Can public policy spur innovations in environmental technologies?

Research impact and public policy

Through a study on harmful pollution from firms in the industries, we address the question of how public policies can be designed to spur impact in the form of research-related outcomes. This is also one of the central questions to OSIRIS, which two of the authors are involved in.

During the last two decades, amid increased concern about climate change and the environment, there has been a wide range of governmental policies aimed at reducing polluting emissions and stimulating innovation in environmental technologies. Market-based indirect regulations, such as environmental taxes, tradable emission quotas and subsidization of emission-reducing technologies, have become more and more popular, both internationally and in Norway. Examples of such policies are the European Union Emission Trading Scheme (EU-ETS), which regulates carbon emissions in the EU and EFTA area, and national CO2 taxes.

When a regulator faces a complex situation due to different emission types, heterogeneous recipients and uncertainty of damages (for example acidification, cancer and lung diseases), there is a case for direct regulations through “command-and-control” instruments. Capturing all these aspects by appropriate pricing may be difficult. However, conventional economic theory, supported by several empirical studies, suggests that direct regulations are inferior to marked-based regulations and provide little or no incentive to technological innovation (Downing and White, 1986; Jung et al., 1996; Milliman and Prince, 1989). The rationale is that there are no incentives for further technological improvements once the required target is reached. In our article we challenge this view.

The complexity of environmental regulation

The incentive for behavioural change stemming from direct regulations is challenging to measure as these regulations involve no explicit price that reflects the marginal cost of emissions to the firm or to the society. Previous studies have therefore measured the costs of direct regulations through rough proxies, for example self-reported level of (excess) pollutant emissions (Jaffe and Stavins, 1995). However, neither the Norwegian Environmental Agency (NEA) nor the Environmental Protection Agency in the USA regard excess emissions as sufficient grounds for sanctions. Instead, regulators tend to focus on technology and institutional violations.

In our study, we use inspection violation status reported by the NEA as a measure of regulatory stringency.  As argued by Jaffe and Stavins (1995) the incentive for changes in environmental behaviour from direct regulations is related to the threat of being sanctioned for violating a permit. The violation status reflects the regulator's assessment of the severity of any violation and captures the probability that a firm may be sanctioned for violating its emission permit. The dataset used in the article includes the regulations of more than 260 types of pollutants by non-tradable emission quotas and technology restrictions that reflect the specific characteristics of the different pollutants.

To measure innovative efforts at the firm level, we use both the number of patent applications and the number of granted patents by technology area, where environmental technologies are identified by International Patent Classification (IPC) codes. The rich firm-level panel data employed in the analyses contain information about environmental regulations, patent applications, granted patents, and several other key economic variables for the total population of Norwegian incorporated firms. The inclusion of organizational numbers in administrative data sets allows the researchers to match patents to data on regulations and control variables from several other sources. This is in contrast to the situation in most countries, where there is no unique identifier allowing researchers to link e.g. intellectual property information directly to other firm-level data (Helmers et al., 2011).

Direct regulations have an effect

We empirically identify strong and significant effects on innovations from the regulatory costs of direct regulations. The results suggest that direct regulations have an effect through warnings of sanctions (in the form of fines, permit withdrawal, prosecution or bad publicity) of violating a permit.

The policy implication of the results is that technology standards and non-tradable emission permits are useful complements to indirect regulations in spurring innovation in environmentally friendly technologies. Incentives for technology development are present for several reasons. If the standard is designed as a requirement for a specific clean technology (e.g., Best Available Technology) rather than as a prohibition against a specific type of (dirty) technology, firms can realize the scope for commercializing a cheaper and more efficient technology. In any case, firms that are exposed to direct regulations are incentivized to minimize the costs of achieving a given level of pollution (even if the quota is fixed). Other strategic concerns may also apply, such as considerations of pre-emptiveness, where firms anticipate that the regulation is likely to become more stringent over time.

This blog was written by Marit E. Klemetsen, Brita Bye and Arvid Raknerud based on their article “Can direct regulations spur innovations in environmental technologies? A study on firm-level patenting” published in the April 2018 issue in The Scandinavian Journal of Economics.