When Does Environmental Regulation Stimulate Technological Innovation?

Environmental regulation usually requires businesses to take actions they would not take in response to market forces alone. Compliance with regulation should reduce the damage to the air, land, water, and living creatures that would have been caused by market-motivated business activity. Although these benefits are often difficult to measure, they outweigh the costs when regulation is well designed.

Technological innovation allows businesses to sell new products and services and to reduce costs by introducing new production processes. It is a very important cause of improvements in living standards in modern society. A majority of long-term economic growth is attributable to technological innovation.

Some experts argue there is an inherent tension between environmental regulation and technological innovation. Environmental regulation deters risk taking that leads to innovation, according to their view. When complying with regulation, firms use well-established methods to minimize uncertainty, even when doing so is costly. Also, spending on regulatory compliance may crowd out alternative investments that might otherwise have led to valuable innovations.

Other experts argue that environmental regulation and technological innovation are complementary. They hold that the need to comply with regulation stimulates businesses to explore neglected technological pathways—which leads to the development of new and improved products and processes. Environmental regulation, from this perspective, is a win for both the public and the regulated industry, because the resulting innovations reduce or even eliminate the cost of compliance even as they limit pollution.

Neither of these polar positions is right all of the time. The Zero Emission Vehicle regulation California established in 1990 is a good example of the tension between environmental regulation and technological innovation. This regulation had to be scaled back when automakers were unable to produce cars that could comply with it at a reasonable cost. Regulation implementing the Clean Air Act of 1970, which required electric utilities to install scrubbers to remove pollutants from power plant smokestacks, on the other hand, illustrates the possibility of complementarity. Innovation yielded scrubbers that were relatively inexpensive, confounding industry predictions of imminent regulation-induced bankruptcy.

These two examples demonstrate the importance of identifying the conditions under which environmental regulation stimulates technological innovation. My review of a growing expert literature on the topic yielded 12 such conditions, which are elaborated in this report:

1. Compliance with regulation is expected to be expensive.
2. Higher authorities are unlikely to force regulators to relax.
3. The threat of regulatory enforcement is legitimate and credible.
4. Industry expects regulation to become increasingly stringent over time.
5. The technological landscape for regulatory compliance is target-rich.
6. Regulated firms have slack resources.
7. The regulated industry is competitive.
8. Prospects for shifting production to “pollution havens” are limited.
9. Regulators rely on performance standards.
10. The regulatory process induces an open exchange of information.
11. Regulators have a sophisticated understanding of the regulated industry.
12. Technology policy complements regulation.

The presence of each condition raises the likelihood that firms will respond to environmental regulation by innovating. But the literature does not show any single condition (or even a combination of conditions) to be a magic bullet that will ensure this outcome in any particular case. Nor does it suggest all 12 must be present for innovation to occur.

Even though the literature does not yield simple prescriptions for environmental policymakers, this list of conditions allows them to diagnose complex situations, so that their actions increase the odds of an innovative response to regulation. To do so, they should adopt an open-minded, patient, long-term, and goal-oriented approach.

This report first defines the key terms of this long-running argument among experts and explains why it is important enough to occasionally take on a quasi-religious tone. It then summarizes each of the 12 conditions that influence whether environmental regulation will stimulate technological innovation. The report concludes by spelling out five rules of thumb to guide environmental policymakers:

1. Study whether the conditions they cannot control in a given case are likely to favor an innovative response from regulated firms.
2. When those conditions are favorable, set regulatory goals over the long term that assume the costs of compliance will decline due to innovation.
3. Be patient but vigilant in the intermediate term as regulated firms explore promising pathways that appear to have the potential to meet long-term goals.
4. Encourage competition among regulated firms to devise specific products and processes that would aid regulatory compliance, while also driving technology policy to create general knowledge they can all draw upon.
5. Develop a sophisticated understanding of the technical and economic challenges facing the regulated industry, in order to credibly and independently assess its progress, and to make adjustments, including loosening standards and schedules, when appropriate.