Over the last century, human population has increased dramatically and the world faces highly complex economic and social challenges. The aggregate demand has been increasing rapidly, though the poverty considerably too (OECD 2012). Since 1950’s, the economic growth has been generally seen the only solution for the courtiers that are struggling with slow economic growth and high rate of unemployment. However, economic activity takes place within and is part of “the natural environment”, the earth and its atmosphere, which is its ultimate foundation. It is a very important asset that ensures not only the economic activity and development but also our existence with its basic life support function provided by flow and stock natural resources. Over the decades, Economist main concern is how to sustain natural resources especially stock resources which are the ones taken from the stock1. Unlike the flow resources: solar radiation, water, wind power etc. Non-renewable stock resources are mostly irreversible and non-recyclable. Moreover, the “today’s consumption” of stock resources has some implication on “tomorrow’s availability”. They are not freely available everywhere and to everyone yet they hold property rights; and are private goods such that privileges and limitations are associated with the ownership of a resource.
Humans by nature are greedy and our wishes are unlimited, however we have limited resources known as scarce resources. According to Boulding (1966), this is the ‘Cowboy’ and ‘Spaceman’ economies2. Spaceship, the earth, has strictly limited life support capabilities that depend upon achieving a delicate balance between consumption, material recycling and energy harnessed from outside. The productivity is the most important determinant of the standard living of a group of people or a nation, therefore the tendency and the speed of extraction and the use of resources is growing with the population. The larger the economy is in relation with the environment, the harder is to maintain this balance (Boulding 1996). After the conference ‘Earth Summit’ in 1992, economist put forward the concept of “sustainable development” because the impact on the climate change and the degradation & the pollution of environment has been growing rapidly. In consequences, over the last twenty years, a strict and wide range of environmental policies and regulations such as command-control policies and Market-based instruments were implemented and were the key policy priority for the OECD governments to sustain and protect environmental conditions. However, these challenges require a deep cultural shift towards “greener” and more innovative sources of growth (OECD, 2012).
Moreover, this paper describes how after 1970’s in most OECD countries, these policies affected not only the environmental outcome but also economic performance and productivity. Some think that is negatively affecting, by imposing externality or Abetment cost on firms which reduce their global competitiveness with a negative effect on Productivity and employment. (See Christiansen and Haveman (1981), Gray (1987), Barbera & McConnell (1990)). However, others just contradict, by emphasizing that such policies have a positive effect on productivity. The focus of the article will be on the counter-argument which, recently implies that such regulations, concurrently create incentives by stimulating innovation that leads to higher productivity and competitiveness (Porter (1991), Porter and Van der Linde (1995)) known as Porter Hypothesis and the existence of double dividend. The findings indicate that regulations may spur innovation in firms that usually leads to competitiveness gains, and productivity growth, not losses. (Hamamoto (2006), Ambec (2013)). The paper is organized as follow: section 2 synopsizes the arguments against the positive effect of regulations. Section 3, a brief overview of Porter Hypothesis, as well as the variations expressed in literature. Section 4 illustrates empirical finding. Conclusions follow.
2. Arguments against the positive effect of regulations
Traditionally, after the enhancement of the first major environmental regulations in 1970’s, the theoretical and empirical literature outcome of environmental regulation on business performance implies that there is a trade-off between achieving the environmental objectives and firm’s productivity3 because of the additional cost imposed on firms. Moreover, environmental regulations like technological standards, environmental taxes or marketable emission permits force firms to allocate some of its inputs (labor, capital) to pollution reduction, which reduces business productivity and profit. Technological standards restrict the choice of input factors used in the production process and marketable emission permits tax firms for their emission pollution which was free before. Therefore, Businesses and Policymakers fear that the large asymmetries in the stringency of environmental policy could shift intense production capacity toward countries or region with less stringent regulation (Levinson and Taylor, (2008)), which may affect the industrial production and their global competitiveness. More precisely, Environmental regulation is commonly thought to reduce productivity. (Norsworthy (1979), Christiansen and Haveman (1981). Furthermore, according to Gray and Shadbegian (1993,1998,2002,2003) examination at the plant level on the U.S. manufacturing industries (paper, oil, and steel) from 1979 to 1990 results that there is negative relationship between the cost of pollution reduction (sulfur dioxide emission) and the total factor productivity. (see also Smith and Sims (1985), Cornard and Morrinson (1989), Boyd & McClelland (1999)). Greenstone (2012) find that total factor productivity declines in 2010 by 4.8 percent for polluting plants in strictly regulated counties (the 1970 Clean Air Act) compared to weakly or unregulated counties (see also Bromberg (2012)). Another research paper by Jaffe (1995) explains that there is only a small amount that the environmental regulation can reduce the employment and the productivity and little evidence that strengthening environmental regulation deteriorates competitiveness. Where Mangani (2005) find negative short-term effects of regulation on productivity levels in US offshore oil and gas field which is becoming positive and enhancing the productivity. Additionally, they are other studies which describe that environmental policies have no effect on productivity. Domazlicky and Weber (2004) studies find no effect on the environmental regulation and adjusted productivity in U.S. chemical sector and Alpay (2002) describe a similar finding in U.S. food manufacturing sector.
3. Overview of Porter Hypothesis and its Variations
However, this traditional paradigm was challenged by a large number of analysts. A number of studies find that the productivity is either enhanced by environmental regulations or unaffected (Alpay (2002), Bremen and Bui (2001), Becker (2011)). The concept was notably investigated by Harvard Business School economist and strategy professor Michael Porter who declared that properly designed regulation could enhance competitiveness and innovation that can improve the productivity (Porter 1991). The general idea behind induced innovation goes back to Hicks (1932). Porter, with his co-author Class van der Linde, propose that pollution is often a waste of resource and reduction in pollution could lead to an improvement in the productivity with the resources used. Furthermore, they suggest that on the market-based instrument such as tax or cap-and-trade emission allowance, more stringent but well-designed environmental regulation can spur innovation that may often not only fully offset regulatory cost but also result in additional profit or so-called Win-Win innovation. (Porter and van der Linde (1995), Ashford (2000)). Over the last twenty years, this approach is known as Porter Hypothesis (PH) and it suggests the existence of double dividend. The porter hypothesis implies that “well designed and enforced” environmental regulations can provide a “Free Lunch”, encourage innovation, motivate firms to reduce waste, increase efficiency and use newer and more efficient production technology. Empirical literature about the PH is vast but mainly on the U.S. Generally speaking, the Porter Hypothesis assumes that there are profit opportunities for firms which are not fully used until the firms are pushed to do so by the implementation of a new environmental policy. (Wagner (2003), Ambec (2013)). Since early 1990s, given the implications for policy making and firms performance, proving or disproving the PH has been the main focus of many empirical contributions. Previous authors have disaggregated the PH into its component part in order to test the theory and evidence. Consequently, in order to find feasible empirical resting approaches, the studies can broadly be divided into three distinct research statements which are nowadays known as weak, strong and narrow version of the PH (Jaffe and Palmer (1997)).
The weak version of the PH indicates that the environmental regulation will lead to an increase in environmental innovation. According to Jaffe and Palmer (1997), firms that are subject to new environmental regulation face an additional environmental constraint next to their financial ones. And since firm’s objective is to maximize profit, they will search for the most cost-effective way to comply with the new regulation. Hence, Porter Hypothesis suggests that firms may do so by innovating to reduce compliance costs, however, does not necessarily imply in total more innovation. So, it is called weak because it does not tell us whether that innovation is good or bad for firms but focus on the relationship between environmental regulation and innovation.
The strong version of the PH states that innovation often leads to increase in firm competitiveness. It discards the profit maximization concept and emphasis instead on productivity, declaring that firms are not efficiently and effectively operating by leaving some unused profit opportunities. Environmental policies might hence encourage the firms to restructure their production process. This might lead to extra profits which can in some cases be even larger than the additional regulatory cost. This hypothesis has been tested in several versions, including the effects on more innovation and on actual company performance.
The narrow version of PH implies that certain types of environmental regulation are designed to target the outcome rather than the design of the production processes and those are more likely to increase innovation and improve company performance (Jaffe and Palmer (1997)). In practice, this version states that redirection of gains in productivity and innovation are more likely under certain types of environmental policies e.g. flexible and market-based instruments. Ambec (2013) in line with Porter and Linde (1995) summarizes the main causal links involved in the PH. by schematizing how “properly designed” environmental regulation (strict but flexible) could lead to “innovation offset” that will not only improve environmental performance but also partially and sometimes fully offset the regulatory cost. Hence the performance of the firm.
In most of the OECD countries and especially in the U.S., the PH has been a subject to a great success in political debate because it opposes the idea that environmental protection is always harmful to economic growth. Yet the PH does not hypothesize that higher abatement cost will lead to innovation instead suggests that more stringent environmental standards lead to investment in R (in terms of organizations or changes in process and so on), which in return leads to innovation. Moreover, the PH encouraged the business organizations to accept environmental regulations because in a well-designed environmental regulation, might in some case lead to Pareto improvement or win-win situation since is not only protecting the environment but also increasing profits and competitiveness through the enhancement of the product or through improvement of product quality.
4. Reviewing empirical findings
The empirical research on the economic effects of environmental policies is discussed in the following literature. The majority of the researches and the studies on the productivity effect of environmental policies so far are on microeconomic level (firm-industry) level and only a few are conducted to macroeconomic level.
One of the fundamental element that guarantees economic growth and environmental improvement is innovation (e.g double dividend) which is usually measured by R expenditure. The empirical research by Jaffe and Palmer (1997) and Lanoie (2011) evaluate the relationship between total R expenditure and pollution abatement costs with a positive correlation. Yet, with reference to Hamamoto (2006), it is also disclosed that increases in R investment stimulated by the regulatory stringency have a significant positive effect on the growth rate of total factor productivity. Therefore, if policies actually increase innovation they can enhance productivity growth. The purpose of encouraging environmental innovation and improving productivity is a major challenge to policymakers (Kozluk & Zipperer (2014). The evidence by Lanjouw & Mody (1996), Popp (2006) and Vries & Withagen (2005) that shows a positive impact of the environmental regulation on environmental innovation is founded to be significantly weak. The recent data confirms that both more stringent and flexible environmental regulation will increase the environmental innovation which further enhances business performance. (the narrow version of the PH).
The designs of environmental policies are extremely important to raise the development and the diffusion of environmentally-friendly technology. Therefore, the characteristic of environmental policy framework can affect the direction of innovation in pollution abatement technology. According to Johnstone and Labonne, (2006),) more flexible environmental policies achieve environmental goals with superior economic outcome (see also De Serres (2010)4. Specially market- based policies allow reaching a given level of environmental protection in more cost-effective way (Bohm & Rusell (1985)). Moreover, Burtraw (2000) provides evidence that the environmental regulations for SO2 emission in the U.S. from a technological standard with emission cap and trade program in 1990 noticeably reduced the compliance cost (40% to 140% lower than projection) even though the effect was still a net cost. However, this instrument stimulates innovation and fostered organizational change and competition in the input market. This allows the firms to select the best strategy for reducing emission such as switch to coal with lower sulfur content which on the other aspect increased the productivity by reducing their input cost.
Along the same path, other authors like Hoglund Isaksson (2005) aspects the impact of a charge on nitrogen oxides (NOX) emission implemented in Sweden in 1992. The author examined the impact on abatement cost functions (of 114 combustion plants during 1990-1996) and suggests that extensive emission reduction has taken place and there is a remarkable increase in technological advancement during the analyzed period. Lanoie (2010) described above, also provide (indirect) evidence on the same issue by showing that performance standards are leading to more innovation and productivity than do more technological standards.
Furthermore, Andersen (2007) analyze environmental tax revenues in seven EU countries that are recycled into other tax cuts like labor or income and discovers a positive net impact on GDP. Therefore, if the market-based instruments generate revenues (e.g. from taxes or marketable permit auctioning), then the efficient recycling of those revenues can improve the competitiveness outcome. Other authors also, such as Xepapadeas and Zeeuw (1999), demonstrate that if the downsizing due to a stricter environmental policy is accompanied by an innovation effect, then the average productivity of the capital stock rises. This means that there is a win-win situation in the sense that the environmental policy improves both the environment as well as the competitiveness5. Also, the data by (Berman and Bui 2001) on the U.S. petroleum indicates that stricter environmental standards caused an increase in productivity in 1987. Furthermore, a recent research by Albrizio (2014) discusses the effect of environmental stringency policy change in OECD countries and their impact on productivity growth. Where they experiment a new environmental policy stringency (EPS) index to test the multi- factor productivity growth then they describe that the effect of environmental policy measures varies with industry pollution intensity and technological advancement. Consequently, their results indicate that after a year of a negative effect of policies on productivity the effect is offset after three years of the realization of the policy change. Also, voluntary act has an important role in productivity. Gamero (2010) experiment command-and-control versus voluntary, and conclude that when environmental regulation stems from voluntary norms, its effects are rather positive. Where investment in proactive environmental management contributes to increasing the competitiveness of the firm. Lankoski (2010) reviews the empirical evidence and find aligned with porter that the regulatory policy should lead to a win-win situation by focusing on the end results instead of the means and economic policies instruments. Finally, Dechezlepre?tre and Glachant (2014)’s new evidence suggest that environmentally-friendly innovation promote foreign innovation and technology transfer which enhance the global productivity.
In summary, if the regulation is appropriate, then the environmental regulations and policies will offer strategic business opportunities for companies, which allow not only increasing the productivity and profit margins, but also expanding market share through innovations in environmentally-friendly products or processes that reduce the costs of production. Moreover, the companies that voluntarily consider environmental protection may improve their environmental outcome, thus improving their products and production processes, spotting inefficiencies, reducing their costs and increasing their capacity to compete in the international markets.
1 They are divided into two classifications; renewable such Flora and Fauna: biotic population and non-renewable (unless in their geological timescale) such as mineral deposits: fossil fuel, oil, gas etc. However, when renewable resources are used or harvested more than reproduction capacity or survival level then they become non-renewable. (Perman R.; Ma Y., McGilvray, J. and Common M., (2003). Natural Resource and Environmental Economics, 3rd Edition.)
2 The first is the notion of limitless resources (space or land) where the success is measure by the amount of throughput of factors of production, so if we use or exhaust one place we find another and keep exploring. However, the second is the notion of the single ‘spaceship’ where the earth is the only place with limits for both extraction and pollution, and where the success is measured by the nature and quality of capital stock (stock maintenance). (Boulding 2016)
3 The literature has taken several approaches to measuring the effects of environmental regulation on productivity (especially total factor of production approach). The three most common are growth accounting (Denison (1979)), macroeconomic general equilibrium modeling (Jorgenson & Wilcoxen (1990)), and econometric estimation (Gray (1987)).
4 De Serres (2010) this review uses the term “market-based instruments” for environmental policy instruments aimed at addressing market failures mainly through price signals. This can include taxes, charges and fees, tradable permits, and subsidies for reducing pollution. Non-market approaches include direct environmental regulations, standards (“command- and-control” instruments), and voluntary approaches.
5 The level of competitiveness differs at industry and nation level. At the industry level, the meaning of competitiveness is clear. However, at state or nation level the notion of competitiveness is less clear because a nation cannot be competitive in everything. Moreover, the proper definition on competitiveness at the aggregate level is the average productivity of industry, were depends on both the quality and the efficiency with which they are produced. Competitiveness at the industry level arises from superior productivity either in terms of lower cost than competitors or the ability of offer products with superior value that justify a premium price. The notion, competitiveness effect, result from the asymmetries in regulatory stringency between entities that are competing in the same market. Some sector face stricter pollution standard than others specially when it come to the case of climate change mitigation policies where different regions are expected to take carbon mitigation action at different speeds. (Jaffe 1995)