The elimination of unwanted production by-products such as discharge of effluent, agricultural chemicals into water, soil, and emissions from vehicles, factories, etc. into air make a negative impact on the environment. Environmental innovation is viewed as a solution to ecological improvement. Thus, firm innovations either initially created for green purposes or indirectly contributing to the environment play an important role in environmental protection by increasing productivity of natural resources (e.g. light bulbs use less electric power), recycling (e.g. paper, plastic), pollution reduction (e.g. low emission cars), and so forth. This paper focuses on how environmental regulations, market, and profitability influence firm investment decision in environmental innovation.
Before we analyze each factor, namely environmental regulations, market, and profitability to see how they affect firms’ investment decision in environmental innovation, it is beneficial to elucidate the term “environmental innovation“ (hereafter eco-innovation) first. In Environmental Innovation: Incentives and Barriers, eco-innovation is broadly described as “the subset of innovations, that lead to an improvement of ecological quality“ (Klemmer et al., 1999, p. 25). And the definition of innovation here is activities resulting in developing new technologies (products, processes), organizational, institutional or social change, then applying and diffusing them (Klemmer et al., 1999). In addition, another more concise explanation based on environmental performance rather than environmental aim proposed by Kemp and Pearson as follows:
“Eco-innovation is the production, assimilation or exploitation of a product, production process, service or management or business method that is novel to the organisation (developing or adopting it) and which results, throughout its life cycle, in a reduction of environmental risk, pollution and other negative impacts of resources use (including energy use) compared to relevant alternatives“ (Kemp and Pearson 2007, p. 7).
2. Factors influencing firm investment in environmental
2.1. Environmental regulations
The study of Cleff and Rennings (2000) shows that environmental regulations have a strong influence on eco-innovation. In this section, we examine some main characteristics of environmental regulations. Primarily, stringency and its impact on eco-innovation will be taken into account. The question of the effectiveness of strict environmental regulations spurs many researchers to figure out an answer. Traditional view says that firm global competitiveness may decline due to additional costs caused by environmental protection (Ambec et al., 2011). This opinion is challenged by Porter Hypothesis whose main idea is more stringent and properly designed environmental regulations can stimulate innovations which benefit firms by “partially or more than fully offset the costs of complying with them“ hence enhance firm competitiveness (Porter and van der Linde, 1995, p. 98). The concept of the effect of stringency on innovation relates to Hicksian notion that “a change in the relative prices of factors of production will motivate firms to invent new production methods in order to economise the use of a factor which has become relatively expensive“ (OECD, 2011, p. 23). Thus, empirical analyses have been conducted to find out the link between strict environmental regulations (e.g. pollution abatement costs used as proxy) and innovation (e.g. R&D expenditures, or number of patents used as proxy), and how firm performance (e.g. productivity used as a proxy) reacts to environmental regulations. Concerning the former, evidence to date proves that there is a positive connection between strict environmental regulations and innovation despite its varying magnitude. However, it should be noticed that innovation in general is triggered not by all regulations but only by “well-designed“ ones which in turn fall into the hand of policy makers (Ambec et al., 2011). Regarding the latter, the conclusion of how environmental regulations affect the firm performance is ambiguous. Instead, the outcome varies among case studies. One of the reasons for fluctuation is the time chosen for regression. As it takes time to bring innovation process into effect (Ambec et al., 2011).
Besides stringency, it is stated that “delays and uncertainty are believed to be more important than the absolute level of stringency“ (Gray and Shadbegian, 1998, p. 7). This point of view relates to predictability, i.e. “what effect does the policy measure have on investor uncertainty, is the signal consistent, foreseeable, and credible ?“ (OECD, 2011, p. 22). “Viscusi (1983) shows that the increased uncertainty due to regulation, combined with irreversible investment, is likely to reduce investment“ (Gray and hadbegian, 1997, p. 9). If firms place a high priority on meeting legal requirements, unstable or uncertain regulations probably add risks to firm R&D investment.
The revision might lead to delay in implementing plans, confusion over technology choices, or costly renovation especially for capital intensive industries (Gray and Shadbegian, 1997). Additionally, if the intention, signals (e.g. implementation timing, durability) given by the policy are unclear, firms tend to postpone their investment in R&D to avoid sunk costs (OECD, 2011).
An example of failure in policy anticipation is Conox (a substance reducing organic pollutant on water) case. It was created by a small Finnish company “in anticipation of increased regulatory measures for closing the bleaching processes“ (Kivimaa, 2008, p. 43). Nevertheless, the regulatory action did not take place (Kivimaa, 2008).
Flexibility is also a key characteristic of environmental regulations because it can offer more low-cost solutions to firms by allowing innovators to have a various choice of approaches based on specific conditions to meet the goal.
Flexibility of regulations is partially influenced by the stringency of commands (Bennear and Coglianese, 2012). For example, a regulation targets pollution reduction but does not impose any fixed technology on firms or at which manufacturing stage that a cleaning process should be applied, hence firms are provided with a wide range of options from replacing low-quality input to installing end-of-pipe technology to treat pollutants (Bennear and Coglianese, 2012). Other relevant features briefly listed here are depth describing the sufficient number and efficiency of “carrots“ which encourage firms to reach and surpass the goals (OECD, 2011), incidence meaning “does the policy target directly the externality, or is the point of incidence a “proxy“ for the pollutant?“ (OECD, 2011, p. 22) since occasionally it is difficult to precisely aim at the externality and therefore proxy can be targeted instead.
As a result, technological innovations are developed to solve the proxy but not the original objective. Furthermore, impacts on innovation depend on different measures and it is found that market-based instruments such as taxes, tradable permits are more likely to motivate innovations than direct controls, namely, technology-based standards, performance standards (OECD, 2011).
Various instrument types have different intensity of these features. For instance, taxes have “predictable price signals – assuming that taxes are set at a level which investors see as being sustainable and credible“, whereas permits display “unpredictable price signals – but (assuming no expropriation) equivalent to commercial risk for investors“ (OECD, 2011, p. 25), tax is also considered as a “deep“ policy as it provides incentives for firms to go beyond standard requirements.
2.2. Market Factors: Customer Demand and Competition
Another important factor affecting eco-innovation is customers’ demand. Market related groups including customers, consumer associations, wholesalers, retailers, investors are raising their awareness of and pressure on companies’ participation in environmental protection (Hemmelskamp, 1996).
Customers’ orientation is found to make a positive impact on product innovation (Lukas and Ferrell, 2000). Their requirements crucially encourage ecoinnovation, particularly regarding environmentally-improved products and process innovations that “increase material efficiency, reduce energy consumption and waste and the use of dangerous substances“ (Horbach et al., 2011, no pagination). Kassinis and Soteriou (2003) shows that adopting environmental practices leads to a positive influence on customer satisfaction which is, in turn, positively related to loyalty and loyalty has a positive relationship with market performance in terms of revenue growth and profitability.
If firms fail to obtain environmental qualifications, customer demands for products decrease because firms are not seen as environmentally responsive. On the other hand, if firms invest in environmental product innovation, one of the obstacles they encounter is whether customers are willing to pay a premium for green (environmentally friendly) products (Peattie, 2001). This issue opens way for other tasks like profit-maximizing level of environmental emissions and price that firms have to tackle in order to balance costs and benefits of environmental investment, developing green marketing, etc. Perceived as a good sign for firms, Boztepe’s findings (2012) suggest that customers now agree to pay more for green products against environmental pollution. Further, the second challenge for firms is only green benefit might mismatch customer needs (Wong et al., 1996). For this reason, to engage customers in purchasing eco-friendly goods, apart from public benefits, private value springing from different sources should be added, e.g. “cost / energy savings through more efficient appliances, improved product quality and durability, better repair, as well as reduced health impacts“ (Kammerer, 2009, p. 4). Kammerer’s statistical analysis (2009) also shows that customer benefit is a core contributor to environmental product innovation. However, the role of consumers in eco-innovation is not more significant than in others for consumers cannot easily identify environmental features (Darby and Karny, 1973; Andersen 1999 as cited in Marchi, 2010) and it may require a sound technical understanding (Marchi, 2010).
In conjunction with customer demand, competition is considered as a determinant of eco-innovation (Cleff and Rennings, 2000). It is described as an effective driver of eco-innovation, particularly if consumers’ taste is inclined to change for environmental performance (Yalabik and Fairchild, 2011). Then a question arises as to whether first-mover advantages exist in competitive market. Theoretically speaking, they do but depend on specific environmental circumstances, viz. Calm Waters (slow technology change, slow market growth), Rough Waters (fast technology change, fast market growth), Technology Leads (fast technology change, slow market growth), Market Leads (slow technology change, fast market growth) (Suarez/Lanzolla, 2005, p. 124 as cited in Cleff and Rennings, 2011). These effects are derived from the combination of technological and market pace which influence strategies firms adopt to approach markets. In terms of ease of maintaining pioneer advantages, “Calm Waters“ ranked first due to low market growth and gradual change of technology hence the likelihood of obtaining high market share through technological leadership by followers is very small (Cleff and Rennings, 2011). Finally, it is verified that “the successful innovator is not necessarily the first but very often one of the early movers within the competition of different innovation designs“ (Cleff and Rennings, 2014, p. 185). Besides that, cooperation in eco-innovation among competitors has been proved to be not dissimilar from that in other innovations (Marchi, 2010).
To put it in a nutshell, the ultimate goal of firms is making profit. Skepticism about eco-innovation profitability is rational. According to Rennings (2000), firms’ incentives to invest in eco-innovation are reduced by a peculiarity of eco-innovation, called “double externality problem“. As other innovations, spillovers of knowledge occur in R&D phase. Additionally, in eco-innovation the spillovers appear as well in diffusion phase due to internalized external costs of environmental impacts (Rennings, 2000). Moreover, the lack of attention to environment and information about its impacts has cast doubt on innovation benefits (Porter and van der Linde, 1995). On the theoretical side, increased revenues from difference sources viz. “better access to certain markets, the possibility to differentiate products, the possibility to sell pollution-control technology“ and reductions in “regulatory cost, cost of material energy and services, cost of capital, cost of labor“ (Lankoski, 2006 as cited in Ambec and Lanoie, 2007, p. 29) resulted from environmental performance have been discussed in literature such as Reinhardt (2000), Lankoski (2000, 2006) (Ambec and Lanoie, 2007). Nevertheless these arguments lack empirical evidence (Ambec and Lanoie, 2007). On the empirical side, Rexh¨auser and Rammer (2014) conclude that eco-innovations whether induced by regulations or not have positive profitability effects provided that resource efficiency of the firm is boosted. Before them, Ghisetti and Rennings’ study (2013) also produced an analogous outcome. These findings are to some degree in line with the conclusion stated above that the effect of environmental regulations on firms’ performance associated with firms’ competitive ability is inconclusive. Because other types of eco-innovations, e.g. end-of-pipe technology, invented in an attempt to diminish waste production such as environmental pollution could be profitable in long term thanks to better environmental regulations, however, in short term it might generate negative profitability effects (Ghisetti and Rennings, 2013), possibly due to investment cost.
It has been shown that environmental regulations, market factors including customer demand, competition, and profitability influence firms’ investment decision in eco-innovation. With regard to environmental regulations, its main characteristics, namely stringency, predictability and flexibility encourage eco-innovation but no convincing evidence for positive impact of environmental regulations on firm performance. Competition as well as customers’ tendency towards green products and processes is considered as drivers however, their effect on eco-innovation does not seem different from that on other innovations. Lastly, profitability gives impulse to this progress. Resource efficient innovations, in particular, pay in a shorter time than other types of eco-innovations.
At the beginning stage, a push from regulations is essential for eco-innovation development. A scenario that we can envision is firms are obliged to the policy. Pioneers view this environmentally friendly transformation as an advantage and use it in their marketing plan to attract customers. A small minority of green customers will grow in number as their perception changes. Profitability is induced since customers opt for green products. Then late movers join the game and share the pie. Competition takes over from regulation as a major effect on eco-innovation. Whether the interplay functions this way or others, together they will untie the knot and boost the eco-innovation progress.
Ambec, S., Cohen, M. A., Elgie, S., Lanoie, P., 2011. The Porter Hypothesis at 20: Can environmental regulation enhance innovation and competitiveness? Discussion Paper No. RFF DP 11-01. Resources for the Future, Washington, DC.
Ambec, S., Lanoie, P., 2007. When and why does it pay to be green? Working Paper No. IEA-07-04. HEC Montr´eal.
Bennear, L. S., Coglianese, C., 2012. Flexible environmental regulation. Research Paper No. 12-03. Institute for Law & Economics.
Boztepe, A., 2012. Green marketing and its impact on consumer buying behavior. European Journal of Economic and Political Studies 5 (1), 5-21.
Cleff, T., Rennings, K., 2000. Determinants of environmental product and process innovation – evidence from the Mannheim innovation panel and a follow-up telephone survey. Innovation-oriented environmental regulation, 331-347.
Cleff, T., Rennings, K., 2011. Theoretical and empirical evidence of timing-to-market and lead market strategies for successful environmental innovation. Working Paper 11-01. Simon Fraser University.
Cleff, T., Rennings, K., 2014. Are there any first and second mover advantages for eco-pioneers? lead market strategies for environmental innovation. Interdisciplinary Management Research 10, 164-189.
Ghisetti, C., Rennings, K., 2013. Environmental innovations and profitability: How does it pay to be green? An empirical analysis on the German innovation survey Discussion Papers No. 13-073. ZEW.
Gray, W. B.,Shadbegian, R. J., 1998. Environmental regulation, investment timing, and technology choice. Working Paper No. 6036. National Bureau of Economic Research. Hemmelskamp, J., 1996. Environmental policy instruments and their effects on innovation Discussion Papers No. 96-22. ZEW. Horbach, J., Rammer, C., Rennings, K., 2011. Determinants of ecoinnovations by type of environmental impact. The role of regulatory push/pull, technology push and market pull. Discussion Papers No. 11- 027. ZEW.
Kammerer, D., 2008. The effects of customer benefit and regulation on environmental product innovation empirical evidence from appliance manufacturers in Germany. Working Paper No. 36. CIS.
Kassinis, G. I., Soteriou, A. C., 2003. Greening the service profit chain: the impact of environmental management practices. Product and operations management 12(3), 386-403. Kemp, R. and Pearson, P., 2007. Final report MEI project about measuring
eco-innovation. UM Merit Maastricht.
Klemmer, P., Lehr, U., L¨obbe, K., 1999. Environmental innovation: incentives and barriers. Analytica, Berlin.
Kivimaa, P., 2008. The innovation effects of environmental policies: linking policies, companies and innovations in the Nordic pulp and paper industry. Working Paper No. 329. Helsinki School of Economics.
Lukas, B. A., Ferrell, O. C., 2000. The Effect of Market Orientation on Product Innovation. Journal of the Academy of Marketing Science 28(2), 239-247.
De Marchi, V., 2010. Cooperation toward environmental innovation: an empirical investigation. Working Paper No. 119. University of Padova.
OECD, 2011. Invention and transfer of environmental technologies OECD Studies on Environmental Innovation. OECD Publishing. http://dx.doi.org/10.1787/9789264115620-en, accessed on: 15.03.2016
Peattie, K., 2001. Golden goose or wild goose? The hunt for the green customer Business Strategy and the Environment 10(4), 187-199.
Porter, M. E., and van der Linde, C., 1995 Toward a new conception of the environment-competitiveness relationship Journal of Economic Perspective 9(4), 97118.
Rennings, K., 2000. Redefining innovation eco-innovation research and the contribution from ecological economics. Ecological Economics 32, 319-332.
Rexh¨auser, S., Rammer, C., 2014. Environmental innovations and firm profitability: unmasking the Porter Hypothesis. Environmental & Resource Economics 57(1), 145-167.
Wong, V., Turner, W., Stoneman, P., 1996. Marketing strategies and market prospects for environmentally-friendly consumer products. British Journal of Management 7, 263-281.
Yalabik, B., Fairchild, R. J., 2011. Customer,regulatory,and competitive pressure as drivers of environmental innovation. International journal of Production Economics 131(2), 519-527