quebec manufacturing sector are

outweighed by subsequent positive effects on multifactor productivity (MFP) growth.

In one of the few European studies to date, Rubashkina et al. (2015) find that environmental

regulation (as proxied by PACE) negatively affects TFP, but the effects dissipate within 2 years.

In a multilevel analysis using a dataset covering 60,000 companies across 23 Organization for

Economic Cooperation and Development countries, 22 manufacturing sectors, and 21 years,

Albrizio, Kozluk, and Zipperer (2014) find no evidence that a tightening of environmental

policy has any permanent effects on MFP growth at either the country or industry level. In fact,

they find that an increase in environmental stringency is associated with a short-run increase in

productivity growth, which translates into permanently higher MFP levels. However, all effects

tend to fade away within less than 5 years. Albrizio, Kozluk, and Zipperer (2014) also find that

the most productive industries and firms experience the highest gains in productivity, while less

productive firms see negative effects, possibly because highly productive firms are better able to

profit from changes required by environmental regulations.

In sum, the evidence indicates that environmental regulation has both negative, short-term

impacts on productivity in some sectors and for some pollutants and positive productivity

impacts in others.
29

However, more research is needed to investigate the longer run produc-

tivity impacts of environmental regulations.

Environmental Regulations and Innovation

From an economic perspective, it is critical for environmental regulations to provide incen-

tives for technological change because new technologies may substantially reduce the long-

run cost of abatement (Jaffe, Newell, and Stavins 2003). From a political perspective, such

policy-induced innovation may also improve the acceptability of environmental policies.

Indeed, in today’s knowledge-based economy, firms’ competitiveness depends largely on

innovation, which is considered to be a key component of productivity growth (Aghion

and Howitt 1992). Thus there is growing literature that seeks to quantify the link between

environmental regulations and technological innovation.
30

The “induced innovation hy-

pothesis,” dating back to Hicks (1932), suggests that when regulated firms face a higher price

on polluting emissions relative to other costs of production, these firms have an incentive to

develop new emissions-reducing technologies. Many studies have clearly shown that envi-

ronmental regulations can indeed encourage the development of pollution-reducing

29
See Kozluk and Zipperer (2013) for a review specifically focused on productivity.

30
For recent surveys, see Carraro et al. (2010), Popp, Newell, and Jaffe (2010), and Ambec et al. (2013).

198 A. Dechezleprêtre and M. Sato

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technologies. For example, Jaffe and Palmer (1997) and Brunnermeier and Cohen (2003)

show that stricter regulation (proxied by higher pollution control expenditures) leads to

higher research and development expenditures and more environment-related patents.

Similarly, higher energy prices have been shown to induce the development of energy-effi-

cient technologies (Newell, Jaffe, and Stavins 1999; Popp 2002). These results are confirmed

in recent studies that use firm-level data, which allows them to control for macroeconomic

factors that might affect both environmental regulation and innovation at the sector level. For

example, using data on approximately 3,000 firms in the car industry, Aghion et al. (2016)

show that firms tend to innovate more in clean technologies (electric, hybrid, and hydrogen

cars) in response to higher road fuel prices. Calel and Dechezleprêtre (2016) find that the EU

ETS has increased innovation activity in low-carbon technologies among regulated compa-

nies by 30 percent relative to a control group.

From a policy perspective, an important issue is determining which regulatory instruments

provide the strongest incentives for innovation. The theoretical literature suggests that

market-based instruments provide stronger incentives for innovation than technology man-

dates and performance standards, and that among market-based instruments, emissions

taxes and auctioned emission permits encourage more innovation than freely allocated emis-

sion permits (Milliman and Prince 1989; Fischer, Parry, and Pizer 2003; Parry, Pizer, and

Fischer 2003). However, the handful of empirical studies on this issue appear to at least partly

contradict the hypothesis that market-based policies encourage more innovation than

command-and-control regulations. For example, Popp (2003) shows that following passage

of the 1990 CAAA, which replaced command-and-control regulation with permit trading,

innovation activity actually decreased in intensity. Taylor (2012) shows that for both the U.S.

SO2 emissions cap-and-trade program and the U.S. Ozone Transport Commission NOx
Budget Program, patenting activity collapsed when traditional regulation was replaced by

cap-and-trade. Thus further research is needed on this issue.

Induced Innovation and Firms’ Competitiveness

Can innovation induced by environmental regulations more than fully offset the costs of

complying with them (Porter and van der Linde, 1995b) and enhance firms’ competitiveness?

While there is evidence that the actual cost of achieving an environmental objective is usually

smaller than anticipated because of induced innovation (see, e.g., Harrington, Morgenstern,

and Nelson 2000, 2010; Simpson 2014), the literature to date does not provide much empir-

ical support for the Porter hypothesis in its so-called strong version.
31

Thus there is currently

no empirical evidence that environmental regulation leads to an increase in firm competi-

tiveness through its effect on innovation.

In theory, environmental regulation can increase productivity growth (and hence com-

petitiveness) if it leads to a permanent increase in the rate of innovation. There is some

emerging evidence, however, that regulation-induced environmental innovations tend to

replace other innovations, leaving the overall level of innovation unchanged. For example,

31
The “weak” version of the Porter hypothesis postulates that properly designed environmental regulation
may spur innovation. The “strong” version of the Porter hypothesis goes further, asserting that in many
cases this innovation more than offsets any additional regulatory costs—in other words, environmental
regulation can lead to an increase in firm competitiveness (Ambec et al. 2013).

Impacts of Environmental Regulations on Competitiveness 199

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in their study of paper mills in the United States, Gray and Shadbegian (1998) found that

more stringent air and water regulations improved environmental innovation, but that the

increased investment in emissions and water abatement technologies came at the cost of other

types of productivity-improving innovation. Popp and Newell (2012) find that alternative

energy patenting crowds out other types of patenting at the firm level. There seems to be a

larger crowding out effect for small firms that are credit constrained (Hottenrott and

Rexh€auser 2013). Aghion et al. (2016) show that innovations in clean cars (electric, hybrid,

and hydrogen) occur almost completely at the expense of innovation in dirty vehicles (com-

bustion engines). In contrast, Noailly and Smeet (2015) and Calel and Dechezleprêtre (2016)

find no evidence of such substitution effects at the firm level, suggesting that some environ-

mental regulations may raise the overall rate of innovation of regulated firms rather than

simply redirecting innovation toward clean and away from polluting technologies.
32

Several studies have examined the causality chain implied by the Porter hypothesis—from

regulation to innovation to profitability—and find that the positive effect of innovation on

business performance does not outweigh the negative effect of the regulation itself (Lanoie

et al. 2011). Thus environmental regulation is costly, but it is less costly than if one were to

consider only the direct costs of the regulation itself and ignore the ability of innovation to

mitigate those costs. This is because, over time, regulation-induced innovations that improve

a firm’s resource efficiency in terms of material or energy consumption have a positive impact

on profitability (Rexh€auser and Rammer 2014).

Porter and van der Linde (1995a) also argue that countries that take early action in envi-

ronmental protection will induce higher costs for domestic firms in the short run, but that the

induced innovation will generate economic benefits in the long run by giving domestic firms a

competitive advantage over foreign firms, which will be constrained by the same regulation

later on. However, to our knowledge, no study has empirically analyzed whether this first-

mover advantage actually leads to competitiveness improvements in the long run.

While there is no evidence that regulated firms’ competitiveness will increase due to policy-

induced environmental innovation activities, global benefits appear to be more likely. Popp

and Newell (2012) find that the social value of renewable energy patents, as measured by

patent citations, is higher than the social value of patents in conventional fossil fuel technol-

ogies that are crowded out. Dechezleprêtre, Martin, and Mohnen (2014) confirm this finding

in a comparison of knowledge spillovers from clean and dirty technologies in the transpor-

tation and energy production sectors. Thus regulation-induced innovation in clean technol-

ogies might increase the innovation activity (and possibly the competitiveness) of some

unregulated companies through knowledge spillovers. This would improve the net social

benefit (or reduce the net cost) of the regulation without cancelling out the competitiveness

effects on regulated companies.

Conclusions and Priorities for Future Research

Some 20 years ago, in their review of the literature on the competitiveness impacts of envi-

ronmental regulation in the United States, Jaffe et al. (1995) concluded that “there is relatively

32
To our knowledge, crowding out between firms, which could occur because the number of inventors in the
economy is somewhat fixed in the short run, has not been analyzed.

200 A. Dechezleprêtre and M. Sato

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little evidence to support the hypothesis that environmental regulations have had a large

adverse effect on competitiveness.” Since then, through hundreds of studies that have used

ever larger datasets with increasingly fine levels of disaggregation, employing up-to-date

econometric techniques, and covering a wider set of countries, this conclusion has only

become more robust.

This article has reviewed the recent empirical literature on the impacts of environmental

regulations on firms’ competitiveness, as measured by trade, industry location, employment,

productivity, and innovation. The cost burden of environmental policies has often been

found to be very small. The recent evidence shows that taking the lead in implementing

ambitious environmental policies can lead to small, statistically significant adverse effects on

trade, employment, plant location, and productivity in the short run, particularly in pollu-

tion- and energy-intensive sectors. However, the scale of these impacts is small compared

with other determinants of trade and investment location choices such as transport costs,

proximity to demand, quality of local workers, availability of raw materials, sunk capital

costs, and agglomeration. Moreover, the effects tend to be concentrated on a subset of sectors

for which environmental and energy regulatory costs are significant—a small group of basic

industrial sectors characterized by very energy-intensive production processes, limited ability

to fully pass through pollution abatement costs to consumers (whether due to regulation or

international competition), and a lack of innovation and investment capacity to advance new

production processes (Sato et al., 2015a). For these subsectors, where pollution leakage and

competitiveness issues represent a genuine risk, a critical avenue for future research is to

assess and evaluate the various policy options available to prevent adverse impacts on trade

and investment without dampening the incentives to develop cleaner processes and products

(Martin et al. 2014; Branger et al. 2015).

This article has also shown that there is strong evidence that environmental regulations

induce innovation activity in cleaner technologies. Thus far the benefits from these innova-

tions do not appear to be large enough to outweigh the costs of regulations for the regulated

entities. Of course, this does not preclude the ability of environmental regulations to foster

the development of global leaders in innovation, but it does suggest that the evidence for the

most controversial interpretation of the Porter hypothesis (i.e., that environmental regula-

tions can lead to an increase in firms’ competitiveness) is lacking. As regulatory designs and

combinations continue to be explored, further research will be needed to identify the com-

binations of research and development and environmental policies that best encourage in-

novation in green technologies (Burke et al. 2016).

This review raises the question of why the effects of environmental regulations on inter-

national industry relocation have been found to be so small and narrow given the strong

concerns about competitiveness in public policy circles. One explanation could be that reg-

ulated companies have an incentive to overstate the potential competitiveness impacts of

regulations as a strategy to lobby against stringent policies by attributing unpopular off-

shoring decisions to public policy rather than to underlying economic factors such as the

shifting locus of supply and demand in global manufacturing or decreasing transport costs.

An alternative explanation for the lack of empirical support for the large pollution haven

effects discussed in the literature is that environmental policy is endogenous, i.e., governments

strategically set stringency levels to be low (high) where there is a high (low) risk of

Impacts of Environmental Regulations on Competitiveness 201

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competitiveness distortions. This argument suggests that competitiveness concerns could

trigger a “race to the bottom” in global environmental protection efforts. To avoid such an

outcome, further research is needed to accurately measure and monitor the competitiveness

effects of environmental regulations to help ensure that policy is based on robust evidence.

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