Translation of my presentation in the 38th Ilmansuojelupäivät in Lappeenranta, Finland, 20.8.2013

If we deconstruct the topic of the panel, “is environmental protection a threat or an opportunity to a country’s competitiveness,” sooner or later we will end up considering the question whether tighter environmental regulation would help or even force firms to develop novel ways of working — novel technologies, in the broad sense of the word — that others would be willing to pay for.

Of course, this is far from being the only possible way through which environmental protection could in principle affect a country’s competitiveness; to mention just a single example, a case could be made that tight regulations preserve the quality of the environment and therefore make a country an attractive location for skilled professionals. However, because I have neither space, time nor competence to deal with these kinds of questions, I shall concentrate on the effects that regulatory constraints may have on technology — and on the effects technology has on the regulations.

In theory, environmental protection and economic activity are possible to combine precisely through “incentivizing” regulation that forces beneficial changes in techniques and operating procedures. For two decades now, the favorite theory trotted out in support of this thesis has been the so-called “Porter hypothesis,” which maintains that tight regulation pays for itself not just because of enhanced environmental protection, but also because of improved goods and services. The logic behind this hypothesis, developed by Michael Porter and others in the early 1990s (e.g. Porter and van der Linde, 1995), is that necessity is a good motivator that makes firms to develop technologies they otherwise wouldn’t bother developing. If the regulation is just properly incentivizing, innovations will flourish and competitiveness soars, more than offsetting the costs of regulation.

As is the case with so many other beautiful theories, the Porter hypothesis is seductive, simple, and very likely not correct. Despite over two decades of research, empirical evidence for the net positive effects of tightening environmental regulation to economy as a whole or even to the success of specific sectors remains slim, and what little evidence there is tends to be problematic to say the least. In general, noteworthy tightening of regulatory constraints, compared to e.g. regulation elsewhere, can promote individual firms and, in some cases, specific sectors, but there is little evidence for broader effects. From the economy’s viewpoint, the evidence is therefore both positive and negative: on the one hand, regulation has only little positive effect, but on the other, the negative effects of regulation to e.g. industry profitability also tend to be small. Unfortunately, the same applies to reductions of environmental pollutants.

Before taking a stab at explaining why this happens, and what we might do about it, I’m going to be explicit about what I’m not claiming. It is clear that tightening regulations and political pressure create additional incentives and pressures for firms to develop their technologies. It is also clear that on occasion, these pressures and incentives can help the development of successful innovations and even novel industries. Furthermore, regulatory constraints are not the only way regulators can influence technological change; regulation can also increase incentives by e.g. subsidizing novel innovations. Finally, there is no doubt that changes in the operating environment are bound to benefit some firms and penalize others. Anecdotal evidence is abundant, and our all-too-human tendencies to seek simple reasons for complicated developments, remember success and brush failures under the carpet easily create the image that the plural of “anecdote” is “data.”

Nevertheless, it is at the very least uncertain whether we can believe that innovations that are developed as a response to regulatory constraint are, on average, net positive developments. Economic theory suggests that this is possible, given the existence of very specific conditions (Mohr, 2002). Unfortunately, research has failed to find much evidence of these conditions being anything but rare occurrences. Because Porter hypothesis requires that firms systematically leave profitable improvement opportunities unexplored — not just that this may happen — the lack of empirical evidence is not surprising.

The problem with combining economic activity and growth with environmental protection through technological development is that sticks and carrots are not the only or necessarily even very powerful forces affecting technological change. It is only a slight exaggeration to say that discourse is often dominated by a conviction that technological solutions to environmental problems require only proper incentives. If incentives are in place, any problem will be solved. In a certain sense this is true, as long as the definition of a “solution” is kept so broad as to fit ocean liners through, and no time limit for the solution is specified. Outside semantic hair-splitting contexts, it is clear that certain problems remain nevertheless unsolved, even though solutions would clearly have extremely significant practical and economic value. A trivial example is a way to locally alter gravity; less trivial but no less valuable examples are, among others, a cheap and scalable method for storing electricity, a cheap, clean source of energy, and a fast method for convincing the majority of world’s population to make great economic sacrifices in the name of environmental protection.

The aforementioned problems remain unsolved, and there are no guarantees that solutions even exist, even though sticks and carrots are decidedly plentiful. A moment’s reflection reveals why this is so: even if these solutions were technologically possible, we lack the “building blocks” required to construct them. All of our tools and techniques are built upon our existing toolkit and knowledge, much like building blocks of a pyramid. In practice, we cannot realize any solution, if we lack the blocks we need to build it. On the other hand, the history of technology from stone axes to Facebook tells that once the pieces are in place, a technology will be developed very rapidly, almost always by multiple independent inventors. Very few if any single causal factor has much effect on the speed of technological change; to pick an extreme example from the realm of pure ideas, one sympathetic biographer was forced to conclude that Einstein’s contribution was to advance physics by ten years, at most.

In short, what is invented is only rarely affected by constraints. In my own PhD research, I have studied one famous Finnish invention, the flash smelting of copper. Developed as a response to serious electricity shortage after the Second World War, this technology had a great effect on metallurgy, once it was broadly adopted starting in the 1960s. Prior literature has repeatedly claimed that the key causal factor behind this invention was the electricity shortage, which required Outokumpu to develop a completely novel method for copper smelting; however, less ink is spilled over the fact that the technology in question had been first described 80 years prior and even patented full half a century before Outokumpu’s experiments, and a body of existing patents and research literature actually caused great problems for Outokumpu when it tried to patent the invention in the United States. Even less discussed today is the fact that another company, Inco of Canada, operating practically without constraints of any kind, developed a notably better technology a full month before Outokumpu. The inevitable conclusion is that the undoubted later success  of Outokumpu’s invention has much more to do with factors other than constraint, and that the invention would have been invented — in a better form, although perhaps not by Outokumpu — even without the constraint. Based on this and other cases, I therefore side with mathematician Alfred North Whitehead in claiming that instead of necessity being the mother of invention, “necessity is the mother of futile dodges” is closer to truth.

If the constraint caused by extreme post-war scarcity did not, in this and other cases I’ve so far researched, have noticeable effect on the content of technological change, what hope remains for those constraints we can effect through regulation? The answer, in my opinion, is “very little.” Recent research has strengthened the belief that regulatory constraints in democratic societies (at least) are born out of a sort of a negotiation process. Desire for brevity forces me to cut various corners, but the gist of the matter is that because material standard of living and improvements thereof remain extremely important to many voters, and more so during times of economic difficulty, regulators must of necessity consider the impact regulatory decisions may have on the economy. If a decision would have significant negative impact on the economy, the decision will be altered. This dynamic, dubbed “Iron Law of Climate Change” by Roger Pielke Jr., is visible in nearly every regulatory process that aims to ease environmental problems; if it’s not visible, there is a reason to believe that the problem is not overly large or difficult.

What kinds of regulation, then, would have significant negative impact? In principle, every regulatory constraint that cannot be met cheaply and relatively speedily with technologies that are available “off the shelf.” By reading proposed and enacted environmental regulations, one will sooner or later notice concepts such as “Best Available Technology” (BAT). The performance of these technologies largely defines the constraints — e.g. emissions, energy consumption, and so on — set by the regulation. I’d go so far as to wager that if one attempts to explain the dismayingly slow process of environmental protection, a key culprit would be a lack of sufficiently cheap technology for satisfying tighter constraints. It is, in fact, usually more accurate to say that technology changes regulations rather than to say that regulations change technology.

When technology exists and is sufficiently cheap, environmental regulation can proceed rapidly. In these cases, regulatory changes promote the spread of existing (if, perhaps, so far poorly commercialized) technology. My personal hunch is that the majority of research literature finding positive relationships between the enactment of tight environmental regulation and technological change has, by accident or by design, studied these kinds of cases. However, it does not necessarily follow that regulation would promote the development of novel technologies as such; more accurate description of the relationship might be that regulation may promote the spread of existing technologies. The difference may seem small to someone not spending hours in the study of technological change, but it is significant: insofar as the solving of environmental problems requires us to develop completely novel technologies, it is not clear that regulations are the best vehicle to promote this development.

What conclusions one should draw from the above? First, one should note that all hope is not lost, not even for the purpose of improving competitiveness. In principle, it is possible that a country or a firm has a disproportionate share of firms and industries with technologies that would benefit from tighter regulation. Tightening regulation undoubtedly benefits the relative competitive position of these industries, and even if the development of novelty were not affected, the adoption of the existing may be sped up significantly.

Secondly, even though individual regulations may have little to no effect, in the long run the trend is hopefully different. By enacting constraining regulation, the polity is sending a message saying that certain activities are considered inappropriate; over time, increasing the domain of inappropriateness with small steps such as these may lead to changes that would be inconceivable if they had to be taken at once.

Third, even if necessity may not be the mother of invention, regulatory constraints can provide the final push for technologies and firms that are not quite ready yet. As an example, even though the invention of flash smelting would have happened without Outokumpu, the constraint very probably caused precisely Outokumpu to be among the inventors — and in a position to profit from the invention later. However, profiting from such inventions is a different matter, and no regulation can force firms to do so.

References

Arthur, B. W. (2009). The Nature of Technology: What it is and how it evolves. New York: Free Press.

Korhonen, J. M., & Välikangas, L. (Forthcoming). Constraints and Ingenuity: The Case of Outokumpu and the Development of Flash Smelting in the Copper Industry. In B. Honig, J. Lampel, & I. Drori (Eds.), Handbook of Research on Organizational Ingenuity and Creative Institutional Entrepreneurship. Cheltenham: Edward Elgar.

Mohr, R. D. (2002). Technical Change, External Economies, and the Porter Hypothesis. Journal of Environmental Economics and Management, 43(1), 158–168.

Porter, M. E., & van der Linde, C. (1995). Toward a new conception of the environment-competitiveness relationship. Journal of Economic Perspective, 9(4), 97–118.

Roediger-Schluga, T. (2004). The Porter Hypothesis And The Economic Consequences Of Environmental Regulation: A Neo-Schumpeterian Approach. Cheltenham: Edward Elgar.