Towards smart environmental regulation that stimulates innovation

Door: Jonathan Verschuuren (TLS) | Categorie: Innovation, Regulation

The economic crisis has spurred legislatures and regulators around the world to take away possible obstacles for economic growth through deregulation and to introduce or amend provisions with the aim to offer businesses greater flexibility and room for experiments. Environmental laws and regulations are often targeted by politicians and regulators because businesses complain that environmental rules and standards present stumbling blocks not just for economic growth in general, but for innovations that lead to a net benefit for the environment as well.

What is the relationship between environmental regulation (used here to indicate the various regulatory instruments such as EU Directives and Regulations, domestic Acts of Parliament and delegated regulations, as well as ordinances at decentralized levels of government) and innovations that leads to major improvements in environmental performance of businesses? When does environmental regulation hinder innovation and when does it promote innovation?

The market does not usually lead to innovation because environmental improvements are not often rewarded by the market: benefits are for society at large, not for individual businesses and do not, usually, lead to greater profits. Research shows that innovation efforts die as a consequence of internal obstacles (lack of know-how, lack of time and financial resources, unclear internal responsibility for innovation processes etc.). Therefore, the government plays an important role. How should the government than foster innovation? In a soft way (through the supply of information, training, subsidies, voluntary rules) or in a legally binding way? Over the past two decades, a lot of research focused on these questions. The starting point of all this research is the so called Porter hypothesis, developed by Michael Porter from the Harvard Business School (Porter 1991). His work has radically changed the way we look at the role of environmental regulation. The dominant idea of economists was that environmental laws and regulations are a burden for businesses. They have a negative impact on businesses even in case the environmental laws lead to benefits for society at large, because the introduction of new rules lead to reduced value within companies. The Porter hypothesis, which is broadly supported by empirical research, states that well designed environmental regulations lead to innovations that not only have a positive impact on the environment, but also lead to cost reductions for companies and, in the somewhat longer run, to a competitive benefit of the innovating company when compared to its competitors in the market. More specifically, environmental laws (Ambec et al. 2013):

  • Indicate businesses that they are possibly using resources inefficiently and show them where potential improvements are;
  • Laws aimed at the collection and dissemination of environmental information within the company helps the company to work better because of increased awareness and involvement of its employees (raising corporate awareness);
  • Diminish uncertainty about the profitability of investments in clean technologies and practices;
  • Introduces pressure that stimulates innovation and progress;
  • Sets a level playing field in a transitional phase as a consequence of which opportunistic companies that do not innovate do not have economic benefits.

What is ‘well designed’ environmental regulation? Three factors are relevant: a) environmental regulation should leave maximum room for innovation, b) environmental regulation should focus on continuous improvement and not on the adoption of a certain technology, c) the regulatory process should leave as little room for uncertainty as possible.

Empirical research has shown that, based on these criteria, environmental taxes work very good, better than emissions trading (because with ETS there is always market uncertainty, and after the biggest players have acquired the necessary allowances, the need to improve is gone, and the ETS has very high transaction costs). Economic instruments like taxes have to be accompanied by other instruments: a) industry policy, patent law, subsidies and taxes aimed at enhancing innovation, b) programmes aimed at supporting managers of business corporations to acquire the necessary knowledge on possible technological innovations that are relevant for his or her company, c) legislation that aims to make information publicly available to spread innovations. The organisation of the business corporation itself needs to be adjusted to foster innovation too. Ground breaking empirical research into environmental performance in the paper from pulp industry in the US, Canada, Australia and New Zealand shows that big differences between companies that merely followed environmental regulations and those that went ‘beyond compliance’ were entirely to be explained from the internal culture of the company (Kagan, Gunningham, Thornton 2003).

Innovation can also be forced by regulators. This is called ‘technology forcing’: innovation is stimulated when the regulator sets unattainable environmental goals, goals that cannot be achieved when applying existing technology and regular practices. Regulation that is gradually becoming stricter leads to incremental changes and not to innovations (‘moving target regulation’). ‘Disruptive regulation’ does lead to innovation, as is best shown through the well-known example of the emissions from cars-standards introduced in the 1970s, first in California, later at the federal level in the US (aiming at a 90% reduction of polluting emissions). The adoption of these standards lead to the introduction of the catalytic converter. In Europe, a similar example exists with the 2000 End-of-life vehicles directive, requiring end-manufacturers to take back all their end of life vehicles and to reuse or recycle 80-95% of the vehicles. This has had a tremendous impact on the entire production chain, as car manufactures required their suppliers to deliver only reusable or recyclable parts.

This brief overview of what we currently know about the relationship between regulation and innovation shows that regulators should develop a regulatory policy aimed at stimulating innovation, rather than applying blunt deregulation policies or introducing all kinds of flexible norms that may or may not lead to innovation. Such a regulatory policy aimed at achieving innovation for better environmental and economic performance should take into account following lessons from more than 20 of academic research:

  • Strict environmental goals that are stable for a good number of years are essential for radical innovation;
  • Incremental improvements are facilitated by standards that gradually become stricter. In case the regulator opts for such gradually changing rules, radical innovation will not happen;
  • The regulator has to take away information asymmetry and, more generally, embed strict environmental goals in a wider innovation facilitating policy.

At the Tilburg Sustainability Center, we are currently researching this issue within the context of the Netherlands Environment Act, which has rules on the environment, water, nature conservation, and land use planning. Empirical research into several cases in which radical innovation was pursued (sometimes successful, sometimes unsuccessful) provides us with very interesting findings. In a later blog, I will report on our findings in more detail. Generally, we find that environmental laws, currently, do not stimulate innovation following the guidelines described above. Instead, environmental laws, at best do not hinder innovations. Other constraints than those present in environmental law are more relevant, such as a non-cooperative attitude with individual government officials. Companies indicate that their enthusiastic new ideas and proposals are often met with scepticism. Often government officials first say: “no, this is impossible”, as they (especially those trained as lawyers!) are used to think in worst case scenarios, and aim for regulating against all possible negative consequences. When asked what the background of their response is, and both the official and the business representative jointly look for a solution for the underlying problem, it often appears that easy solutions exist.

Local political issues are a far bigger reason for failure or at least delays. Local politicians are interested in short term benefits for the local community that they represent. The direct, local impacts of innovations are not always known as we cannot rely on much experience (that is a typical feature of any innovation!). Local communities may, therefore, resist the unknown.

Problematic too are the number of government levels, agencies and divisions within one government level involved in some of the innovation project we researched, especially when the innovations have major spatial implications (such as the development of a zero emissions sustainable business park, applying circular economy principles). In such cases, it is important that there is business can rely on one contact point for all government issues involved. This person should coordinate the activities of various authorities involved, meet relevant officials and those bearing political responsibility, talk, persuade, and explain the project to all stakeholders involved, including local communities.

More generally, the case studies show that a positive, constructive personal attitude of all of those involved in the decision-making process is essential for the success of an innovation.

One element remains problematic, even with the presence of a lot of constructive and positive stakeholders, and that is the element of time. The experience of time in businesses is completely different from that within governments. Businesses see opportunities in the market and want to jump into these opportunities rather tomorrow than the day after. The decision-making process, especially when various levels of government are involved and a project becomes the subject of political deliberations, can take several years. At a given point, the market opportunity is gone, at which point the company or companies involved will have lost interest in the innovative project. This is a pity, not just for these companies, but also for the environment.

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