The effect of environmental regulation on environmental innovation

Environmental expenditure estimates resulting from US environmental policy are based on current technology which may overstate policy's true costs. Existing evidence shows that ex ante cost estimates are greater than realized costs due to unexpected technological progress. This research programme asks whether innovation is a response to environmental regulation or whether the true regulatory compliance costs are overestimated ex ante when technological advancement is ignored? The author conducts an empirical study of the US manufacturing industry's environmental patent activities and environmental regulation as measured by pollution abatement and control expenditure (PACE) data. She finds a statistically significant positive relationship between environmental regulation and innovation when estimated by ordinary least squares (OLS). However, the OLS coefficient of pollution abatement costs is inconsistent because of a correlation between the explanatory variable and unobservable variables. Two-staged least squares addresses the inconsistency problem, resulting in positive and significant PACE coefficients. Thus, there is evidence that innovation is a response to environmental regulation.