What if environmental regulations could increase corporate profits?

According to conventional economic wisdom, the cost of complying with environmental regulations represents a burden that eats into companies’ profits.

But another view, known as the Porter hypothesis, holds that environmental regulations can spur innovation and increased efficiency, ultimately increasing profitability.

Economists have debated these ideas for the past two decades but have had little direct empirical evidence to help settle the matter. Now, researchers Dietrich Earnhart of the University of Kansas and Dylan Rassier of the U.S. Department of Commerce have provided such a real-world test with a look at the U.S. chemical manufacturing industry between 1995 and 2001.

The researchers point out that the strictness of environmental regulations depends both on the pollution limits set out in laws and regulations, and on how vigorously those limits are enforced. Theirs is the first study to tease out the effect of each of these two components of regulation on profitability.

To do so, they gathered information on Environmental Protection Agency permits that prescribe pollution limits for wastewater discharge from individual manufacturing facilities. They also tracked how often these factories were visited by government inspectors. Finally, they folded in data on profitability of chemical firms from Securities and Exchange Commission filings.

Environmental regulations can indeed increase profits—but only under specific conditions, the researchers reported recently in the Journal of Regulatory Economics.

Wastewater discharge permits may give factories a quantity limit (e.g., pounds of pollution per day), a concentration limit (e.g., milligrams of pollution per liter of wastewater), or both. When regulations focus on quantity limits—the absolute amount of pollution a facility can release—tighter limits increase profitability, regardless of how strictly the limits are enforced. That finding supports the Porter hypothesis.

But quantity limits generally depend on the scale of the facility, so the researchers argue that concentration limits are probably more broadly applicable. And when it comes to concentration limits, they found, profitability depends on the balance of legal limits and enforcement efforts—or more precisely, it depends on an imbalance between the two.

For example, when factories face both tight scrutiny and stringent concentration limits, this results in lower profits, in line with conventional wisdom.

But if monitoring is absent, then tighter limits on the concentration of pollution released in wastewater increase profits.

And on the flip side, if concentration limits are loose, then more vigorous monitoring increases profits. That relationship holds even if the overall quantity limit on pollution is strict.

These latter results also support the Porter hypothesis. They suggest that firms faced with either strict limits on pollution discharges or close monitoring of factories can generate higher profits, compared to firms that are subject to both loose regulation and lax monitoring.

The idea that we should either regulate or enforce, but not do both too stringently, is a little uncomfortable from an environmental point of view. After all, the real goal of regulations is protecting public health and environmental quality, so a purist could be forgiven for thinking that pollution limits set with those imperatives in mind really ought to be strictly enforced.

On the other hand, it’s nice to have confirmation that the conventional wisdom that sees a fundamental conflict between business and the environment doesn’t always get it right. “Any agencies working on clean water or clean air regulations should be concerned about how they induce compliance and what the trade-offs are,” says Earnhart. “If there is a win-win situation, everyone should want to learn about it.” — Sarah DeWeerdt | 30 August 2016

Source: Earnhart D and DG Rassier “Effective regulatory stringency” and firms’ profitability: the effects of effluent limits and government monitoring.” Journal of Regulatory Economics2016.

Header image credit: Royal Olive via Flickr.