A major challenge facing society is discovering new ways to grow economies without growing environmental impacts, commonly referred to as “decoupling” economic growth from environmental degradation. It is, however, a widely held belief among both economists and regulators that the adoption of environmental regulation will, by nature, impair economic growth. In this view, policies or regulations designed to improve the environmental performance of economic actors (for example, firms) will, by default, reduce the potential for economic growth — which means decoupling is not viable as a policy objective. One need look no further than the current paralysis with the international negotiations to limit greenhouse gas emissions (and decarbonize economic growth) to see the implications of this perception.

There is little question that in the long run, unconstrained environmental impacts will have a significant effect on the prospects for economic growth. However, traditional economics argues that placing environmental restrictions on firms — for example, to reduce emissions of air or water pollution — will necessarily restrict firms’ potential decisions and, therefore, ultimately decrease their potential profits (Palmer, Oates and Portney 1995). Quite simply, economic theory did not accept that a profit-maximizing firm would systematically ignore opportunities to improve economic performance by reducing environmental impacts — it held that the firm should already be taking advantage of those opportunities, without the need for regulation. Hence, environmental regulation had to impose a net economic cost.

In 1991, Michael Porter directly challenged this economic orthodoxy by suggesting that well designed environmental regulation could potentially enhance competitiveness, and thereby improve economic performance by generating substantial “innovation offsets” (Porter 1991). Termed the “Porter Hypothesis,” this argument has sparked an extensive, international body of research over the past 20 years (Ambec et al. 2013; Lankoski 2010). While this research has deepened our understanding of the relationship between environmental regulation, innovation and competitiveness, it has also produced widely divergent findings on many key points. 

The research project, Greening Economic Growth undertaken through a CIGI-INET grant, was designed to systematically analyze the weight of evidence on the Porter Hypothesis. It was conceived in two parts. The first part aimed to provide a rigorous analysis of the existing empirical evidence on the Porter Hypothesis, to see if we could understand why different studies have reached divergent conclusions. Questions asked included: to what extent are these divergent conclusions due to methodological differences (for example, how productivity or innovation is measured)? To what extent do they stem from differences (or changes over time) in regulatory approaches (for example, flexible or market-based instruments), characteristics of the firm (for example, the sector or degree of competitiveness) or other factors (for example, available technological substitutes)? An extensive review of the literature was conducted for this part of the project, through which literally hundreds of papers were catalogued and reviewed for relevance and application of findings to the Porter Hypothesis, and their pertinence to the relationship between environmental regulation, innovation and economic competitiveness.

The findings of this extensive literature survey confirmed that, while most studies find that environmental regulation generally spurs innovation, there is significant disagreement over the strength of this signal and the impact of the resulting innovation on economic performance (Johnstone et al. 2009; Johnstone, Hascic and Popp 2010). The greatest conflict surrounds how environmental regulation affects competitiveness (normally measured through productivity — or how much economic output can be produced given a fixed amount of inputs). Simply put, while most early studies concluded that regulation negatively affected productivity, a growing number of studies from the last decade of research are finding that environmental regulations can have a positive effect on productivity, in the right circumstances. Statistical examination of the existing literature, using a meta-analysis approach, failed to produce any clear indications of why different studies have reached such divergent conclusions, due to the considerable heterogeneity in the findings across studies, a wide range of regulatory measures examined and changes in the empirical techniques in the literature over time.

The second part of the project aimed to contribute new evidence to the Porter Hypothesis debate by recognizing that changes in the productive efficiency of market outputs following regulation may be augmented by increased productivity in the mitigation of non-market, environmental outputs as well. This implies that, when firms are faced with environmental regulations, they might develop innovative means of dealing with those regulations, thereby increasing their combined productivity over all outputs that society cares about — both by increasing their output of market “goods,” while reducing the production of environmental “bads.” Our research, therefore, sought to build on the existing body of literature described above by investigating the relationship between regulation, innovation and productivity, and evaluating a case where output of both desirable “goods” and undesirable “bads” are considered.

Specifically, this research explored the relationship between environmental regulation, innovation and competitiveness by generating new empirical evidence drawn from a global dataset of patented “environmental” inventions, a global dataset of power plants and a unique dataset developed specifically for this project on environmental regulations directed at combustion (power) plants. The data used covers the thermal power plant sector in 34 countries over 20 years, from 1990 to 2009. The results of this study shed light on the impact of policies, pollutant characteristics, plant vintage (i.e., age) and plant size on productive efficiency across this range of countries and years.

The most general finding emerging from this work is that overall regulatory stringency is found to have a significant and positive effect on productivity in most models — providing general evidence in support of the Porter Hypothesis in this case. More specifically, findings show that in the near-term, technologies that target the emission of pollutants such as sulphur oxide (SOX) and nitrogen oxide (NOX) gases in an integrated manner, throughout the combustion process, are more efficient than those that rely on post-combustion emission-reducing technologies. In the long term, those policies that relate to more general efficiency of production processes of power plants overall are more efficient than those that attempt to specifically target particular emissions, such as NOX and SOX, individually. This latter result is consistent with the principle that addressing joint pollutants in an integrated manner is more efficient.

Finally, results also show that regulatory approaches that give preferential treatment to existing plants (for example, by requiring improved performance of new plants differentially) have negative consequences for the efficiency of abatement for the power plant sector as a whole. Grandfathering plants can keep older, unregulated plants in service longer, and indeed it was found that the effects of such policy differentiation become more important over time. Vintage-differentiated regulations show increasingly strong adverse implications further in the future, as they delay projects that would eventually bring newer, more efficient plants into service, in favour of older plants that do not fall under the new regulatory structure. Moreover, age-differentiated regulatory programs may be politically appealing, since incumbents are often more capable of applying pressure for less stringent regulation than new entrants.

By using new, detailed datasets and advanced analysis techniques, this research has added to the evidence that it is possible for environmental regulation to help improve overall economic productivity and competitiveness, if those regulations are properly designed and targeted. Through a detailed analysis of the power plant sector, suggestions have also been provided for how regulatory design can be improved and implemented to have the greatest chance of increasing the overall productivity of the sector, across economic outputs. These findings help to clarify what is a controversial literature, and also to argue against the conventional economic orthodoxy that environmental regulation must, by necessity, negatively impact economic growth. In particular, the findings of this research illustrate approaches to environmental regulatory design that are shown to boost eco-innovation, and provide evidence of how these approaches could help to further decouple the traditional linkage between economic growth and environmental impact. This goes to the heart of the challenge of developing sustainable economies.

Works Cited

Ambec, S., M. A. Cohen, S. Elgie and P. Lanoie. 2013. “The Porter Hypothesis at 20: Can Environmental Regulation Enhance Innovation and Competitiveness?” Review of Environmental Economics and Policy 7 (1): 2–22.

Johnstone, N., I. Hascic, R. de Vries and N. Medhi. 2009. “The Effects of Environmental Policy on the Type of Innovation: The Case of Automotive Emissions Control Technologies.” OECD Economic Studies 45 (2009/1).

Johnstone, N., I. Hascic and D. Popp. 2010. “Renewable Energy Policies and Technological Innovation: Evidence Based on Patent Counts.” Environmental and Resource Economics 45 (1): 133–55.

Lankoski, L. 2010. “Linkages between Environmental Policy and Competitiveness.” OECD Environment Working Papers No. 13. www.oecd.org/dataoecd/0/8/44392874.pdf.

Palmer, K., W. E. Oates and P. R. Portney. 1995. “Tightening Environmental Standards: The Benefit-Cost or the No-Cost Paradigm?” Journal of Economic Perspectives 9 (4): 119–32.

Porter, M. E. 1991. “America’s Greening Strategy.” Scientific American 264: 168. 

These findings argue against the conventional economic orthodoxy that environmental regulation must, by necessity, negatively impact economic growth.
  • Paul Lanoie is currently a full professor at HEC Montreal (École des Hautes Études commerciales de Montréal). He holds a M.Sc. in management (1984) from HEC Montreal and a Ph.D. in economics (1989) from Queen’s University in Kingston (Canada).