A Comparative Analysis of Theoretical Reasoning and Empirical Studies on the Porter Hypothesis and the Role of Innovation

In 1991 US economist Michael Porter proposed that stringent environmental regulation under the condition that it is economically efficient leads to win-win situations, in which social welfare as well as the private net benefits of firms operating under such regulation can be increased. Innovation plays a pivotal role in this, since they are the mechanism which allows offsetting additional compliance cost from tightening environ­mental regulation. However, opponents of the hypothesis criticize the hidden assump­tion that firms would systematically overlook opportunities for voluntarily improving their environmental performance that would also increase their competitiveness. This paper analyses the Porter hypothesis with regard to two aspects. First it analyses the theoretical reasoning behind the hypothesis by discussing and analyzing the argu­ments brought forward in favour of and against the hypothesis based on the discussion of different theoretical analyses and models. Second, I review empirical studies trying to test the Porter hypothesis. The analysis of empirical work allows to assess whether theoretical conclusions about the Porter hypothesis are confirmed by empirical re­search, thus providing further insights about the conditions under which the hypothesis holds and will thus provide important information for future policy making. The paper concludes that factors related to capital structure make trade-offs less strong but also that this effect may be reversed if learning e.g. as part of innovation activities is taken into account. Empirically the evidence for the hypothesis is mixed, but largely pointing to limited positive effects of strict regulation on competitiveness in a dynamic and longer-term perspective most appropriate to capturing the effects of changes in innovation activity. Results also suggest that asymmetric reward struc­tures for agents can provide incentives for them not investing into R&D despite of tightening environmental regulation and that a favourable demand structure and organisational inertia as well as use of specific economic instruments make innova­tion offsets more likely. The paper concludes by pointing out the sensitivity of these insights to different levels of analysing the hypothesis, the issues surrounding meas­urement of the stringency of environmental regulation and in particular the relevance of innovation as prime mechanism to make the hypothesis to hold.