Introduction

The impact of environmental regulation on the competitiveness of businesses is central to the policy debate on trade and the environment. Standard eco-nomic theory predicts that the tightening of national environmental regula-tion reduces the internaregula-tional competitiveness of domestic firms. It is argued that imposing a constraint on local markets by requiring domestic firms to re-duce pollution externalities would crowd out efficient alternative investments and consequently erode international competitiveness (Jaffe et al., 1995; Palmer et al., 1995). The widely-citedpollution-haven hypothesis, the idea that polluting industries will relocate to jurisdictions with less stringent environmental regu-lations, as well as often-expressed concerns regarding a trade-induced race-to-the-bottomof environmental standards correspond to this widespread assump-tion. However, the validity of the conventional trade-off between providing the environmental public good and protecting domestic industries is increas-ingly challenged.

The argument that stringent environmental policy causes undesirable com-petitiveness effects has been undermined by many empirical studies, from To-bey (1990) to Costantini and Mazzanti (2012), which did not detect any sig-nificant negative effects of environmental regulations on international trade.

The relative unimportance of pollution control compared to other production or transaction costs has initially been suggested as a possible reason. Borrow-ing from evolutionary thinkBorrow-ing, the idea of regulation-induced environmental innovation has however increasingly been called upon as an explanation for the absence of negative impacts or even as a justification for positive effects of environmental regulation on competitiveness.

The famousPorter Hypothesisfor instance maintains that strict environmen-tal regulation does not necessarily result in a competitive disadvantage of do-mestic businesses compared to less regulated rivals (Porter, 1990). Porter and van der Linde (1995) argue that properly designed environmental regulation can create incentives for innovation that may offset the related costs, by en-hancing profits through the induced improvement of production processes or the enhancement of product quality. The salient point is why firms would sys-tematically fail to invest in new technologies that actually increase their com-petitiveness.

Indeed, even more than 20 years after its publication and despite substan-tial empirical research about the influence of environmental regulation on

in-novation the Porter Hypothesis remains highly controversial. The empirical evidence is still inconclusive, often anecdotal and usually restricted to highly developed economies. One possible reasons why previous empirical studies of the Porter Hypothesis were not able to provide a clearer picture of the actual competitiveness effects of environmental regulation is the conceptual fuzziness concerning the location and the timing of these beneficial impacts.

First of all, it seems reasonable to expect a certain time gap between the ocurrence of negative compliance costs and the positive effects of induced in-novation which has to be considered when empirically assessing regulatory impacts. Secondly, while Porter and van der Linde (1995) ground their theory on cases where firms have actually profitted from complying with stringent regulation, it is more compelling to expect the largest part of induced innova-tion to be realized by others than the directly regulated companies. Putting a price on the environmental externality will probably not benefit most those companies that use pollution as an input factor, but actually foster innovation in theenvironmental industry(Feess and Mühlheußer, 1999), less polluting firms or new market entrants. We thus focus our analysis on the competitiveness ef-fects of environmental regulation at country-level rather than at the level of the individual firm.

An explanation for national gains in competitiveness is provided by the concept oflead markets for environmental innovations(Beise and Rennings, 2003, 2005; Jacob et al., 2005) which supports the notion that the adaptation of a lo-cal production system to a stringent regulatory landscape creates early-mover-advantages because of the anticipation of global trends, directing technolog-ical change towards an emerging field of eco-innovation. The positive effect yet hinges on the ability of domestic firms to timely realize economies-of-scale and learning curve effects and to consequently set the dominant design in the globally emerging green market. It goes without saying that such an indus-trial policy strategy can only work out for a few players and does not justify a generally positive relationship between environmental regulation and com-petitiveness.

It is thus by no means trivial to generally expect social benefits from en-vironmental regulation at the country-level that go beyond the reduction of negative pollution externalities. Following Blind (2012), we refer to the en-dogenous growth theory as described by Carlin and Soskice (2006) to motivate the analysis of the influence on innovation. This macroeconomic framework allows for both positive and negative overall effects of environmental

regu-lation, by modeling an endogenously determined equilibrium rate of techno-logical progress as the result of two intersecting relationships between capital intensity and the rate of innovation: while theSolow Relationdefines a negative link between capital per efficiency unit of labour and the productivity enhanc-ing rate of technological progress, theSchumpeter Relationassumes that with increasing capital intensity more investment goes into research and develop-ment of new technologies.

Tightening environmental regulation changes the equilibrium rate by af-fecting both relationships. First, by reducing the available resources for in-vestments in innovation like a tax, the costs of compliance with environmental regulations shift the Solow relation curve down left. Second, by changing the incentives to innovate, the Schumpeter relation curve is also shifted. Arguably, the incentives to invest in R&D either increase or decrease, moving the curve up left or down right. The resulting equilibrium rate of innovation depends on both the extent of compliance costs and the actual direction and size of the in-centive effect. In order to result in an overall increase of the innovation rate the incentive effect has to be positive. However, while the negative effect of com-pliance costs on business performance is immediate, the potential innovation offset is likely to take time before showing an impact on competitiveness.

In view of the global challenges, the possibility of achieving environmental gains without compromising economic cohesion has certainly created much interest in the development policy arena, since it substantiates the feasibility ofintegrating environmental innovations into economic catching-up processes(Walz et al., 2008; Walz, 2010). Other than suggested byEnvironmental Kuznets Curve models (Stokey, 1998; Andreoni and Levinson, 2001), developing countries would not have togrow out of environmental problems, by first increasing pol-lution intensity before reaching an income level that allows for environmental improvements, but could potentially use environmental regulation as a policy instrument that would even contribute to economic growth by forcing domes-tic firms to innovate. This possibility gives rise to the hope that developing countries may take a less environmentally-damaging development path than industrialized countries have taken in the past bytunneling through the environ-mental Kuznets curve(Munasinghe, 1999).

The ability of effectively regulating pollution to induce eco-innovation re-quires sophisticated quality institutions. In a world where the relevant knowl-edge is widely diffused and not easily shared among economic agents, an insti-tutional infrastructure is required that provides both the regulator and market

Figure 3.1: The influence of regulation on innovation, adapted from Blind (2012)

actors with reliable assessment mechanisms for informed decision making. It is therefore highly questionable whether less developed economies do indeed possess the necessary social capabilities to design appropriate regulatory struments, adequately respond to and effectively profit from strengthened in-novation incentives induced by environmental regulation. This study explic-itly encompasses a broad sample of developed and developing countries when empirically assessing the impacts of environmental regulation on the compet-itiveness of businesses and how these effects are influenced by the prevailing institutional framework conditions.

In the next section we will briefly discuss the vast empirical literature on the effects of environmental regulation on innovation and competitiveness. Then our empirical approach will be introduced and discussed along with the data set. Our reasoning about the influence of environmental regulation design and non-regulatory framework conditions will be given, after which the applied estimation method and the empirical results are presented and discussed. Fi-nally, we will summarize our findings concerning the role of different char-acteristics of environmental regulation for its effects on competitiveness and draw conclusions regarding the compatibility of sustainable development and economic catching-up as simultaneous policy goals in developing countries.