Negative incentives to tackle market failures or empowering market incentives to foster voluntary environmental engagement

Other institutional solution aimed at internalising externalities is the introduction of negative incentives into the regulatory system, to reduce polluting activities and promote innovation. The second of these two goals can only be achieved (although not in every case) if there is a fierce competition in the sector with multiple actors and where the lack of innovation activities would result in competitive disadvantage and loss of market power. Essentially, it

96 depends on market institutions and formal economic institutions as to whether negative incentives can exert an innovation-promoting effect or whether instead they result in the reduction of production and/or inflation. It can be supposed that if a company reacts to environmental restrictions by innovating (despite reducing its production), it could meet environmental standards with the same or even higher productivity (Figure 8). Consequently, an ecotax will not put extra charge on production and the firm can remain competitive in prices (FEIERABEND 2011).

Figure 8: The effect of technological innovation on productivity, meeting GHG reduction goals Source: FEIERABEND 2011, p. 130.

Consequently, technological innovation results in a more cost-efficient production method with better environmental performance. As the production possibilities curve shifts up, pollution norms can be met or overperformed with higher productivity.

If it is so, why do economically and technically supportable innovations not become a reality? The reasons for this can be due to market imperfections, and the internal characteristics of the enterprise, which can be analysed from a behavioural economic approach. There is a time lag between the initial (high) investment costs and the return on investment. There can be a substantial conflict of interest between the owners (with long-term interests) and managers (with short-term interests), the latter tending to be risk averse. Complex decision-making processes might prevent environmentally efficient innovations from being carried out due to market risks, and another reason might be companies having negative cash flow at the beginning of the innovation process. Companies might tend to make suboptimal technical changes to meet environmental requirements while reducing the amount of taxes to pay.

97 4. Do environmental regulations ensure better environmental

performance?

On a theoretical basis I have argued that environmental policy measures, positive and negative incentives might not achieve the desired environmental goals. In my empirical analysis I will use the Environmental Policy Stringency (EPS) index developed by OECD⁴⁷ to measure the depth of environmental policy measures, and I would like to analyse whether there is a correlation between EPS and environmental performance (measured in CO2 emissions per GDP PPP, on 2015 basis).

Since policy measures generally have their effect in the long run, and not instantly, I will carry out a statical linear regression analysis with 3, 5 and 10 years of time lag. The latest data on EPS is of 2012 for all countries involved in the analysis⁴⁸.

The result of the linear regression (Table 3) suggests that there is practically no correlation between environmental policy stringency and environmental performance. We have a similar result (R² = 0.011) in case of running linear regression on EPS (2012) and

Table 3: Statistical relationship between CO2 emissions (CO2/GDP as of 2017) and EPS index as of 2012, analysed in SPSS

Source: The author

Thus, there arises the question: if environmental policy measures do not explain differing environmental performance among developed countries, what factors does it depend on?

My assumption is that economic and political institutions do matter and institution stability can have an innovation-promoting effect by affecting market environment in a positive way, entailing market mechanisms. To measure economic and political stability I have prepared a composite indicator with the following factors – indicators prepared by the World Bank – (calculating with 0.2 weight in case of each of them): rule of law, government effectiveness, voice and accountability, regulatory quality, and Doing Business ranks.

47 The OECD EPS index includes market-based policies (taxes, trading schemes, FITs, DRS) and non-market policies (standards, R&D subsidies).

48 The involved countries in the analysis: Austria, Belgium, Czech Republic, Denmark, Finland, France, Greece, the Netherlands, Ireland, Poland, Hungary, Great Britain, Germany, Norway, Italy, Portugal, Spain, Switzerland, Sweden, Slovak Republic, Slovenia.

98 In a statical analysis I wanted to study the relationship between institutional stability and innovation performance for the above-mentioned group of countries. I measured innovation performance by the Global Innovation Ranking. I found that there is a strong correlation between the governance composite indicator and innovation performance (Table 4).

Model Summary Model R R Square

Adjusted R Square

Std. Error of the Estimate

1 .855^a .731 .722 1.39186

a. Predictors: (Constant), governance

Table 4: Statistical relationship between governance indicators and innovation performance, 2016, analysed in SPSS

Source: The author

On the following figure (Figure 9) we can observe to what extent do Business R&D activities (relative to GDP PPP) determine environmental performance measured by GHG emissions. We can see that actual data points are in line with the linear regression curve. The correlation between Business R&D investments and GHG emissions/GDP resulted to be strong (R² = 0,7). That is, higher R&D performance will result in less GHG emissions.

Figure 9: Business R&D investments and GHG emissions Source: The author, based on OECD data, analysed in SPSS.

99 Empirical analysis shows that there is a strong correlation between innovativeness and environmental performance. Therefore, economic policy measures (not only environmental policy, because it is important to achieve policy synergies when tackling environmental problems) should focus on innovation promotion and fostering low-carbon investments. That means that a proactive policy approach is needed to facilitate economic structural change.

From this perspective, environmental policy stringency, by itself, cannot efficiently face the climate challenge, if it is not embedded in a broader innovation policy which boosts digitalisation, energy efficiency and low-carbon technologies in all sectors, including households. Nevertheless, supportive formal institutions can only achieve their aims if informal institutions also provide a stimulus for clean technology investments.