Bachelor thesis

Chinese industrial enterprises’ performance analysis based on

environmental regulation—validity demonstration of Porter hypothesis in

China

Chen, Pan

International economics and finance

S419870

Supervisor: Drs. J.T.R. Stoop

1

Contents

1 Introduction ............................................................................. 3

2 Literature review on the Porter hypothesis .............................. 4

2.1 Main points of the Porter hypothesis .................................... 4

2.2 Opponents and proponents of the Porter hypothesis........... 10

3. Case study: Haier.................................................................. 19

4. Data analysis......................................................................... 22

5. Conclusion ............................................................................ 24

6. Recommendations ................................................................ 25

7. Appendix............................................................................... 27

2

8. List of references .................................................................. 28

1. Introduction

After The Earth Summit held in Rio de Janeiro in 1972, more and more countries

around the world enhance environmental regulation one after another. This trend has

attracted remarkable attention of different scientists to the micro-effect of

environmental regulation on industrial competitiveness. The Porter hypothesis,

expounded by Professor Michael Porter in 1991, is often cited when this issue is

discussed. It asserts that, "Appropriately planned environmental regulations will

stimulate technological innovation, leading to reductions in expenses and

improvements in quality. As a result, domestic businesses may attain a superior

competitive position in the international marketplace and industrial productivity may

improve as well" (Porter, 1991). Since the hypothesis was raised, it has been a

world-wide spotlight as a counterargument to the traditional view that the regulation

has negative effect on industrial productivity and competitiveness, as it leads to brings

about increased costs for the firm. With respect to the fierce debate, in this paper, I

will do some literature review first, then look into one real life case study about the

performance of a Chinese household-electrical-appliances manufacturing company as

a result of environmental regulation implementation and finally make a simply data

analysis to test the validity and feasibility of Porter hypothesis in China. China, the

biggest developing country, is experiencing a considerable economic growth. Its every

movement is attracting worldwide attention. In the current situation that

environmental problem is on the slide, to realize the collaborative development of

economy and environment, China is devoting itself to environmental conservation

through implementation of various environmental regulations. As a most important

3

player in the world, its actions do not only affect itself but also other countries.

Therefore, testing the effect of environmental regulation in China is significative and

meaningful. In this way, my research question is formed: Chinese industrial

enterprises’ performance analysis based on environmental regulation—validity

demonstration of Porter hypothesis in China.

2. Literature review on the Porter hypothesis

In this section, I will do some literature review on the Porter hypothesis based on its

main points and opinions of its opponents & proponents respectively.

2.1, Main points of the Porter hypothesis

2.1.1, There is not necessarily a tradeoff between environmental conservation and

competitiveness.

According to Porter’s perspective, it is not appropriate that the traditional dichotomy

regards environmental conservation and firm’s competitive power as two mutually

conflicting parties. Strict environmental regulations can spur on firms to undertake

technological innovations, which help firms to be more internationally competitive.

Therefore, there is not necessarily a tradeoff relationship between them (Porter, 1991).

In traditional concepts, environment protecting activities will impose a heavy

economic burden on firms, which always causes people to think of the tradeoff

between social welfare and private cost. Nevertheless, on the contrary, Porter thinks

that only in a static model, can the tradeoff between environment and economy be

inevitable. In such a model, firms seek for cost minimization while holding

technologies, products, producing processes and customer demands fixed. Once they

have to make extra investment in the environmental conservation, their production

costs will be necessarily increased, which do harm to their competitive power. Porter

4

points out that in the recent 2-3 decades, international competitiveness has not been an

issue in a static model any more, but a new dynamic model instead, which is

established on the basis of innovation. Generally speaking, firm’s being more

competitive means that it has higher productivity or lower cost than competitors.

Varieties of case studies show that the reason why some big companies can be

internationally competitive is not that they use the cheapest production inputs or have

the biggest scale, but because they are capable enough to keep with technological

improvement and innovation; competitive advantages are not achieved through the

static effectiveness or optimization with restricted conditions, but achieved by

changing the original restriction owing to the innovative capability to enhance

productivity.

2.1.2, A dynamic viewpoint is necessary to measure competitiveness.

Porter thinks that in order to respond to the dynamic trend of international

competition, every country should revise its traditionally static analysis model and

instead, a dynamic viewpoint is necessary to measure and assess the relationship

between environmental regulation and competitiveness. In such a case, the focus of

regulation should be fixed on the final result instead of process (Porter, 1991). As is

expounded by Porter, during the process of pollution control, it is possible for firms to

be less competitive at the beginning because of increased costs, especially in the

international competition, facing other foreign competitors who do not take

pollution-control activities, they have temporary competitive disadvantage. However,

since nothing is kept constant for ever, their continuous technological progress will

urge them to adjust production processes: adopt innovative technologies to reduce the

lavishness and make the production more efficient and then improve productivity. In

this way, environmental regulation can stimulate technological innovation and owing

to the innovation, firms can finally become more competitive as well as reducing

pollution. Porter thinks that the reason why traditional economists hold opponent

attitudes is that they have made some hypothesis not conforming to the real

5

competition model—assuming that the firm is experiencing a static competition

model. According to their points of view, without the supervision of regulation, the

firm will go to exploit every beneficial business opportunity and not ignore the

so-called regulatory benefits by Porter. However, in the real life, the firm is locating in

a dynamic environment that its production input combination and technology are

continually changing and innovated, which leads to its failure in making the actually

optimal strategic decision and miss some profit-seeking opportunities. As a result, as

long as there is some stimulating power behind (regulation), there are still various

beneficial opportunities such as engagement in pollution control activities existing in

reality, which are waiting for the firm to exploit. For example, environmental

regulation enforces the firm to undertake pollution control, which stimulates its

technological innovation and then improves productivity and bring about competitive

advantage to the firm finally. Consequently, Porter has the idea that appropriately

designed regulation can stimulate the firm to carry out more technological innovation,

improve the producing procedure such as designing a procedure with little pollution

that conforms to the environment protecting criteria and produce products that have

more applicable efficiency: reducing the use of scarce resources or toxic resources on

one hand and recycling resources that are nor used effectively on the other hand. In

such a case, innovation not only mitigates the economic burden, but also improves

product quality and reduces production cost at the same time and then enhances firm’s

productivity and improves product’s competitiveness. To support his standpoints,

Porter (1991) cites 3M as an example to illustrate the relationship between

environmental regulation and competitive power. Since 1975, owing to its

implementation of pollution control strategy, it has saved expenditures of more than

480 million dollars and because of elimination of 0.5 million ton wasted materials and

pollution, energy using expenses have been reduced by 650 million dollars. This fact

shows that the investment in pollution control will not impose any economic burden

on the firm. Instead, it can offset those increased costs by innovation and then make

the firm more competitive. In brief, regulation can trigger innovation offsets through

substitution of less costly materials or better utilization of materials in the process

6

(Porter and van der Linde, 1995).

2.1.3, Type of regulation

In Porter’s study about environmental economics, there are three main instruments for

environmental policy making, which are emission quota, environmental taxes and

tradable permits. Emission quota sets an upper limit of emissions for polluters, which

commands them to carry out production within some constraints. As a

standard-oriented instrument, the tax here is based on price-standard approach

(Baumol & Oates, 1971), which achieves a specific emission target that does not have

to be Pareto efficiency. In other words, the implementation of taxes can make

someone better off without harming anyone else. In the assessment of these

instruments, Porter expounds the comparison between them. He points out that for the

design of regulatory criteria, government should think about carefully whether they

have included the use of market incentives, including pollution taxes, deposit-refund

schemes and tradable permits. In his opinion, pollution taxes can be implemented as

effluent charges on the quantity of pollution emissions, as product charges based on

the potential pollution of a product. Under a tradable permit system, like that included

in the recent Clean Air Act Amendments, a maximum amount of pollution is set, and

rights equal to that cap are distributed to firms. Firms must hold enough rights to

cover their emissions; firms with excess rights can sell them to firms who are short.

Such instruments as pollution taxes and tradable permits often allow considerable

flexibility, reinforce resource productivity, and also create incentives for ongoing

innovation, whereas mandating outcomes by setting emission quota is not able to

provide firms with enough incentives for their efforts into continuous innovation.

Furthermore, the implementation of emission quota policy will also tend to freeze a

status quo. In this situation, firms will only comply with it reluctantly rather than

engage in environmental conservation willingly and consequently, the outcome may

be far behind the expectation. In contrast, if there are enough market incentives, firms

will have great enthusiasm to carry on innovation actively and the technological

7

outcome achieved therefrom is likely to exceed current standards.

2.1.4, Cleaner production and end-of-pipe

Typically speaking, there are two different types of environmental technologies that

eliminate negative environmental impacts: cleaner production and end-of-pipe

technology. Cleaner production reduces the use of resources and pollution by using

cleaner products and producing procedures while end-of-pipe technology limits

pollution emissions by implementing add-on measures. Uncompetitive firms in the

first place are less able to innovate in response to environmental pressures, and thus

be prone to end-of-pipe solutions whose costs are easily measured, whereas

competitive industries are capable of addressing environmental problems in

innovative ways that have a lower compliance cost. Therefore, cleaner production is

considered in preference to end-of-pipe technology. In such a case, Porter and van der

Linde assert that “the environmental regulation should encourage product and process

changes to better utilize resources and avoid pollution early, rather than mandating

end-of-pipe or secondary treatment, which is almost always more costly” (Porter and

van der Linde, 1995, p.111).

2.1.5, Government plays a role of stimulator

Although the firm engages in pollution control activities and benefits from

technological innovation, however, because of information asymmetries, a lot of firms

hang back and ride the fence. Therefore, government regulation is imperative to

stimulate the firm to take actions without so much fear and hesitation (Porter and van

der Linde, 1995). In Porter’s opinion, he thinks that from a long run perspective,

although environmental regulation will positively affect firms, however, because of

sudden cost increase in the short run, firms can produce uncertain and unsafe feelings,

together with information asymmetries, they are likely to ignore some investment

opportunities and fail to make an optimal strategy. In such a case, government

8

regulation is regarded as an intermediary to stimulate innovation. Porter points out

only in a statically optimized framework together with complete disclose of

information, can the strategy to seek for the profit maximization work. Nevertheless,

with the dynamic competition model in the real life, because technology is changing

over time, there is a potential space filled with endless innovation and improvement,

accompanying highly incomplete information and managerial inefficiency, firms

cannot make the actually optimal decision. As a result, once they improve technology

and enhance interior management, the potential improvement space will also be

enlarged, which creates more benefits. The role of the government is to implement a

strict environmental regulation to urge firms to recognize every potential

profit-making opportunity, revise the initial production combination and make an

optimal strategy for the profit maximization. Furthermore, taking the example of

American energy-saving plan, Porter illustrates a truth that the implementation of

environmental policy needs firm’s coordination to comply with its standards and

being aware of the profit-making opportunity to engage in pollution control and then

the environmental policy can be carried out efficiently.

2.1.6, Well designed regulatory criteria

Porter hypothesis is built on the basis of a “well-designed environmental regulation”,

which requires that the regulation has to be based on the market mechanism and have

a stimulation effect on firms. As is expounded, an environmental regulation, which is

helpful for the improvement of competitiveness, must have several criteria as follows.

First of all, it has to provide firms with a big innovation space so that the regulatory

objective can be achieved by flexible means. Secondly, the regulation should be able

to promote continuous innovations instead of focusing on a specific technology and

realize its objective through the stimulation on innovations. Thirdly, the regulation

should be implemented step by step in order to minimize uncertainties. Based on its

operational scheme and feature, the regulation can be classified into two types, which

are market-oriented stimulating regulation and command-and-control regulation. A

9

well-designed regulation is mainly directed at the former that without market-oriented

regulatory measures, the further conclusion of Porter hypothesis cannot hold. In short,

a strict environmental regulation with appropriate design can enable the firm to

produce big-scale innovation and innovative compensation effects while a relatively

loose regulation can only increase pollution control costs without any innovative

effects: at most, it only uses the end-of-pipe approach or remedial measure afterwards.

Stricter regulation focuses on making the firm pay more attention to its pollution

emission, urge it to adopt radical solution starting from updating products and

producing procedures. Although the cost is increased in the short run, however, owing

to the offset effect of innovation, the firm will reduce its net costs and even obtain net

profits finally.

2.1.7, First-mover theory

Porter thinks that when the domestic regulation correctly foresees and represents the

international trend of environmental conservation, then firms in this country can get

competitive advantage from the initiative. At present, the international market demand

is trending towards environmentally friendly products. Germany takes the lead to

actualize product recycling standard, which creates a first-mover advantage for

German enterprises in the development of less packed products and enables them to

be leaders in the international market.

2.2, Opponents and proponents of the Porter hypothesis

2.2.1, Fundamental concepts:

It is a unanimous oppugn from almost all critics about Porter Hypothesis that there is

not a free lunch in the world (Jorgenson and Wilcoxen, 1990; Cropper and Oates,

1992; Jaffe et al., 1995; Simpson and Bradford, 1996). Palmer, Oates and Portney

(1995) do not agree with the viewpoint that some painful choices can be avoided

10

when the environment objective is fixed; they warn the government of a “no-cost

paradigm” and argue that there is always a tradeoff between environmental regulation

and firm’s competitive power.

Porter thinks that as long as regulatory criteria are properly designed, then the

regulation can stimulate innovation, which will benefit firms instead of harming them.

However, on the contrary, according to the theoretical framework of neo-classical

economics, now that firms engage in activities to seek for the profit maximization, it

is impossible for them to give up any profit-making opportunities. If everything is

going on as Porter says, not only the compliance cost can be offset by the benefit

produced by innovation, but even a net profit can be created, then it doesn’t make

sense for the firm to give up the investment opportunity. Porter’s saying has

undoubtedly implied that there is not a tradeoff relationship between environmental

regulation and firm’s competitive power, that is to say, firms can get benefits

gratuitously without any extra inputs. If so, then the environmental regulation will

become a free lunch. Therefore, generic critics do not believe in Porter’s opinions and

think that even though enforcing firms to undertake pollution control can admittedly

internalize its external cost and improve the social welfare, however, it will also

deteriorate their productivity owed to the increase in private costs.

2.2.2, Practical feasibility

In Porter’s opinion, as long as the regulation is well designed, it will stimulate

innovation for sure to realize the effect of innovation offsets. This kind of regulation

concentrates on the outcome rather than the transitional process. In other words, there

must be some kind of environmental regulation that can stimulate innovation and

achieve a win-win situation of reducing pollution and benefiting firms simultaneously.

Directed toward this point, Jaffe and Palmer (1997) make a general survey into

current American environmental laws and regulations and they find that there is

indeed a positive relationship between growth in R&D and growth in PACE, whereas

“regulatory compliance costs have no detectable impact on patenting activity” (Jaffe

11

and Palmer, 1997, p.617). Furthermore, Jaffe et al. point that the current information

is restricted to the exact standard of so-called stricter environmental regulation, which

leads to a trouble in the empirical analysis that it is difficult to assess the effect of

regulation on economy through regression analysis. Even though every country has

the information about firm’s PACE, some deviations still exist because of variances in

different measuring methods: even for the U.S, who always has perfect information

about the environment, its information about firms’ PACE is regarded not to be very

reliable either. Simpson and Bradford (1996) directly criticize that even though

Porter’s proposal is workable theoretically, it is really doubtful in practice if the

environmental policy is actually implemented as an instrument to achieve the

industrial objective. Although Porter cites varieties of successful examples in his

literature (Porter and van der Linde, 1995) to prove the positive effect of

environmental regulation on firm’s performance, there are also lots of failing

examples that he does not record. Moreover, the positive effect produced by those

successful examples is not necessarily big enough to offset the negative effect resulted

from failing examples that firms have to spend considerable costs to comply with the

regulation. Therefore, opponents concentrate on the doubt about the practical

feasibility of Porter hypothesis. According to their opinions, Porter’s proposal is too

unrealistic and even though the offset effect is really workable in theory, however, in

practice, there is still lack of enough information accordingly to prove its practicality.

2.2.3, Is regulation the only way to stimulate innovation?

According to Porter’s perspective, traditional analysis all ignores the stimulation

effect of environmental regulation, and then exaggerates the pollution-treatment cost

as a result. A properly designed regulation can stimulate innovation to partially or

completely offset the cost. Opponents think his statement implies that regulation is the

only instrument to stimulate innovation and make firms more competitive. Simpson

and Bradford (1996) doubt this argument that if it is true, then why firms do not

undertake R&D on products or processes directly, but must be restricted by such a

12

cost-consuming regulatory strategy instead. If firms can really benefit from it, then

they will devote themselves into it voluntarily, even though in absence of government

regulation. Therefore, it does not seem very wise to use environmental policy to

stimulate innovation so as to achieve the industrial objective. It might be better if the

government subsidized firms on R&D directly. Although Porter asserts that only the

regulation can stimulate a comprehensive innovation with more cost-efficiency to

make resources be used more effectively. Nevertheless, shown by the study of

Sheridan (1992), if firms carry out a corporate total quality management program to

strictly monitor the producing process and remedy the quality problem in time to

confirm product’s quality and avoid the production of wasted materials, they can also

reduce pollution and benefit from the innovation-offset effect.

2.2.4, Is the strategy optimal?

Porter points out that due to the incomplete information in real life, firms cannot make

an optimal strategy. Furthermore, locating in a constant operational mechanism, firms

have no incentive to look for new technologies to update products or processes

voluntarily while being facilitated by the environmental regulation, they are urged to

start the searching and reconsider those constraints that are not considered before the

regulation in the process of seeking for profit maximization. As soon as they take

account of the restriction into the model of profit maximization, they will adopt a

different strategy and make investment in innovation, which can enable them to

satisfy the requirement at a lower cost. In this way, firms can comply with the

environmental regulation and get more benefits simultaneously. Palmer, Oates and

Portney (1995) don’t agree with that. They expound figure 1 about the correlation

between polluting firm’s cost and abatement level to see how the firm will be affected

by the innovation of abatement technology and whether its R&D investment is

optimal. The original MAC curve represents firm’s current marginal abatement cost,

which indicates the cost incurred by the firm to enhance the abatement level by an

additional unit. Its upward slope implies that the firm’s marginal cost of pollution

13

reduction is rising. As the firm moves down its MAC to , the effect of its

marginal cost on pollution abatement is getting bigger. However, it also has to spend

more money on R&D about new technology, which is necessary for the shift. In this

model, market-oriented regulators use emission charges to encourage pollution

abatement. As long as the cost in pollution abatement is less than emission charges,

the profit-maximizing firm will do it willingly. However, after the point where the

abatement cost is more, the firm will make an opposite choice. In this model, it is

assumed that the firm initially faces an emission charge of P, and it chooses a

profit-maximizing level of abatement at A in accordance to B, where the cost is equal

to the emission charge. Besides the cost, this figure also depicts benefits to the

polluting firm from its R&D efforts, which are embodied by the cost reduction in

original abatement on one hand and new technology on the other hand. The total

benefits gained from innovation are represented by the area of OFCB, which cannot

offset the cost of R&D efforts that move the firm from MAC to if the firm is

operating at A. Now, a more stringent environmental standard is introduced and the

emission charge rises to

*MAC

*MAC

"P . No matter whether the firm will keep the old technology

and end up at H or invest in a new one and end up at D, generated profits are both

lower than B. Therefore, there is no ambiguity that a higher emission standard reduces

firm’s profits. Thus, they conclude that “in this model of innovation in abatement

technology, an increase in the stringency of environmental regulations unambiguously

makes the polluting firm worse off. Even if the firm can invest and adopt a new, more

efficient abatement technology, if that technology wasn't worth investing in before, its

benefits won't be enough to raise the company's profits after the environmental

standards are raised, either” (Palmer, Oates and Portney, 1995, p.125). In such a case,

it is not optimal for the firm to make R&D efforts into the technological innovation.

14

Figure 1

Jaffe et al. think that Porter’s statement implies that firms are not operated in

production possibility frontier, which has to be thought about prudently. To invest in a

new technology, firms have to devote extra costs. Suppose initially, they do not find

any new technology that is more efficient and they do not adopt any new until the

regulation enforces them to do it, then their initial strategy before the regulation is still

efficient because in reality, there must be a lot of feasible and efficiency-improving

approaches. However, to look for them and put them into practice, firms have to make

more related investment. Suppose a firm has successfully invested in a

benefit-enlarging approach then its strategy, which has been sub-optimal before the

investment is still efficient. However, restricted by its limited resources, it does not

focus on whether it can find new production procedure to increase benefits, but

focuses on whether it can get more and better approaches to increase benefits resulted

from the searching job triggered by the stimulation of innovation than by other means,

whereas Simpson and Bradford (1996) think that in the real situation, firms

sometimes inevitably ignore many benefit-making opportunities at cost saving. They

cannot recognize them until a strict regulation urges them to be aware of them.

15

Nevertheless, this fact does not say that the pre-regulation strategy is not optimal,

because no one can guarantee the uncertain benefits from innovation are big enough

to offset those extra costs induced by the increase in firm’s marginal cost and

investment in pollution control.

2.2.5, Is there any tradeoff between environmental regulation and competitiveness?

In Porter’s opinion, traditional analysis either exaggerates the real cost of regulation

or underestimates innovation’s benefit, which brings about a unanimous finding from

varied studies that environmental regulation will increase cost and make firms less

competitive. They all get a consensus that the environmental regulation brings firms

too high a cost that it has been a heavy burden on the industry. With respect to this

finding, Porter emphasizes that the tradeoff is undoubtedly inevitable if the innovation

factor is neglected. Besides, there is not sufficient evidence to show the negative

effect of environmental regulation on competitiveness based on the empirical analysis

of previous literature (Meyer, 1992; Leonard, 1988; Repetto, 1995). Porter shows that

proved by the practical evidence, the cost of environmental regulation is tiny relative

to GDP or total production cost, which only takes up 2-3% of GDP (Cropper and

Oates, 1993; Jaffe et al., 1995). In such a case, it will not cause an adverse shock to

the economy. As a proponent for Porter, Berman and Bui (1998) inspect the effect of

American air quality control Act in the petroleum refining industry between 1977 and

1993, during which period America gradually raises environmental standards. The

result reflects that firms in regions with stricter regulations improve productivity more

quickly than those ones in regions with relatively loose regulations. It is because the

former has adopted new technologies by force of pressure from environmental

regulations. However, Palmer et al., think that although the percentage is very small,

due to the diversity of different countries in labor, material cost, capital cost and

exchange rate fluctuation, such a small percentage can still be strong enough to affect

a country’s economic development, and even result in a recession. Furthermore, in

many countries, especially developing countries, some firms have undertaken

16

environmental conservation overly, which consequently restrict their competitive

advantage. Additionally, some transnational enterprises are inclined to build facilities

with low pollution, even though in a region without any regulation. Therefore,

although a stricter environmental regulation does not affect the competitive status of

America, it is not enough to support Porter’s argument about the cost-offset effect.

Porter’s proposition implies that the environmental regulation is costless because

costs will be finally offset by benefits. With the example of American manufacturing

industry, Jaffe et al., make an empirical study into the relationship between the

regulation and firm’s competitive power. Based on the result, there is not clear

evidence to support the argument that the environmental regulation can facilitate the

promotion of international competitiveness. The cost of regulation is so high that it

will do harm to industrial competitive performance, which indicates a mutual-

tradeoff relationship between them.

2.2.6, Doesn’t the investment in innovation have a crowding out effect?

Porter thinks that in the production process, firms produce pollution emissions to

cause some inefficient use of production resources. In order to improve their

productivity, firms engage in some activities to comply with the environmental

regulation, which urges them to take a comprehensive innovation. As a result, their

costs of supervision, remedy and maintenance are reduced and they can achieve a

win-win outcome of reducing pollution and improving productive efficiency at the

same time. What is more, the investment in pollution control is only too small a part

of total investment to hinder them from engaging in other investment activities.

However, according to Simpson’s and Bradford’s opinion, granted that a strict

regulation can actually make the firm more competitive, the firm will be likely to

crowd out other investment plans that are more beneficial for them because of its

investment in pollution control.

2.2.7, Attitudes towards environmental problems

17

According to Porter’s opinion, the regulation is appropriate only if it turns its

consideration of the environment into the requirement for competitive advantage.

Previous studies on the environment restrict firm’s abilities in technological

improvement and innovation and only concentrate on the pollution abatement and

elimination afterwards instead of the precaution in advance. In future, when the

related department implements the regulation, it should actively stimulate firm’s

technological progress and adopt an inducement mechanism to achieve the objective

of environmental conservation rather than only restrict firm’s pollution emissions

passively. If the method adopted is correct, then efforts into environmental

conservation will certainly bring about a positive effect on the competitiveness.

However, on the contrary, Simpson and Bradford criticizes that Porter’s proposition is

a something-for-nothing argument, which attempts to persuade the government to

implement a stricter environmental regulation by asserting the attractiveness of a

win-win outcome. Nevertheless, its feasibility is doubtful to use a phenomenon that

does not have a normal state as a suggestion for the implementation of practical policy.

The whole society should try to improve the environmental quality from a more

meaningful aspect and make a pragmatic research into how to allocate the heavy

burden of environmental issue in a realistic manner instead of prating about any

unconstructive proposition that arises so many disputes like Porter. Furthermore,

Palmer et al., also emphasizes that before the implementation, every proposal has to

be tested for its social value by means of cost-benefit analysis, which uses the

comparison between input cost and benefit arising therefrom to measure the economic

benefit rather than assume a wrong premise of cost-free regulation in advance.

Moreover, according to the perspective of Jaffe et al., what the government should do

is not to implement a strict environmental regulation that might lead to a high cost,

but to establish a preferential focus and objective of the regulation, which include

some inevitably produced tradeoff resulted from the regulation and try to carry out a

cost-effective policy instrument under the principle of cost-benefit balance.

18

3. Case study: Haier

As the biggest developing country, China is confronted with an even bigger problem

about how to realize the balance between the environmental conservation and

industrial performance improvement. In this section, I have a look into a real life case

about the strategies that a world-famous Chinese manufacturer adopt in response to

the environmental regulation and test what kind of relationship exists between

regulation and their competitive performance. Haier, who has realized a transition

from compliance with criteria to setting up criteria owing to the independent

innovation. Its products successfully entered European and American markets, which

indicated that in the background of globally economic integration, enterprises from

developing countries had to cope with technological barriers implemented by

developed countries and only if by means of independent innovations, could they gain

the competitive advantage.

3.1, Two directives from the European Union: effect on exports of Chinese traditional

household appliances (WEEE and RoHS directive)

The European Union formally implemented WEEE directive in August, 2004, which

has caused a preliminary effect in exports of Chinese related products. Those products

involved in the directive include white goods, small household appliance, lighting

equipments, toys and other 6 types of products. Whereafter, it implemented another

directive called ROHS, which affected exports of Chinese traditional household

appliances and products with low added values, such as miniature measuring

instruments. The effect in the former is relatively smaller than the latter because

information, telecommunication and digital products have higher technological

standards and selected materials are always environment-protecting materials.

Therefore, most of them have cohered with EU criteria. Another reason is that those

products have high added values and 90% of them are exported by means of

processing trade. Therefore, they are affected less by recycling expenses. These two

19

directives have a bigger effect on the latter mainly because recycling expenses of

waste products, new-material replacing and adoption of new environment-protecting

technics will all increase firm’s producing and managerial costs whereas traditional

household appliances have low added values. Therefore, increased costs will have a

bigger effect in this kind of products.

3.2, Technological innovation of Haier

In fact, Haier came across green barrier when it exported its electric refrigerators and

washing machines to America and European Union in 1999. Haier took it as an

opportunity, successfully passed the certification of ISO14000 and became Chinese

first enterprise that passed the certification. Additionally, the green refrigerator

developed by Haier in accordance with European environment-protecting legislation

and technical requirement became Chinese first household appliances product marked

with the environment-label.

Haier took the initiative to establish the firm-specific database system of domestic and

foreign patents, which was suitable for itself and build up pointed patent-document

base depending on product categories and technological fields. Attributed to the

development of database, Haier could dig for more technological innovation

opportunities from an international range and look for technological cooperators to

carry out strategic comparisons. Developers made searches and analyzed former

patents before getting down to the development of some product or technology in

order to keep away from and exceed existing patents. As a result, owing to its

effective innovation and establishment of new intellectual property rights, Haier was

able to improve its developing efficiency and capability. Additionally, it set up the

managerial institute of intellectual property right to guide all staffs to cultivate the

awareness of the right, providing the firm with a reliable guarantee to improve its

capabilities on the creation and application of the right.

With more and more products exported abroad, Haier has been gradually increasing

its foreign-patent application percentage as well as making efforts to apply for

20

domestic patents. Till the first half of 2005, it had obtained 5469 Chinese patents

accumulatively, 582 of which were got in 2004. Shown from its sales report,

environment-protecting two-motor washing machine is the product sold most quickly

at the end of 2005. This innovative product was regarded as the fourth kind of

washing machine by the global market and had been exported to more than 10

countries. Its price in the international market was 3 times higher than other

conventional washing machines. It was also listed in the proposal of international

criteria by some related international organization. In this way, Haier started to lead

the formulation of washing machine criteria in the world. Furthermore, the

independent innovation schema explored through the process of developing the

environment-protecting washing machine enables Haier to obtain 70 more patents for

new products within 1 year. The washing machine series, which owned most patents

also earned the highest profit rate for the firm in 2005.

3.3, Transitions from innovative products to innovative international criteria

Haier realized a transition from innovative products to innovative international criteria.

After it obtained patent protections from technological innovations, it turned into the

competition for criteria from competition for patens. So far, it has participated in the

setting and modification of 86 Chinese national criteria accumulatively and possessed

5730 enterprise standards.

On the basis of continuous independent innovations, Haier achieved a breakthrough

development from a single technology to integrated innovations. The process of its

technological innovations indicates that technological innovations aim for the

possession of products with international competitiveness rather than for the

technology itself. Innovations broken away from products that can match the

requirement international competitiveness are valueless. Firm’s core competitive

power is not reflected by the difference in element resources. Instead, it is created by

the dynamic technological innovations, which is in accordance to Porter’s concepts.

21

4. Data analysis

In this section, by means of data analysis, I will look into the real situation of China

about its implementation of environmental regulations and the effect arising therefrom

to test the feasibility of Porter hypothesis in China.

4.1, Data description

1) R&D: technological innovation is undertaken based on the capital investment. Its

level cannot be improved without the guarantee from strong capital power. Therefore,

R&D expenditure is an important index to measure the level of technological

innovation. In Porter’s opinion, a stricter regulation can stimulate more innovation

and finally result in an increase in profit. Here, we do not have any data about how

firm’s profit is changing over time but instead, we have data about R&D expenditures

collected from China S&T Statistics yearbook of 1998-2007. Its growth is a necessary

condition for the profit increase.

2) PACE: PACE is an important measurement about the regulation intensity. When

the regulation gets stricter, firms have to spend more money on pollution treatment

and the cost is increased with the improvement of regulation intensity. Therefore,

PACE is good indicator to well reflect the intensity that firms are confronted with. To

show the trend of PACE investment in China, I collect related data published in China

environment yearbook of 1998 to 2007.

3) Patent: different from R&D and PACE, patent is the output of technological

innovation instead of input. It is a good measure to reflect firm’s innovative capability

and level. Because there is a lag existing between patent application and authorization,

I use the quantity of patent application here instead of patent approval. The data about

patent application are also collected from China S&T Statistics yearbook of

1998-2007.

4.2, data analysis

22

With the help of excel, I do a simple statistical analysis into the data mentioned above

and make two scatter plot graphs to show the correlation between 3 variables. The

upward straight line can reflect a general trend about the effect of environmental

regulation in China from 1998 to 2007. From the result, we can see that in the long

run, environmental regulation has some stimulation effect on technological

innovations of Chinese enterprises: every 1% increase in pollution treatment

investment results in a 0.26%-increase in R&D expenditures and 0.3% in No. of

patent applications respectively. These statistical data tell us a truth that China has

been making more and more efforts into pollution abatement and control. In response

to government’s enhancing power in the environmental conservation, firms are aware

that they cannot stick with their old products or technologies any longer and go no

further. Instead, they have to think over what they should do to deal with those

potential challenges from the trend. Linear regressions above give the answer: they

make more investment in R&D aiming for product innovation and technological

progress. As a result, there is a continuous growth in patent applications. This finding

is consistent with the hypothesis that environmental regulation can stimulate

innovation. However, I cannot affirm whether this increase in R&D is only a

diversion from some other R&D efforts of the firm or the evidence to prove that

regulation can awake firms to think in new ways about their productions. Moreover, it

is also ambiguous how this finding will change cost-benefit analysis of regulation.

Furthermore, because of the difficulty in classification by industries and shortcomings

of using pollution treatment expenditures as a measure of regulatory stringency, there

is still a long way to go before this result can be summarized into a definite

conclusion.

23

y = 0.2609x + 0.2526

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

0.0% 10.0% 20.0% 30.0% 40.0%

growth of investment in pollution treatment

growth of R&D expenditures

y = 0.3948x + 0.2289

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%

growth rate of investment in pollution treatment

growth rate of No.of patent

application

5. Conclusion

Based on the analysis above, it can be seen that even though Chinese environmental

regulatory policies cause some cost burden on firms, they can also spur on firms to

recognize challenges and opportunities in front and carry on innovation willingly. In

this way, firm’s competitive performance is improved, which is reflected in growing

patent applications. It seems that this causal relationship partially proves the validity

of Porter hypothesis in China. However, there are still some ambiguity remaining in

the data analysis and many unanswered questions, such as whether the R&D efforts

24

inspired by regulation can reduce production costs or bring about new products and

finally increase firm’s profits. In such a case, we cannot be so subjective to conclude

that as long as there is a positive relationship between growth in compliance costs and

R&D, Porter hypothesis is completely valid. Instead, we need to take a critical attitude

towards the result of data analysis and think over how the data should be improved in

order to be more reliable.

6. Recommendations

With the acceleration of industrialization, industrial pollution is more and more

deteriorated day by day and simultaneously, regulatory intensity is increasingly

enhanced. As China is experiencing considerable economic development, there is a

big dilemma between environmental conservation and economic development;

pollution control and firm’s performance. Therefore, it is imperative for the industry

to try its best to reduce the adverse effect of environmental regulation on its

performance together with its compliance with the regulation so that a win-win

objective of pollution abatement and performance improvement can be achieved.

Based on the conclusion of this paper, there are some recommendations I would like

to put forward.

First of all, the government should appropriately improve the standard and intensity of

environmental regulations to further stimulate technological innovations. Through the

compensation effect of innovation, those negative effects on firm’s performance can

be offset and exceeded. According to the empirical analysis in the paper, at present,

the intensity of stimulation in China is small. Therefore, the compensation effect of

innovation is not big enough to completely offset all adverse effects. In such a case, it

is suggested that China should improve the regulatory intensity in order to enhance

the stimulation and take full advantage of innovation’s compensation function to

realize a win-win situation.

Secondly, we should choose a best policy instrument that can stimulate the

technological innovation to a biggest extent. Although enhancing the regulatory

25

intensity is important, the improvement cannot be endless. With the intensity fixed,

the government should choose a policy instrument to maximize the stimulation. For

example, seen from the research, some instruments based on the market, such as

pollution taxes and the tradable pollution permits system can greatly promote the

innovation. Therefore, China should actively and stably push on the revolutionary

practice of environmental regulatory policy instrument so as to maximize the

innovative effect as well as achieving the objective of pollution control.

Finally, regulated firms should adopt active strategies in response. They can carry out

clean production, develop ecological industry, undertake recycling economy, and

make full use of compensation effect of technological innovation to eliminate

regulations’ negative effects on firm’s performance. The effect of regulation not only

reflects the quality and validity of policy itself, but also reflects the industrial

capability and level in response to the regulation. As parties being regulated, firms

should have the awareness that environmental regulation is not only the arch-criminal

for the deterioration of industrial performance; it is also the opportunity, by which

they can improve economic performance and obtain the competitive advantage.

26

7. Appendix

Comparison between proponents and opponents of Porter hypothesis

Proponent Opponent

Assumptions Dynamic model:

technology is changing

over time

High information

asymmetries

Failure of firm’s interior

organizations

Static model:

Technology is fixed

Products and producing

process are fixed

Consumer demands are

fixed

Complete information

Model Profit-maximization Cost-minimization

Restrictions from

environmental regulations

Regulations-stimulate

innovations-reduce

costs-improve competitive

advantages

Regulations-internalize

external costs-increase

costs-destroy

competitiveness

Regulation player Media that stimulates

innovations

Extra costs imposed on

firms

Suggestions

Do not passively engage in

remediation after

something bad has

happened; actively

participate in the pollution

abatement and control

Do not only put forward

instigating theories; take

some pragmatic actions to

allocate the burden of

environment

27

8. List of references

Baumol, W. J. and W. E. Oates, 1971, "The Use of Standards and Prices for

Protection of the Environment". Swedish Journal of Economics 73: 42-54.

Cropper and Oates, 1992, “Environmental Economics: A Survey,” Journal of

Economic Literature, in Stavins, Chap. 4

Eli Berman & Linda T. M. Bui, 2001. Environmental Regulation And Productivity:

Evidence From Oil Refineries. The Review of Economics and Statistics, MIT Press,

vol. 83(3), pages 498-510.

Jaffe, Adam B. and Palmer Karen, 1997. "Environmental Regulation And Innovation:

A Panel Data Study," The Review of Economics and Statistics, MIT Press, vol. 79(4),

pages 610-619, November.

Jaffe, Adam B., Steven R. Peterson, and Paul R. Portney. "Environmental Regulation

and the Competitiveness of U.S. Manufacturing: What Does the Evidence Tell Us?"

Journal of Economic Literature, March 1995

Jorgenson, Dale W. and Peter J. Wilcoxen (1990), “Environmental Regulation and

U.S. Economic Growth,” The Rand Journal of Economics, 21(2), pp. 314-340,

Summer.

Leonard H. J., (1988), Pollution and the Struggle for the World Product: Multinational

Corporations, Environment and International Comparative Advantage, Cambridge

University Press.

Meyer, S. (1992), ‘Environmental and economic prosperity: testing the environmental

impact hypothesis’, unpublished manuscript, MIT.

28

Palmer, K., W.E. Oates and P.R. Portney, 1995. “Tigthening environmental standards:

The benefit-cost or the no cost paradigm.” Journal of Economic Perspectives, 9:

119-132.

Porter, M.E ”America’s Green Strategy”. Scientific American, No. 168, April 1991.

Porter, M.E & C. van der Linde, 1995, Toward a New Conception of the

Environment-Competitiveness Relationship, Journal of Economic Perspectives 9,

97-118.

Repetto, R. 1995. Jobs, Competitiveness, and Environmental Regulation: What are

the Real Issues? World Resources Institute, Washington, D.C.

Simpson, R. D. and Bradford, R. L., III. 1996. Taxing variable cost: Environmental

regulation as industrial policy. Journal of Environmental Economics and Management.

30 (3): 282-300.

29