Better evidence for regulatory

reform: rapid evidence

appraisals Contract research report ERG117

Centre for Environmental Risks & Futures School of Applied Sciences

January 2013

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This research report was prepared by A. Angus, C. Booth, S. Pollard and G. Armstrong under the guidance of a project steering committee of P. Ekins (UCL), A. Goulson (University of Leeds), S. Pollard (Cranfield University) and P. Young (SKM Enviros). The research was supported by Defra’s Better Regulation Team, Defra, Ergon House, Horseferry Road, London, SW1P 2AL. The Defra project manager for contract ERG117 was Edward Lockhart-Mummery. Please cite this research report as: Angus, A., Booth, C., Armstrong, G. and Pollard, S.J.T. (2013) Better evidence for regulatory reform: rapid evidence appraisals, Contract report ERG117 prepared for the Department for Environment, Food and Rural Affairs (Defra) by the Centre for Environmental Risks and Futures, Cranfield University, Cranfield, Bedfordshire, UK, 136pp. with appendices.

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TABLE OF CONTENTS

1.1 REA 6: ECONOMIC IMPACTS OF ENVIRONMENTAL REGULATORY POLICY ................................ 5

1.1.1 Introduction ........................................................................................................ 5

1.1.2 Impact on business production costs ............................................................. 5

1.1.3 Impact on productivity ..................................................................................... 6

1.1.4 Environmental regulation and innovation ..................................................... 8

1.1.5 Impact on competition, imports and exports ............................................. 10

1.1.6 Impact on investment ..................................................................................... 12

1.1.7 Impacts on aggregate demand and employment ....................................... 14

1.1.8 Unintended consequences of regulation ..................................................... 15

1.1.9 Discussion .......................................................................................................... 15

1.1.9.1 Opportunities arising from environmental regulations ..................... 15

1.1.9.2 What policy characteristics promote opportunities for growth in

the environmental services and goods sector?...................................................... 16

1.1.9.3 Who benefits from stringent environmental regulation? .................. 16

1.1.9.4 Conclusions ................................................................................................ 17

1.1.9.5 References .................................................................................................. 17

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1.1 REA 6: Economic impacts of environmental regulatory policy

This rapid evidence appraisal (REA) is one of six REAs commissioned on evidence for regulatory reform. They are available separately and as a consolidated main report.

1.1.1 Introduction

In the developed world the cost of meeting environmental regulations has increased regularly over time. In the USA the cost was estimated to be $184 billion in 2000, equivalent to 2.6% of US Gross National Product (GNP) (Cole, 2001). Defra (2011) estimated that between 2011 and 2021 UK environmental regulation will have a net cost to UK business of £3.6bn per year. Many believe that these compliance costs hinder economic growth. The actual evidence on actual economic impacts of environmental policy is keenly debated. Therefore, this REA will review the evidence relating to the impact of environmental regulation on important economic indicators.

1.1.2 Impact on business production costs

Several examples show that environmental regulation has either a benign effect on production costs, or leads to win-win opportunities. For instance, Thomas (2009) found that environmental regulations (controlling the emission of hexavalent chromium) in California had a benign effect on the growth of the metal finishing industry. In fact the metal finishing performed better or comparable to two other industries despite having more stringent environmental regulation.

Many other environmental regulations result in low-cost or zero cost actions. Hilson and Murck (2001) found that senior executives in the North American gold industry believed that adoption of leading edge environmental management technologies would have a relatively short pay-back period. Similarly an increase in the regulation of discharges from the electroplating industry in Denmark was achieved through better house-keeping, new methods of using waste-water, use of ion exchanges, and waste water treatment (Christensen and Georg, 1995).

Appropriately designed regulation can increase environmental compliance and lower production costs. Specifically, regulations that drive firms to proactively improve their operations, such as avoiding unnecessary waste (materials and energy), can achieve better environmental performance while also decreasing production costs. Firms that are cost efficient with a higher level of operating efficiency generate superior environmental achievement and financial performance.

The costs of complying with regulations are also falling over time or may be overstated by industry lobby groups. For example, the costs of flue gas desulphurisation decreased by 4% per annum over 20 years to 1999 (Chua, 1999). Industry has a tendency to overestimate the actual costs of regulation implementation during negotiation and these estimates are often used to form the basis of opposition to regulation. Industry may also underestimate the potential for new technology and its ability to improve production efficiency (Haq et al., 2001).

However, this benign result is not universal and some studies find that environmental regulation has a negative effect on productivity, cost and a firm’s

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market value (Rassier and Earnhart, 2010). Sneeringer and Hogle (2008) found that changes within the California state’s dairy industry caused a decline in the number of small farms and slight decline in farm size. Olatubia and Hughes (2002) found that US wetland planning regulations increased production costs in selected industries, although this effect was small.

1.1.3 Impact on productivity

Environmental regulations are beneficial where they either increase the productive efficiency (producing more with fewer inputs) of business processes, the value of outputs, or reduce pollution to a level where pollution control costs are outweighed by social benefits.

Broadly there is mixed evidence regarding the impact of environmental regulation on business productivity in the UK. There is evidence that UK Air quality regulation has been effective at controlling a range of pollutants (SO2, NOx, total acidifying pollutants, CO, PM10 and CO2), which in turn has enhanced industrial productivity. Using a dataset covering 22 industries between 1990 and 1998 Cole et al. (2005) found UK air quality regulation had decreased the quantity and intensity of emissions from UK “pollution intense” firms decreased over the period. In certain cases UK Environmental regulations have directly improved the economic performance of industrial sectors. Ramanathan (2010) studied the links between regulations, innovation and performance in the UK manufacturing sector. Firms that have proactively complied with environmental regulation have improved their productivity relative to those who have responded reactively to regulation.

Some UK regulations have a negative impact on economic productivity. Evidence suggests that UK planning regulations have reduced average retail store size, industry productivity and consequently national Gross Domestic Product (GDP). Haskel and Sadun (2012) used UK retailing microdata to explore whether tightened planning regulation caused the reduction in UK retailing productivity growth between 1997 and 2003. They found that as regulation stringency increased, average store size and retailers’ measured productivity decreased.

Other studies have shown regulation to be a neutral factor in productivity change. Cordeiro et al. (2012) used stochastic frontier analysis, to generate estimates of the technical efficiency of solid waste management by 299 Welsh SMEs in 2003. They demonstrate that the ranking and efficiency scores of the Welsh SMEs studied correlate significantly with environmental auditing practices but not with regulation.

Evidence from Europe has generally shown that environmental regulation has little effect on productivity or can improve productivity when environmental improvements are included within measures of productivity. Lopez-Gamero et al. (2009) found that the Integrated Pollution Prevention and Control Directive (IPPC) had no observable effect on the productivity of regulated firms in Spain a finding supported by Rave and Triebswetter (2008) who found that for the steel and glass sector, the costs of complying with IPPC were relatively small compared with other production costs. Similarly Bokusheva et al. (2012) undertook a study on the effects of environmental regulation on Swiss farm productivity between 1993 and 2001 and found no strong evidence that farm productivity changed as a result of environmental agreements. Telle and Larsson (2007) found that regulation had decreased industry productivity when measures of productivity exclude

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environmental performance. However, a positive and significant relationship between regulatory stringency and productivity growth was identified when measured in a way that credits plants for emission reductions.

There is strong evidence that environmental regulation had a significant impact on US industrial productivity in the 1960s, 1970s and 1980s. Barbera and McConnell (1986) found that between 1960 and 1980 environmental regulation reduced both average labour and capital productivity growth in the chemical and metal sectors. Barbera and McConnell (1990) found that environmental regulation caused between 9-55% of the 10-30% reduction in 1970s productivity growth in pollution intensive industries, while Christainsen and Haveman (1981) estimate that the fraction of the labor productivity slowdown explained by public regulations during 1973–1977 is 12–21%. Gray (1987) finds that environmental regulation reduced the annual rate of US productivity growth by 0.17–0.28%, accounting for 12–19% of the 1970s slowdown.

However, recent studies find no evidence that environmental regulation is impacting on contemporary industrial productivity. Becker (2011) undertook a review of the productivity effect of local environmental regulation in the US on all manufacturing industries. They found, on average, there is no statistically significant effect of pollution abatement expenditure on productivity for firms in the US. Fujii et al. (2012) compared the relative productivity impacts of environmental regulation in the US and Japan, using a dataset encompassing 330 US manufacturing firms observed from 1999 to 2007, and 466 Japanese manufacturing firms observed from 2001 to 2008. The results show that productive inefficiency decreased in all industrial sectors in the United States and Japan from 2001 to 2007. In particular inefficiency in the electrical products industry decreased rapidly after 2002 for both countries, possibly because of the enforcement of strict environmental regulations for electrical products exported to European markets.

Other studies indicate that stringent regulation has a mixed productivity impact on different sources, but more flexible mechanisms of regulation have a beneficial effect. Fleishman et al. (2009) examined whether regulation controlling Sulphur dioxide (SO2) and nitrous oxides (NOx) has affected the productivity of US power plants. More stringent SO2 regulation had a negative effect on coal plant efficiency, although this became less negative after accounting for pollution abatement benefits, but increased efficiency in gas powered plants (this may be because of the low SO2 content of natural gas). Conversely NOx regulations appear to have no significant effect on coal plant efficiency, but a negative effect on gas plant efficiency, although again accounting for the benefits of pollution abatement lessens the negative effect. The results showed that where regulation decreased efficiency in power plants, these impacts were not outweighed by the environmental gains. An additional observation was that firms who had participated in the first phase of the Acid Rain Programme (an emissions trading scheme) benefited from regulation.

In other sectors environmental regulation has decreased productivity, but this has been outweighed by other productivity gains. The results from Managi et al. (2005 and 2006) show an upward trend in productivity in the Gulf of Mexico offshore oil and gas industry, despite resource depletion and increasingly stringent environmental regulations. Over the 28-year study period, technological change can be partitioned into approximately 80% in the market sector (oil and gas

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production), and about 20% in the environmental sector. Overall environmental regulations had a negative impact on productivity, but this was outweighed by other production driven improvements.

A strand of literature linked to the topic of environmental regulation and productivity is the concept of Eco-Efficiency (EE). EE is the delivery of comparatively priced goods and services that satisfy human needs, while progressively reducing ecological impacts and resource intensity throughout the product or service life cycle. Strengthening eco-efficiency has also been identified by the OECD as one of the major strategic elements in its work on sustainability (OECD, 1998). The concept was first presented by Schaltegger et al. (1989). Who define eco-efficiency as ratio between environmental impact added and value added. Eco-efficiency aims at achieving more goods and services with fewer resources as well as less waste and emissions Mahlberg et al (2011).

There are clear business benefits of adopting eco-efficiency practices. Najjar and Anfimiadou (2012) find that earning per share (EPS) in UK firms is positively and significantly influenced by environmental variables for all the sample firms. The study by Guenster and Bauer (2011) showed that the shares of most eco-efficient firms relative to the least eco-efficient firms were initially undervalued but later experienced an upward price correction. The study by Al-Najjar and Anfimiadou (2012) found that previous evidence on the relationship between financial performance and environmental activities was inconclusive, as much of the evidence was based on insufficiently robust method or data.

There is conflicting evidence about the progress of Eco-efficiency across Europe. Korhonen and Lupatik (2004) analyzed the performance of a sample of 14 countries of the European Union for the period 1995–2004 and showed a clear growth in eco-efficiency, with productivity growth was driven by environmental-savings. Mattila (2012) analysed eco-efficiency in the Finnish national economy between 2002 and 2005. The results show that increases in GDP and ecological footprint were found to be negatively correlated: both the ecological footprint and GDP increased between 2002 and 2005.

1.1.4 Environmental regulation and innovation

Environmental regulation has been identified as a positive driver of innovation. Pickman (1998) and Hamamoto (2006) showed that innovation is a typical industry response to environmental regulation a finding supported by Brunnermeier and Cohen (2003) who found that increases in pollution abatement expenditure were associated with an increase in environmental innovation. Using data from 14 European Union countries (1996-2007), Costantini and Crespi (2008) showed that environmental regulation provided a positive driver for investment in advanced technology and Lee et al. (2012) showed that the US auto emissions regulations forced both automotive and automotive component suppliers to innovate more advanced emission control technologies. However, they also highlight that environmental regulation per se was insufficient; a country needed the technological competency to address the challenge created by regulation. This is supported by Hitchins et al. (2003) who found that firms with better economic performance adopt more environmental initiatives.

A common theme through the evidence is that environmental regulation can be beneficial if it drives innovation and UK environmental regulation has been

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demonstrated to stimulate this innovation. Becker and Shadbegian (2008) found that environmental regulation has a greater positive influence on export performance than domestic productivity performance because environmental regulation seemed to foster EU competitiveness in international markets, with the high technology sector responding most positively. Kneller and Manderson (2012) examined the relationship between UK environmental regulations and innovation between 2000 and 2006. They found that environmental regulations stimulated environmental R&D, and encouraged industries to adapt their production facilities to integrate environmental protection into the production process.

There is evidence that R&D driven by environmental regulation has displaced other R&D; this effect seems more prominent in small firms, whereas it may increase overall innovation in large firms. The study by Kneller and Manderson (2012) found no evidence to suggest a link between environmental compliance costs and total R&D or total capital investment. Hence any increased environmental innovation is possibly crowding out non-environmental R&D. Kammerer (2009) found that firm size was shown to play a role in environmental product innovation with larger firms able to overcome initial obstacles more easily than smaller firms because of economies of scale or better financial and human resources.

This R&D displacement effect may only be a short-run phenomenon, with benefits arising over the longer term. Ramanathan et al. (2010) found that UK investments in pollution control expenditure tend to negatively influence innovation in the industrial sectors over the short-run, because it displaces other innovation activities, with benefits occurring over the long-term. Thus, environmental compliance when incorporated into strategic decision making can profoundly influence financial performance and innovation activities, but this takes time.

Product innovation has been shown to be more beneficial than process innovations and the benefits of innovation are different in different industries. For instance, Rennings and Rammer (2011) suggest that German innovations in novel products arising as a result of environmental regulation increased sales and profitability, while process improvements (changes in production systems to comply with environmental regulation) increased costs without increasing income. German industries such as sustainable automotive and waste management benefited from innovation driven by regulation.

Levels of innovation depend on the adoption characteristics of firms and the structure of regulation. Haq (2001) demonstrate that regulation can have a positive effect on innovation for those organizations that are open to adaptation and acceptance. Based on a German empirical study Horbach (2008) showed that firms demonstrating general or environmental innovativeness in the past are likely to show similar present behaviour. Horbach termed this technological capability for innovation as ‘knowledge capital’. The nature of incentives nested within regulation is also important. Smith and Crotty (2008) find that a limitation of the EU end of life Directive (ELVD) is that it encouraged the automotive industry to become focused on resolving short-term, localized environmental degradation rather than radical dematerialization and innovative product design.

The regulatory targets must match the technological capabilities of the dominant firms. For instance, Pilkington and Dyerson (2006) explored the

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emergence of alternative fuel technologies in response to US regulation. Overall, the regulations for incremental emission reduction have proved highly effective as firms have used technological consolidation or modular substitution. However, the same success has not been evident for the more radical regulation of the US electric vehicle mandate: where regulation demanded systemic substitution the progress has been slow, as complex system issues rather than technological barriers have prevented the widespread adoption of alternative fuels.

Performance-based technology standards are a relatively poor instrument for fostering innovation. Murphy and Gouldson (2000) found that Integrated Pollution Control (IPC) legislation in England and Wales, which required firms to meet technology standards, failed to establish environmental issues as a strategic concern of industry and as a result, the potential of the legislation to promote radical innovations was missed. In contrast Roediger-schluga (2003) found the Austria Volatile Organic Compound emission standards accelerated the rate of product innovation in a formerly sedate industry. Compliance efforts yielded new ideas and allowed firms to acquire new competencies and technologies, which they would not have acquired in the absence of regulation.

The time between implementing regulation, innovation and diffusion of technology is a complex issue and has a devoted literature, which falls outside the scope of this study. However, Brunnermeier and Cohen (2003) estimate that environmental innovations usually follow pollution abatement expenditure with a one to two year lag. Battisti (2008) notes that the time period between the first use of a technology and approximately 90% diffusion within or across household and firms takes up to ten years.

Not all innovation is stimulated by regulation. A study by Koop and Tole (2008) showed that there is no statistical evidence of differences in environmental or technological efficiency for gold mines across a range of regulation stringency. Kammerer (2009) showed that customer demand fosters the implementation of environmental product innovation rather than regulation.

1.1.5 Impact on competition, imports and exports

The combination of the regulatory effect on production costs, productivity and the interaction with innovation will determine an industry’s competitiveness. A nation’s competitiveness effects the quantify of goods and services exported or imported.

Most of the literature on the relationship between environmental regulation and competition focuses on whether the costs of environmental regulation will encourage industries to move to countries with relatively lax environmental regulations, beginning a so called ‘race to the bottom’. In a race to the bottom countries with less stringent environmental regulation consequently become specialised in producing pollution intensive goods (Cave and Blomquist, 2008).

The weight of evidence suggests that compliance costs related to environmental policy are generally low as a proportion of a firm’s total costs and are unlikely to significantly restrict profits and competitiveness. Chua (1999) reported that in the 1980s and 1990s pollution abatement capital expenditure accounted for only 0.24% of the total value of production and 7.4% of new capital expenditure in the US manufacturing sector. In their review of the relative costs of environmental regulation Vogel (1997) found that the costs of environmental regulation were

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insufficient to force developed countries to choose between environmental protection and competitiveness. Other costs, such as the relative cost of labour between developed and developing nations is a greater influence on firm location.

Several studies find no evidence to suggest that the stringency of a country’s environmental regulations effects trade and competitiveness (Tobey, 1990; Jaffe et al., 1995; Janicke et al. 1997). Hitchins (1998) and Harris et al. (2002) found that environmental regulation is not a major source of competitive advantage or disadvantage. Findings suggest that firms decide upon plant location based on a range of attributes, which includes environmental regulation, but this is rarely a deciding factor (Millimet and List, 2004). Akbostanci et al (2008) found that in Turkey free trade had no significant effect on clean imports, or on the export demand of “clean” and “dirty” industries, although there was weak evidence that the demand for dirty imports declined.

In some instances environmental regulation appears to have been beneficial for domestic producers. Roediger-schluga (2003) investigated whether the Austria Volatile Organic Compound emission standards had an impact on the competitiveness of Austrian manufacturers of paints, coatings, printing inks and adhesives. Result showed that the standards had a dampening effect on import competition and competition from abroad would have been considerably stronger in the absence of the environmental regulations. However, the regulation had no clear impact on the relative competitiveness of domestic manufacturers. Similarly, Rave and Triebswetter (2008) found that IPCC helped improve competitiveness across Europe in the glass and steel sector. Firms that were already performing to high environmental standards were better able to prosper, relative to their competitors who had taken no previous environmental action.

In many cases environmental standards in consumer nations have encouraged increased international environmental performance. Tewari and Pillai (2007) investigated how a product from a labour-intensive developing country (Indian leather goods) complied with German regulations on two commonly used leather chemicals (PCPs and Azo dyes). The stringent standards added to firm cost but the presumed trade-off between compliance and export competitiveness did not materialise. Compliance is widespread and exports to demanding industrial markets have increased as have the margins for PCP and Azo dye-free exports. The adjustment process resulted in significant technical transfer from the standard-imposing country to India and has led to new, internationally certified testing capabilities in India. The creation in India of Asia’s first Germany-funded ISO certified leather testing and certification laboratories in 2002 provided important benefits for the industry that go well beyond the segments originally affected by the regulations.

Conversely other studies have shown that environmental regulation has negatively impacted competitiveness. Mulatu, et al. (2010) estimated that the effect of EU environmental regulation on industry location was similar to other determinants of location such as labour skill and county characteristics. Mani and Wheeler (1998) undertook a study of import–export ratios for pollution intensive industries and found evidence of a race to the bottom. Other studies have shown that pollution intensity in developing countries was highest in periods when OECD environmental regulations were strengthened (Birdsall and Wheeler, 1993). Cole et al. (2010) found that for Japan, environmental regulation has had a significant

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effect on imports of pollution intensive products, especially from China. Ederington and Minier (2003) find that the effect of regulation on competitiveness for pollution intensive, capital intensive industries is negative, but relatively small.

The competition effect of environmental regulation appears to vary by type of environmental impact and industry. Costantini and Crespi (2008) found that environmental regulation increased international competitiveness in the export of energy technologies. However, in their analysis of imports into the European Union Cave and Blomqvist (2008) found that imports of industries with high energy intensities increased from low income countries between 1970 and 1999, as the EU applied more stringent environmental regulation. By contrast imports of industries with high toxicity levels were lower from low income countries during the same period. A study looking at the growth of US multinationals in other countries found evidence supporting the race to the bottom theory whereby 8.6% of US multinational growth can be attributed to relative decline in environmental policy and enforcement (Kellenberg, 2009). Cole and Elliott (2005) found that for pollution intensive industries, less developed counties with higher capital endowment relative to stringency of environmental regulation will be more competitive than those with lower capital endowment, despite lower labour costs, owing to the capital intensity of these industries.

Environmental regulation can lead trade barriers and distort competition. Gurtoo and Antony (2007) found that imposing product restrictions can alter the structure of an industry, distorting competition. This is particularly true for regulations that stop certain products from entering the supply chain. For instance, Denmark banned the use of drink cans, which meant only countries with the ability to substitute other packaging materials had the capability of continuing to supply this market. This changes industry’s primary supply motivation from minimising cost to supplier capability and transport logistics. The growing popularity of regulation requiring take-back markets has increased the importance of effectively designed reverse logistics.

Where environmental regulation imposes barriers of entry it decreases productivity and competition. In these circumstances large incumbent firms may actually have a vested interest in encouraging environmental regulation with large up-front costs to exclude competition (see Gutoo and Antony, 2007 paper example of German detergent manufacturer Henkel).

Several studies have found evidence of changing industrial structures as a result of end-of-life regulations requiring reverse logistics. In end-of-life markets the consumer becomes the supplier of the product. There is evidence of a co-operative approach across the supply chain (including new re-processors) and inter and intra organizational co-operation.

1.1.6 Impact on investment

Several studies have concluded that less stringent environmental regulations tend to attract FDI in polluting industries. Xing and Kolstad (2002) analysed the impacts of environmental regulation on capital movement of polluting industries including chemicals and primary metals. The results suggest that less stringent environmental regulations tended to attract FDI in polluting industries, but not in less pollution intense industries. Spatareanu (2007) considered the effect of different environmental regulations on investment flows between 25 western and

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eastern European countries. They found that the relative stringency between the investor and host country encouraged the flow of FDI, but in general, large countries with well-defined property rights and good governance structure attract more FDI.

There are several illustrative studies of a flow of FDI into relatively lax regulatory systems. Wagner and Timmins (2009) found that if a country reduces its regulatory stringency by one standard deviation (they give the example that this is the difference between Austria and neighbouring Slovakia), then the host country would gain on average €122,032 in FDI per year. This effect may depend on the geographical mobility of the industry in question. In a study of FDI into Mexico Waldkirch and Gopinath (2008) found that a small number of industries benefited from extensive FDI linked to environmental regulation in the host country. Taken together, this FDI represented a significant total of that received by Mexico. The results also found that there are a number of industries for which the FDI-pollution relationship is negative and much FDI is largely driven by Mexico’s comparative advantage in labor-intensive production processes.

However, several studies find no evidence of investment moving to countries with relatively lax environmental regulation. In a study of 25 transition countries largely from Eastern Europe and the former Soviet Union FDI (Smarzynska and Wei, 2004) looked at the firm level and considered key determinants of investment such as host country environmental standards and corruption levels. The results found that environmental regulation was not a determinant of investment. Tole and Koop (2011) investigated the effect of environmental stringency on location of mining firms and found that environmental regulation stringency either attracted or had no effect on location of gold mining firms. This is because a gold mining firm’s environmental reputation is an important part of their corporate image, which is more important than any gains from regulatory laxity. Cole and Elliott (2005) found the stringency of environmental legislation is less influential on US outward FDI than would be predicted by a race to the bottom.

There is some evidence that investment can follow regulatory stringency. For instance, Kirkpatrick and Shimamoto (2008) suggest that Japanese foreign direct investment appears to be directed to countries with transparent and stable regulatory frameworks, rather than those with relatively lax environmental regulation. Eskeland and Harrison (2003) reviewed the evidence for a race to the bottom using US FDI data between 1977 and 1990 in relation to Ivory Coast, Morocco, Mexico and Venezuela. This analysis suggests that pollution abatement had no systematic impact on the pattern of foreign investment; the biggest draw to foreign investors was the size of the domestic market. They also concluded that FDI tended to be greater in those countries with relatively low import penetration because foreign investors locate where there is low competition from imports. The analysis suggested that there was “a significantly positive relationship between air pollution and foreign investment in several countries”, but this effect was reversed for water pollution and toxicity (where foreign investment is less likely where emissions are high).

Some industrial strategies have been to deliberately channel FDI into pollution intensive industries. During the 1970s many Japanese investment decisions focused on a desire to move polluting industries overseas. Industry relocation was often a strategic response to firms wanting to escape protest against existing facilities,

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concerns over building new plants in Japan and firms relocating to undertake production banned in Japan (Hall, 2009). For better or worse, the movement of industry often opens up employment opportunities in developing regions. Foreign direct investment (FDI) in Japan in the 1970’s moved much of Japan’s polluting industries to less regulated ‘pollution havens’ in Asia thus generating new industries and employment opportunities in these new regions, though at an environmental cost. A more recent example is the increasing Asian trade in hazardous waste, most notably the importation of ‘e-waste’. Though Japan has tough environmental regulation they are opposed to international bans on hazardous waste trade which would limit their ability to export to Asian markets (Hall, 2009).

1.1.7 Impacts on aggregate demand and employment

Very few studies have focused specifically on the effect of environmental regulation on aggregate demand, although results can be implied. The broad conclusion by Morgenstern et al. (2002) is that spending on environmental abatement, initiated by regulation, could lead to overall job increases and hence, all other things remaining equal, would increase aggregate demand. Cole et al. (2010) found that increases in the stringency Japanese environmental regulation caused a decline in domestic consumption, which was substituted for imports, primarily from China. Olatubia and Hughes (2002) considered the impact of the Wetland Resource Program in Louisiana on agricultural production; fishery, forestry, and agricultural services; mining; construction; manufacturing; trade, finance, insurance, real estate and utilities; and services. The impacts on demand were small and mixed. Demand increased in some sectors (primarily food, fisheries and forestry) fell because of net payments to households holding easement on the enrolled lands.

The available evidence (which is very limited) suggests that at the economy level, the impact of environmental regulation stringency has a minimal or even slightly positive effect on aggregate employment. The most detailed quantitative study on this subject is Morgenstern et al. (2002), who combined a unique US plant-level dataset with industry-level demand information to determine the impact of a simulated increased environmental spending (related to compliance with regulation) on employment within four heavily pollution intensive sectors (pulp and paper mills, plastic manufacturers, petroleum refiners and iron and steel mills). They estimate that across all four industries in their model, there is a net gain of 1.5 jobs per $1 million in additional environmental spending, which is a statistically insignificant effect although the effect varies between industries. Using the most pessimistic and optimistic scenario from the study by Morgenstern et al. (2002), US environmental spending may have accounted for the loss of at most 14,000 jobs over the period 1984-1994 (2% of total job losses), or could have created as many as 29,000 jobs.

Other studies have highlighted that employment effects of environmental regulation are either beneficial or negligible. Scholtens (2001) assessed the Dutch 'Green Project Facility’ (DFL), which has been operated since 1995. The authors estimated that the investment of 10 billion Guilders in the DFL would generate additional employment of 21,500 labour years, relative to a business-as-usual scenario. Triebswetter and Wackerbauer (2008) found positive long-term employment opportunities from fifteen innovations initiated by environmental

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regulation or the threat of regulation in Germany. Most of the new employees had University degrees or were apprentice trained workers. Rennings et al. (2006) found that environmental process innovation in response to EMAS had a positive effect on the number of employees. Cole (2001) found that employment losses caused by regulation could be smaller than previously predicted, partly because polluting intensive industries tend to be capital intensive, rather than labour intensive.

This benign conclusion does not hold in all circumstances. The US wetland mitigation plans were predicted to cause a net loss of jobs, representing 0.005% of the Louisiana state total (Olatubia and Hughes, 2002). The loss is greatest in agriculture (0.5%), which is partially offset by increases in other sectors, like construction. Cole et al. (2010) show that Japan’s environmental regulation led to a reduction in domestic production of pollution intensive goods, which are substituted with imports. Increased net imports, all other things remaining equal, imply reduced domestic production and employment.

1.1.8 Unintended consequences of regulation

Environmental regulation can move pollution from one environmental medium to another. For instance, waste reduction regulation, which has led to more recycling, has required more energy intense production for some materials. Environmental regulation can also spatially move pollution rather than achieve an absolute reduction. This occurs where developing countries undertake pollution intensive production for export to countries where the use of certain processes or materials are strictly controlled or prohibited. These products are usually based on the use of natural resources, or energy, which usually results in large scale pollution. Where multinationals are involved, these effects have been mitigated as they have improved pollution control technology (Antony and Gutoo, 2007).

Some environmental regulation is extending the working life of inefficient capital stock. Bushnell and Wolfram (2012) analysed the relative effects of differentiated regulations on new and old installations, known as vintage differentiated regulation (VDR) in the US. They find some evidence that VDR has the perverse effect of operators keeping their capital in service for longer as building a new plant that complies with new regulation is more expensive, but no evidence that this led to reduced fuel efficiency or increased emissions. However, Hamamoto (2006) found that pollution control expenditures have a significant negative relationship with the average age of capital stock.

1.1.9 Discussion

1.1.9.1 Opportunities arising from environmental regulations

The weight of evidence suggests that there is no significant economic impact of environmental regulation. Most studies indicate that environmental regulation enhances economic performance, or at worst has a small negative impact. However, it is worth noting that the literature is highly contested and that the evidence presented is heavily contingent on the methodology and data availability, so that no overall definitive conclusion can be drawn.

Most significant economic benefits from environmental regulation flow from investment in innovative products or abatement solutions. In their seminal work Porter and van der Linde (1995b) proposed world demand is increasingly favouring low-pollution and energy-efficient products and processes. This REA has found

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evidence that innovations driven by regulations have reduced production costs, produced novel, environmentally friendly niche products, which has increased profit and broadened market share.

1.1.9.2 What policy characteristics promote opportunities for growth in the environmental services and goods sector?

Well-designed regulation can give industry greater incentive to innovate, or even induce new operating strategies and products, which enhance economic performance. Innovations driven by environmental regulation or the anticipation of legislation made more contribution to overall productivity that innovation undertaken voluntarily. Thus, environmental regulation that is designed to foster innovation has the potential to increase industrial competitiveness.

In terms of regulatory drivers, outcome-based regulations have greater potential than technology based standards to induce innovation because they do not limit advancement to single technologies. There is relatively little empirical evidence on what design characteristics make environmental regulation promote economic growth, but the literature suggests that regulations giving greater flexibility to business in how they meet environmental regulations is more beneficial for innovation. Demirel and Kesidou (2011) explain that many regulations are so restrictive, that they can only be met by end-of-pipeline measures, so innovation is limited to this abatement approach, which yields the least economic benefit, relative to more systemic change. However, the ‘best policy’ will depend on the environmental problem, the structure of the industry to be regulated, the characteristics of their products and the ability of the regulator to implement various instruments. What is apparent is that those instruments that allow industry freedom in how they meet environmental standards are more likely to support economic development and minimize costs (Ambec et al., 2011).

1.1.9.3 Who benefits from stringent environmental regulation?

It is predominantly larger firms that are able to benefit from environmental regulation. Costantini and Mazzanti (2012) and Rennings and Rammer’s (2011) both indicate that high-tech firms are more able to innovate to deal with environmental targets, while the medium to low tech sector has relatively high abatement costs and limited scope for innovation. Angerer et al. (2008) suggests that additional regulation places a greater burden on small rather than large companies and also those importing cheap raw material from non-EU countries.

Pro-active firms tend to perform particularly well following the introduction of environmental regulation (Thomas, 2009). Firms with a higher level of operating efficiency generate superior environmental achievement and financial performance. Also those firms who are able to develop clean-tech products that gain a niche market are able to pass costs through to consumers, while those firms selling simple bulk products are more likely to have to absorb the costs of regulation.

The performance of firms under environmental regulations depends on the structure of the firm and industry. For many, the cost of environmental regulations is small as a proportion of total operating costs. Other factors may impede the relocation of producers in spite of strict environmental regulations, such as the proximity to the domestic market, a strong property right regime and access to skilled labour (Ederington et al., 2005). For firms with these

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requirements, they are likely to adapt to more stringent in order to maintain their market position. However, some studies find that relocation to jurisdictions with lower environmental regulatory stringency is more common in commodity bulk product based and geographically mobile industries. Rave and Triebswetter (2008 found that although the costs of complying with environmental regulation are small relative to other production costs, sectors producing 'simple' products for export to other manufacturers were limited in their ability to pass on these costs and fared worse relative to other sectors.

It is worth noting that some literature emphasizes that there are important links between environmental regulation and international trade. Vogel (1997) found that fears of a race to the bottom have been unfounded, developed nations have been able to increase the stringency of environmental regulation without a significant reduction in economic growth. Also developing nations are increasingly adopting the stricter environmental standards of their trading partners. However, governance mechanisms are needed to adequately address regional and global environmental problems which require substantial changes in the behaviour of poorer and less green nations Waldkirch and Gopinath (2008).

1.1.9.4 Conclusions

There is conflicting evidence with regard to the economic impacts of environmental policy.

This REA has reviewed evidence across a range of countries and economic indicators and on balance the evidence suggests that the environmental regulation is generally beneficial, or not significantly costly, with the exception of a small number of industries.

Where environmental regulation has had a positive effect on firms, the regulation has stimulated environmental innovation. Environmental innovation has enabled firms to cut costs and introduce new niche products, which boosts profit and market share. Where regulation is effective in stimulating innovation it is flexible, specifying environmental outcomes, rather than prescribing end-of-pipe abatement technologies.

The industries that have benefited most are hi-tech, producing high-value, or niche products. Larger firms also tend to benefit from regulation as they can invest in R&D, can more easily absorb the short-term costs and can withstand longer payback periods. There are cases in the EU where environmental regulation has actually protected EU firms from less expensive, but more polluting competitors.

In some instances, particularly for FDI, environmental regulation has induced investment to relocate. These industries tend to be low to medium tech, producing bulk products. This migration may be a natural consequence of changing consumer preferences or global economic structure, but provides examples of where regulation could be more effectively targeted.

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