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Environmental regulation and industrial competitiveness -- The Porter hypothesis

S. Venu

IN A 1991 article published in Scientific American, Mr Michael Porter, the Harvard guru of `competitive advantage' fame, said: "Strict environmental regulations do not inevitably hinder competitive advantage against foreign rivals; indeed, they often enhance it."

The significance of what has become known as the `Porter Hypothesis' is that it apparently contradicts the conventional wisdom that environmental regulations shift formerly external costs back to firms, burdening them relative to competing firms in countries with less strict regulations.

Second, putting aside the obvious gainers in the environmental services sector, the Porter hypothesis can be taken to imply that, under stricter environmental regulations, some regulated firms will benefit competitively at the expense of other regulated firms. If, for example, larger firms find it less costly to comply than smaller firms, the former might actually benefit from regulation if higher prices from reduced competition more than offset increased costs.

There are several levels on which the so-called Porter hypothesis may be interpreted. First, it can be taken simply to mean that some sectors of private industry, in particular, environmental services, will benefit directly from more stringent environmental regulations on their customers (but not on themselves). Thus, the acid-rain reduction provisions of the US Clean Air Act amendments of 1990, which call for significant reductions in sulphur dioxide (SO) emissions from electric utilities, unambiguously represent good news for manufacturers of fluegas purification equipment (scrubbers) and producers of low sulphur coal. It would not be surprising if environmental regulation induced innovation with respect to technologies to achieve compliance. Catalytic converter technology today is superior to what it would have been if auto emissions had never been regulated.

Internationally, it has been suggested that German firms possess some competitive advantage in water-pollution control technology and US firms dominate hazardous waste management because of relatively stricter regulations.

A study of the patents originating from inventors in different countries, in patent classes deemed to be environmental technologies found that increases in environmental compliance costs were related to increases in patenting of such technologies with a one- to two-year lag. Firms, forced by strict regulations to be first-movers, may get a relative advantage developing the technology, achieving efficiencies or by some other means.

In the OECD countries, automobile firms with small-sized models benefited relatively more than GM or Ford from fuel efficiency standards.

The costs of pollution abatement vary widely across industries. They are high for paper, chemicals, petroleum, leather tanning and metals, moderate for electrical equipment and low for printing, non-electrical machinery, etc. Leather tanning is a big polluter in India and other developing countries that have tanneries. So, too, the sugar industry. Its polluting `run-off' can be categorised in the same bracket as paper.

Gross annual costs for pollution abatement are equal to the sum of operating costs attributable to pollution abatement and payments to the government for sewage services and solid waste collection and disposal.

In addition, we have the `one-off' cost of pollution control equipment. At this stage, we must enter the caveat that no government or private agency in India has undertaken a comprehensive empirical study, sector or industry-wise, to ascertain the effects of environmental regulations.

Hence our conclusion merely states probabilities based on theoretical postulates which, however, are highly plausible.

Even ignoring export possibilities, it has been suggested that environmental regulation can increase domestic efficiency, either by wringing inefficiencies out of the production process as firms struggle to meet new constraints or by spurring innovation in the long term through "out-of-the-box-thinking".

The notion is that the imposition of regulations impels firms to reconsider their production processes, and hence to discover innovative approaches to reduce pollution and decrease costs or increase output.

If this happened widely enough, total social costs of regulation could be no greater than measured compliance costs.

Indeed, if the innovation-stimulating effect of regulation were large enough, then regulation would offer the possibility of a "free lunch", that is, improvements in environmental quality without any costs.

Note that the suggestion of proponents of the Porter hypothesis is not that the benefits of environmental regulation (in terms of reduced health and ecological damages) exceed the costs of environmental protection.

This is obviously possible, and it is an empirical issue. Rather, the notion of a "free lunch" — putting aside the benefits of environmental protection — is that the costs of regulatory action can be zero or even negative (a "paid lunch").

Lower production costs in the non-ferrous metals industry in OECD countries were brought about by new environmental regulations that led to the introduction of new, low-polluting production practices that were also more efficient.

Finally, one could argue that regulation, by forcing a re-examination of products and processes, will induce an overall increase in the resources devoted to "research".

Mr Porter, it must be stressed, has not examined the adverse effects of regulations highlighted by other analysts.

First, environmental investments could conceivably crowd out other investments by firms. Second, many environmental regulations exempt older plants from requirements, in effect mandating higher standards for new plants. This "new-source bias" can be particularly harmful by discouraging investments in new, more efficient facilities. Third, the requirement that firms use the best available control technology to reduce pollution may increase the adoption of these new technologies at the time regulations go into effect, but subsequently blunt firms' incentives to develop new pollution control or prevention approaches over time. This is because their emission standards may be tightened each time the firm innovates with a cost-saving approach.

The jury is still out for a final verdict on the Porter hypothesis. Currently, the evidence is slightly on the positive side. As one analyst pithily remarked: "Porter's claim has spawned a number of papers, both pro and con, in business and academic journals. Most are anecdotal, some are theoretical and a few are empirical."

(The author is a Chennai-based management consultant.)

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