Indirectly Induced Innovation: Consequences for Environmental Policy Analysis

Environmental regulation is increasingly judged on its ability to stimulate innovation. While prior studies focus primarily on the direct effect on innovation by regulated firms, this paper examines the importance of indirectly induced innovation by both regulated and unregulated firms. Two channels for indirect effects are considered: passthrough of regulation-imposed costs into output prices and knowledge spillovers. Both are well-documented phenomena on their own, but their consequences for innovation by unregulated firms are largely ignored. This paper uses simple models to illustrate such effects and the resulting bias in standard policy analysis, then employs dynamic count models to empirically test these claims in an application to the European Union Emissions Trading System. Estimates suggest that indirect effects of regulation on innovation are at least as large as commonly estimated direct effects. Indirectly induced innovation may thus form an important part of the overall innovative response to environmental regulation.