Unravelling the competitiveness debate

European EnvironmentEur. Env. 12, 284–290 (2002)Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/eet.301

UNRAVELLING THECOMPETITIVENESS DEBATE1

Evan Williams,* Kenneth Macdonald2 and Vanessa Kind

Scottish Environment Protection Agency, Castle Business Park, Stirling, UK3

As the global marketplace has developed,businesses have become increasinglyconcerned about their ability to compete.The question of whether environmentalregulation may be an influential factor inthis respect has been the subject ofconsiderable debate, much of which hasfocused on the costs associated withregulatory compliance. In a global sensemany of the key points in this debate maybe academic since it might be argued thatcompanies operating under widelydifferent market conditions should beexpected to experience different levels ofcompetitiveness. However, within thesetting of the EU, where it is intended thatindustry should operate on a level playingfield, the issue becomes much moreimportant and the debate takes on greatersignificance. This paper considers the

* Correspondence to: Evan Williams, Environmental Economics,SEPA, Corporate Office, Erskine Court, The Castle Business Park,Stirling, FK9 4TR, UK. E-mail: [email protected] Neither Her Majesty’s Stationery Office of SEPA CorporateOffice accept any responsibility for the accuracy of any recipe,formula or instruction published in this article or in the journal.2 Kenneth Macdonald is now at URS Corp. Ltd, Blackfriars House,5th Floor, St Mary’s Parsonage, Manchester M3 2JA, UK.3 The views expressed in this paper are those of the authors anddo not reflect the policy or views of the Scottish EnvironmentProtection Agency.

Copyright Crown Copyright 2002. Recorded with the permissionof the Controller of Her Majesty’s Stationery Office. Published byJohn Wiley & Sons, Ltd.

opposing sides of the argument in anattempt to gain a clearer indication ofwhether differences in regulation mightlead to differences in competitiveness. Inso doing, the paper examines the Porterhypothesis (Porter and van der Linde,1995), which suggests that strictenvironmental regulation may be a spur toincreased industrial competitiveness.After exploring the logic underlying thehypothesis, the paper considers variousefforts to corroborate or refute theargument. On the surface, the hypothesisshould be relatively simple to test with thequestion ‘does new environmentalregulation result in a net increase in costsof production relative to those of a firm’scompetitors?’. Unfortunately this questionhas proved virtually insoluble, and in thispaper we attempt to explore why this hasproved to be such an intractable problem.Copyright Crown Copyright 2002.Recorded with the permission of theController of Her Majesty’s StationeryOffice. Published by John Wiley &Sons, Ltd.

Received 18 July 2002Revised 20 July 2002Accepted 25 July 2002

UNRAVELLING THE COMPETITIVENESS DEBATE

INTRODUCTION

The neoclassical argument

Business interests in industrialized nati-ons have long held the view that compa-nies in regions or countries which adopt

stringent environmental regulations may beplaced at a competitive disadvantage whencompared with companies in other, less strin-gently regulated areas (Esty and Geradin,1998). This has led to claims that industry maybe induced to locate in areas with less stringentrequirements in order to gain competitive posi-tion. Furthermore, there has been speculationthat certain governments may attempt to create‘pollution havens’ in order to attract inwardinvestment, or that countries may becomeengaged in a ‘race to the bottom’ in which theyadopt sub-optimal regulatory regimes with theaim of protecting the position of their domesticindustries (Stewart, 1994).

Views such as these are based on the asser-tion that the costs of complying with envi-ronmental regulation are largely unavoidableand can constitute a significant proportion ofoverall company expenditure. As a result, dif-ferences in such costs which result from vari-ability in the stringency of regulation can leaddirectly to measurable differences in the cost ofproducing goods and, in turn, such differencescan lead to lost sales, reduced profit, lowerlevels of investment and slower growth forcompanies that are subject to relatively strin-gent regulation (Stewart, 1994).

Traditional neo-classical economic analysistends to regard firms as efficiently profit max-imizing such that any external influence orconstraint must necessarily impose an addi-tional cost on the firm (see Figure 1). The extracosts imposed by regulation result in a shiftin the supply curve so that the firm producesand sells less at the prevailing market price (ashift from quantity A to B at the same price).Depending on the elasticity (responsiveness tochanges in price) of demand the firm will beable to pass some of the additional costs onto consumers, but the generalized effect will

P

SI

S

EI E

0B A Q

Figure 1. Neoclassical view of effect of environmentalregulation on firm productivity

be reduced output and reduced profitability.It is argued that any existing opportunitiesfor increasing profit will have already beentaken and studies that appear to suggest thatfirms can profit from actions taken to meetenvironmental regulations must therefore omitimportant costs. It is only in the (very rare)area of asymmetric information or in situa-tions of high search costs where neoclassicaleconomics acknowledge that regulatory actionmay indeed contribute positively towards thefirms’ bottom line.

This line of argument is essentially staticin nature, but a compelling account of whatmay happen in a dynamic sense is providedby Gabel and Sinclair-Desgagne (2001). Theirinsight is that the profit maximizing assump-tion, which treats the firm as a black box thatwill always act economically rationally, missesthe reality of firms establishing systems androutines by which they act. These systems androutines may well be initially optimized forprofit maximizing but may over time becomeconstraints on profit maximizing. There aretwo effects that seem to be at work here. Oneis simply time in that over time the firm’ssystems and routines drift away from the opti-mal set as external influences or technology

Copyright Crown Copyright 2002. Recorded with the permission of the Controller of HerMajesty’s Stationery Office. Published by John Wiley & Sons, Ltd.

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change. A second is that the effort involvedin changing systems and routines and poten-tially their cultural importance within the firmmeans that sub-optimal systems may be tol-erated far longer than would be expected byan efficient profit maximizing assumption. Theanalysis illustrates that the external pressureof regulation may simultaneously force a shiftto a new set of routines that are closer toprofit maximizing (and more profitable) thanthe set they replace but nevertheless result inless profit than would have been possible inthe absence of regulation. Gabel’s propositionwhile undeniably plausible retains a clear linkto the neo-classical tradition.

The case against positive benefits of environ-mental regulation is given weight by claimsand anecdotal accounts from industry. A 1994study of companies in the UK metal sec-tor found that 70% were of the opinionthat expenditure to enable compliance withintegrated pollution control (IPC) legislationwould affect their profitability, and some com-panies thought that the effect on their abil-ity to compete could lead to closure (ENDS228, 1994). In the same year, it was reportedthat environmental regulation was imposingincreasingly serious problems on the UK chem-ical industry, and that these problems wereresulting in lost business (DTI, 1994). Simi-lar claims have been made by industry inthe Netherlands and Germany, where the sys-tems of environmental regulation are amongthe most demanding in the EC (ERM, 1996;Swiss, 1992a).

Regulation enhancing competitiveness

The problem with these claims and, indeed,with the whole of the case outlined aboveis that there is very little empirical evidenceto support them. Despite this lack of evi-dence, the argument that stringent regulationcan adversely affect competitiveness remainswell used, and, has been influential in shap-ing action on regulatory reform and EU level

harmonization4. Unsurprisingly, in view of thelack of evidence to support the above case andthe action stemming from it, a strong counter-argument has been developed by parties whobelieve that relatively demanding environmen-tal regulation does not negatively affect indus-trial competitiveness. The early proponents ofsuch claims, Michael Porter and Claas van derLinde, contend that traditional models of com-petition and regulation, in which regulationinevitably raises costs and therefore reducesmarket share, are no longer valid. They arguethat since competitiveness at industry levelarises from superior productivity, either interms of lower costs than those of competi-tors or in the ability to offer products withsuperior value that justify premium prices,internationally competitive companies are notnecessarily those with the cheapest inputs orthe largest scale but those with the capacityto continually innovate and improve (Porterand van der Linde, 1995). In the view ofPorter and van der Linde, effective, properlydesigned environmental regulation can lead tosuch innovation and improvement by focusingattention on fundamental solutions to environ-mental issues. The benefits of this innovationmay, in turn, more than fully offset the costs ofregulatory compliance, and these ‘innovationoffsets’ can not only lower the overall costsof complying with regulation, but can lead toabsolute advantage over competitors who arenot subject to similar regulation (van der Linde,1993). Recently, Porter and Esty have foundpreliminary empirical evidence supporting apositive link between the quality of a coun-try’s environmental regulatory regime and itsbroader economic and legal context (Porterand Esty, 2001). Their research, which rankedcountries against three determinants of envi-ronmental performance: level of urban partic-ulates, energy usage per unit of GDP and SO2

4 There have been instances of this in the UK, Germany and TheNetherlands. See ENDS 248, 1995a and Swiss, 1992a, 1992b forexamples.


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concentration, found that strong environmen-tal performance appears to be positively cor-related to competitiveness. Countries such asFinland and Sweden, which rank the highest interms of environmental regulatory regime, alsorank high competitively. Lower income coun-tries implement a range of standards of envi-ronmental regulation, and, interestingly, theirstatistical analysis indicates that the countrieswith more stringent regulation have achievedmore rapid economic growth. It seems thereare two paths to economic growth: a ‘clean’path and a ‘dirty’ path, and following thecleaner path is more likely to result in win–winscenarios. Although the correlation betweencompetitiveness and environmental regulationdetermined in the study does not prove causa-tion, it does indicate that the two variablesare not inconsistent. This is supportive ofPorter’s hypothesis, which argues that com-petitiveness need not be sacrificed to achieveenvironmental progress. Additionally, envi-ronmental performance appears to improveto the extent that a country’s environmentalregulatory system is reinforced by an envi-ronmentally proactive private sector and solidrelationships with international environmen-tal bodies. This would imply that innovationand regulation are mutually beneficial ratherthan exclusive, though it is not possible to dis-cern from the study whether competitiveness isdetermined more by industry’s initiative thana country’s regulatory regime.

These views are apparently shared by theEC. In a brief section on international compet-itiveness in the manufacturing sector, the FifthEnvironmental Action Programme states that

. . .the perceived conflict between environ-mental protection and economic competi-tiveness stems from a narrow view of thesources of prosperity and a static view ofcompetition. Rather than reduce compet-itive advantage, stringent environmentalrequirements can actually enhance it bytriggering upgrading and innovation (CEC,1993).

Furthermore, the case in favour of stringentand efficient regulation would appear to bestrengthened by the existence of two otherbenefits to industry that may arise fromenvironmentally driven innovation. Firstly,‘early mover’ or ‘front runner’ advantagemay be gained by companies that developgreen products, use environmentally soundprocess technology and/or adopt progressiveenvironmental management strategies (Porterand van der Linde, 1995; Fischer and Schot,1993). Secondly there are likely to be spin-offeconomic benefits for companies involved inthe environmental technology sector, due toincreased demand for process and abatementequipment.

Unlike the traditional argument, whichclaims that stringent regulation damages com-petitiveness, the more recent argument out-lined above is supported by empirical evi-dence. In addition to the recent work by Porterand Esty, there are a number of examples ofregulation driven innovation leading to over-all efficiency gains and cost savings in firmsincluding BP, 3M, Pfizer and Allied Colloids(ENDS Report 248, 1995b; Porter and vander Linde, 1995; Gabel and Sinclair-Desgagne,2001). In addition, the environmental goodsand services sector has emerged as one of thefastest growing markets globally, largely as aresult of new environmental legislation. In fact,legislation is such an important factor in thecontinued growth and competitiveness of thesector that its representatives have lobbied forregulation to be stronger, claiming that weakregulation is costing the £2 billion annually inlost sales (ENDS Report 257, 1996).

Balancing the competing claims

Just as there are weaknesses in the traditionalargument, the opposing argument is far fromfully proven and appears to have a numberof important flaws. There is some reasonabledebate about the way in which the regulationis framed, and some ways of regulating maybe more effective at enhancing competitiveness


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than others (this is explored briefly below).Many of the studies that have been citedin demonstrating that there is little connec-tion between regulation and competitivenesshave been concerned with competitiveness atmacro-economic (country) level. This is obvi-ously very different from competitiveness atmicro-economic (industry) level, which is thelevel to which most claims regarding compet-itiveness effects relate. As Palmer et al. (1995)point out, given the huge number of compa-nies operating in the industrialized world, itwould be difficult not to find a few whosepositions have benefited from environmentalregulation, and the evidence is therefore farfrom conclusive. In addition, investigation ofsome of the cases at the level of the firm citedby Porter and van der Linde has revealed thatthe innovation offsets experienced by somecompanies were relatively small in comparisonwith overall environmental expenditure, andthat, on the whole, environmental expenditurecontinued to represent a significant net cost forthe companies in question (Palmer et al., 1995).Considering the issue in a broader sense, thebasis for the case of Porter and van der Lindeis that within industrial organizations there aresome pre-existing opportunities for cost sav-ings or profitable product enhancement thathave previously gone unnoticed and that arerelatively easy to take advantage of. The exis-tence of such opportunities has however beenquestioned by a number of commentators, andis an area that is still the subject of much discus-sion5. Finally, and perhaps most importantly,is the fact that The case of Porter and vander Linde rests upon the existence of stringent,well designed and efficient regulation: whatPorter (1991) refers to as the ‘right sort’ of reg-ulation. However, Porter’s criteria for the rightsort of regulation are quite specific, and quitedifferent from the systems of direct regulationprevailing throughout developed countries6.Thus while the hypothesis of Porter and van

5 See, for example, Oates et al. (1993).6 See Porter (1991) for details.

der Linde may be sound, it seems unlikely thatall of industry will experience benefits to thefull theoretical extent under existing regula-tory regimes.

From the above it can be seen that thedebate regarding environmental regulationand industrial competitiveness is likely to per-sist, and it will continue to be difficult togauge which case is closer to representing thesituation in practice. However, one possibleexplanation is that each case is accurate to adegree, but that no single argument is entirelyrepresentative of the situation in practice. Thispossibility stems from the fact that all of thepositions outlined above rely to some extenton claims regarding the nature of the costsassociated with environmental regulation andthe importance of those costs in the context ofoverall business investment. In practice, how-ever, these factors are heavily dependent uponindustrial sector and are extremely variable.For example the average cost of regulatorycompliance to industry as a share of addedvalue is approximately 2% of total investment(DEFRA, 2002), but for the chemical sector it isaround 7.4% (ENDS 267, 1997) and for certain,potentially more polluting, industries interna-tionally the figure can rise to 20% of totalinvestment (OECD, 1993). It therefore seemslikely that for industry in some sectors, theburden imposed by regulatory costs will beminimal and the effects of differences in thosecosts according to location will be negligible.For companies in other sectors, the burdenmay be potentially more significant, but whendriven by relatively stringent regulation, com-panies in certain locations may be able to offsetthose costs and gain competitive advantage.For a final set of sectors, regulatory costs maybe substantial and unavoidable. Differences inthe stringency of regulation between locationsmay therefore have a significant bearing onthe costs of production, and ultimately mayhave adverse effects on the competitivenessof companies subject to stringent regulation.This scenario was in fact the one that, in 1993,an OECD panel considered was likely to be


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in existence throughout its member countries.The panel found that the effect of environ-mental control costs could be significant andconcluded that

Certain sectors and firms may experi-ence negative competitiveness effects dueto stringent environmental regulations. . ..Obversely, certain sectors and firms maygain competitive edge from stringent envi-ronmental regulations, at least in the longterm (OECD, 1993, p. 10).

From the perspective of this paper, the lastparagraph provides a key point since it indi-cates that differences in environmental regula-tion can have some kind of effect on industrialcompetitiveness. Whether that effect is positiveor negative is clearly a matter of consider-able debate; for our purposes the key questionis whether companies competing within thesame market may experience different levels ofcompetitiveness effect. Clearly if one companybecomes more competitive than a rival, theremaining companies become relatively lesscompetitive, and vice versa. What is impor-tant is to ascertain which facets of environ-mental regulation, when different accordingto for example location, may have an impacton competitiveness. It is important to explorefurther the potential for innovation friendlyregulation and innovation friendly regulatorystyles. It might be possible to devise a com-plementary policy mix that seeks to minimizenegative impacts (costs in particular) and max-imize or enhance positive ones (Gouldson andMurphy, 1998).

There is a growing use of economic instru-ments and voluntary instruments of regula-tion within the Community. In theory, themore flexible mechanisms such as taxes andtradable permits offer similar environmentalresults at a lower cost to the firm, which isespecially significant for firms that face differ-ent costs of compliance, or of different scaleand output. Such instruments are increasingly

influential in directing investment by compa-nies. The effectiveness of direct regulation isnot solely dependent upon the existence ofstandards. Instead, it is determined to a greatextent by the manner of the implementationof standards, the strength and credibility ofmonitoring and enforcement, and the levels ofsanctions imposed for violations7,8. Thus, evenif two countries have exactly the same stan-dards on paper, the pressure that is applied onindustry to take improvement action, and theresulting levels of investment, might be signifi-cantly different. This is supported by a numberof sources, including Stewart (1994, p. 2069),who states that

. . .international divergences in compliancecosts may be due not only to varia-tions in the stringency of environmen-tal measures, but also to differences inthe regulatory instruments and legal andadministrative systems used to implementthose standards.

In its Communication on ImplementingCommunity Environmental Law, the Commis-sion takes a similar view, pointing out that ifthe legal framework for the environment is notproperly complied with and equally enforcedthroughout the member states, there is poten-tial for uneven levels of protection in differentcountries, and for distortions of competition(European Commission, 1996). The Fifth Envi-ronmental Action Programme also recognizedthe potential competitiveness effects arisingfrom disparity in implementation and enforce-ment and recommended a range of initiatives

7 There are numerous examples that serve to illustrate this point,including that of the former USSR and GDR where environmentalstandards were among the toughest in Europe but where, forvarious reasons, they were not enforced. As a result, the countriessuffered from extreme pollution and environmental degradation(Cairncross, 1995).8 There are also examples from fields other than environmentalprotection. It has been reported that the use of ‘red light’ camerasat traffic junctions has in some instances reduced accident ratesby as much as 65%. The standard–the red light–existed formany years, but effective enforcement has dramatically improvedcompliance (Strathclyde Police, 1999).


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to drive improvement (OJ C138, 1993). Indus-try in the EC has expressed concern regardingthe issue on numerous occasions, includingover potential differences in interpretation andimplementation of the IPPC Directive (ENDS225, 1993). In conclusion, while evidence tosupport a positive relationship between com-petitiveness and environmental regulation atthe international level is gaining some ground,at the micro-level this relationship remainsinconclusive. Gross expenditures for meet-ing environmental regulations are neverthelesssizeable, exceeding ¤6 billion in the UK (Euro-pean Commission, 2001; DEFRA, 2002). Thescale of this issue means that understandingit is not simply a matter of academic interest,rather it is a matter of good governance.

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Unravelling the competitiveness debate