Environmental regulation effects: Implications for sustainable development

What is it about?

With increasing climate change, policy makers must impose environmental regulations that lead firms to adopt a sustainable corporate model. According to the Porter hypothesis, environmental regulation can favour the implementation of business strategies that improve economic and environmental performances. In this study, we examine how the European Union Emission Trading Scheme (EU ETS) regulation impacts firm performance, widening the examination beyond the regulation to evaluate an economic crisis, which potentially confounds regulation effects. We estimate a panel model with time- and firm-fixed effects for different subsamples that disentangle the effect of the EU ETS policy from the 2008 economic crisis. The results indicate that the EU ETS policy in its third phase can activate the Porter hypothesis and is effective in fuelling the implementation of sustainable corporate models by firms. However, the economic crisis neutralises the effects of the regulation on firm performance, precluding the triggering of the Porter hypothesis in severely affected firms.

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Photo by Marcin Jozwiak on Unsplash

Photo by Marcin Jozwiak on Unsplash

Why is it important?

Environmental regulation plays a key role in determining the positive relationship between environmental and economic performances. According to the Porter win-win hypothesis (Porter, 1991; Porter & van der Linde, 1995), under an appropriate flexible institutional framework, environmental regulation can spur firms to implement strategies that favour both economic and environmental performances. To examine the impact of environmental regulation on firm performance, it is important to widen the gaze both theoretically and empirically beyond the regulation to evaluate macroeconomics factors that potentially confound the regulation effects, thus biasing the Porter hypothesis. To achieve this goal, we use data on Italian firms for the EU ETS implementation period (2005-2017) and estimate a panel model with time and firm fixed effects for different subsamples that allow us to disentangle the effect of the EU ETS policy from the 2008 economic crisis. This study provides evidence of the effects of the economic crisis on the Porter hypothesis. Our results show that firm managers perceive the regulation’s coercive pressures in different ways according to the trend of the business cycle. In relation to firms not severely affected by the crisis, the reformed regulation has been effective in fuelling the implementation of a sustainable corporate model. The coercive pressures of environmental regulation have determined business strategic decisions that have increased environmental efficiency and safeguarded economic performance. In the first and second phases, the surplus of EUAs deters firms from implementing pollution abatement strategies; in the third phase, free allocation under the level of verified emissions tends to incentivise managerial decisions for technology investments for abating emissions, confirming the evidence of Venmans (2016). In contrast to the Porter hypothesis, our results do not show evidence of an improvement in economic performance ascribable to the EU ETS regulation. The limited period of the third phase may not be sufficient to appreciate the positive effect of strategic decisions about pollution abatement on economic performance. Strategic decisions to abate GHG emissions may consist in innovation investments, which take several years to generate future economic benefits. Nonetheless, the results show that the EU ETS regulation does not have a negative impact on firms’ economic performances.

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