“Effective regulatory stringency” and firms’ profitability: the effects of effluent limits and government monitoring

The Porter hypothesis asserts that properly designed environmental regulation motivates firms to innovate, which ultimately improves profitability. Specifically, the Porter hypothesis posits that more stringent environmental regulation, i.e., greater regulatory stringency, leads to greater profitability. In contrast, the conventional “costly regulation” hypothesis posits that greater regulatory stringency weakens profitability mostly by driving up abatement costs. This study empirically tests these two hypotheses. Of course, regulatory stringency is difficult to measure. More important, regulatory stringency as codified in legislated acts and promulgated rules does not necessarily reflect regulatory stringency in practice, which we deem as “effective regulatory stringency”. Measurement of “effective regulatory stringency” is even more challenging. With this challenge in mind, we divide “effective regulatory stringency” into its two constituent components—(1) legal requirements and (2) regulatory scrutiny—the latter representing government efforts to ensure compliance with the legal requirements. For our analysis, we examine legal requirements in the form of facility-specific effluent limits and regulatory scrutiny in the form of government monitoring inspections. For our empirical analysis, we analyze the U.S. Clean Water Act under which the U.S. Environmental Protection Agency imposes numeric wastewater discharge limits on permitted facilities and conducts wastewater-related inspections. As its primary contribution, our study separately examines the effects of legal requirements and regulatory scrutiny on firm-level profitability in order to appreciate the influence of “effective regulatory stringency”.