An idea commonly heard in the entrepreneurial community is that stronger government regulations mean less profitability. However, new research from the University of Kansas (KU) suggests that more-stringent regulations, when coupled with a light-touch enforcement approach, often lead to more profitability for private companies in the long run.
Dietrich Earnhart, a KU professor of economics, and Dylan Rassier, a KU alumnus and an economist with the U.S. Bureau of Economic Analysis, studied the effects of the U.S. Clean Water Act and its implementation by the U.S. Environmental Protection Agency (EPA). The study provides support for "the Porter hypothesis," formulated by economist Michael Porter in 1995, which states that strict environmental regulations could lead to innovation and improved efficiency that would ultimately improve a company's ability to compete.
The study rests on the idea of "effective regulatory stringency," which the authors separate into two parts: legal requirements and government attempts to enforce compliance. The researchers examined government inspection data from the EPA's Permit Compliance System database and used U.S. Securities and Exchange Commission filings to determine profitability for publicly traded firms. Comparing the two sets of data, Earnhart and Rassier found that when regulations are strict but enforcement actions are infrequent, companies are more likely to innovate and, thereby, increase their future profitability.
"If an environmental agency pushes hard on a pollution limit, but does not monitor the limit too stringently, the agency creates a space in which companies can be creative and discover ways in which they can either market their environmental protection efforts to customers and secure a bigger market share or find less costly ways of manufacturing their products or dealing with waste," Earnhart, the lead author, said in a statement. "The regulations put a different pair of glasses on companies. By looking through a new lens, companies get creative."
Specifically, in the case of the Clean Water Act, the researchers found that when wastewater-discharge limits were strict and government inspections were commonplace, profits declined; those results follow the conventional line of thinking, that regulation inevitably stifles economic growth. However, when enforcement actions and inspections were infrequent, companies tended to experience more profitability, a trend that is consistent with the Porter hypothesis.
Earnhart suggested that by working to reduce discharged wastewater, companies more thoroughly examined their operations and created new, more efficient management practices. Moreover, the ability to market themselves as environmentally friendly may have helped them achieve a larger market share, Earnhart said.
"With a new perspective and with new information, these companies could find a way to defy conventional wisdom," Earnhart said. "Any agencies working on clean-water or clean-air regulations should be concerned about how they induce compliance and what the trade-offs are. If there is a win-win situation, everyone should want to learn about it."