Win–Win Opportunities and Environmental Regulation: Test of the Porter Hypothesis

Environmental regulation makes firms internalize the costs of environmental externality generated by them. It may result in firms complying with the regulation being less competitive in the market than the noncomplying firms. This conventional view about the effects of regulation on the competitiveness of firms has recently been subjected to scrutiny, especially in the context of empirically testing the so-called Porter hypothesis (Porter, 1990, 1991). Porter and van der Linde (1995) argue that properly designed environmental standards can trigger innovation that may partially or more than fully offset the costs of complying with them. Such “innovation offsets,” as one can call them, cannot only lower the net costs of meeting environmental regulations, but even lead to absolute advantage (p. 98). The authors further contend that innovation offsets occur mainly because pollution regulation is often coincident with improved efficiency of resource usage; the inference is that stiffer environmental regulation results in greater production efficiency. Many economists (e.g., Palmer et al., 1995) remain skeptical of the widespread existence of this hypothesis or such “win–win” opportunities. Although Palmer et al. clearly do not accept the basic arguments of the Porter hypothesis, they do agree that environmental regulation and production efficiency may be related. According to them, “we acknowledge that regulations have sometimes led to the discovery of cost saving or quality improving innovation; in other words, we do not believe that firms are ever vigilantly perched on their efficiency frontier.” However, they indicate that more systematic studies are needed to establish the extent of the effect. Indeed, empirical literature on the relationship between environmental regulation and production efficiency is still rather scarce. The objective of this chapter is to study the effect of environmental regulation relating to water pollution by the manufacturing industry in India on the productive efficiency of firms. The panel (time series–cross section) data of 92 water-polluting firms for the three-year period 1996–1999 are used to test the Porter hypothesis.