How institutional pressure affects innovation by firms

In recent years there has been much scholarly attention to firms' environmental strategies, particularly with respect to efforts to reduce emissions that contribute to the global climate crisis. Failure to comply with environmental standards or to reduce pollution often imposes significant costs on firms; both in terms of financial penalties and reputational damage. Given these dire consequences, scholars maintain that firms respond to these escalating institutional environmental pressures by searching for novel technological approaches and thus increasing their rate of innovation.

But – despite extensive research on the relationship between institutional environmental pressures and innovation – the link between the two remains unclear. Most prior studies have treated environmental innovation as a uniform category, failing to provide nuanced distinctions; for example, by equating environmental innovation with any technology that reduces pollution and greenhouse gas emissions. But this ignores the differences between technologies related to renewable energy sources (“green” innovation), improvements to existing fossil-fuel technologies (“brown” innovation) and technologies that reduce firm carbon footprint by improving operational efficiency “general efficiency” innovation). (Notable examples of "green" innovations include wind energy and nuclear-fusion reactors, while "brown" examples include emissions abatement from stationary sources, oil spills and pollution clean-up.)

Innovation in unrelated areas

Additionally, past studies have primarily concentrated on environmental innovations. However, responding to environmental pressures can have broader effects, potentially sparking innovation in unrelated areas. For example, increased institutional pressure for environmental action might trigger search for new business models to eliminate inefficiencies and improve product offerings. In essence, because addressing sustainability challenges often requires a broader change, firms may adopt a more comprehensive approach to innovation, extending beyond energy-related aspects.

Whereas institutional pressures may affect different types of innovation in a distinct way, previous research has often conflated these varied outcomes of environmental innovation and has only minimally addressed innovations not directly related to the environment, despite the potential impact of institutional pressures on these areas as well. Importantly, because different technologies have been considered as equivalent, we lack a more precise understanding of how institutional pressures to meet sustainability demands affect each innovation type. As a result, our understanding of how institutional environmental pressures affect overall firm innovation strategies remains limited.

A broader perspective

To assess comprehensively the impact of environmental pressures on innovation, I, along with my fellow researchers Raffaele Conti from ESSEC and Marcin Kacperczyk from Imperial College Business School, adopt a broader perspective that extends beyond the traditional focus on environmental innovation alone, using an abductive approach. Rather than presenting a set of hypotheses, we aim to identify patterns in how firms allocate resources to different types of innovations in response to institutional environmental pressures.

There are important challenges from the empirical perspective. First, our study requires identifying a context in which the different types of innovation within a firm can be identified; yet observing and separating the different types with precision is prohibitively difficult, because access to detailed information about project type is often limited. Second, establishing a causal relationship between institutional pressures and innovation is non-trivial.

This is for two reasons. First, the link between the two can be spurious if it is driven by confounders that are hard to account for, such as culture. Second, the key relationship may be reversely causal if efforts to produce environmental innovation increase stakeholders’ demand for additional improvements, leading to intensified normative pressures for further pollution reduction.

Using innovation patents, we address these challenges in two ways. First, we categorise patents into environmental and non-environmental innovation. And, within the category of environmental innovations, we distinguish between (i) "green" patents denoting environmental technologies capable of substituting carbon dioxide-emitting technologies with carbon dioxide-free alternatives, (ii) "brown" patents dedicated to technological innovations improving existing fossil fuel-based technologies; and (iii) "general efficiency" patents focusing on technologies designed to enhance process efficiency and so reduce carbon emissions.

Beyond measurement challenges, we address the identification challenge by leveraging the staggered enactment of US state-level Climate Change Adaptation Plans (SCAPs) between 2004 to 2020. These plans increased normative pressures on firms headquartered in the adopting state by making non-binding recommendations for environmental action to address climate change. Using the difference-in-differences estimator, we thus identified the impact of such plans on environmental innovation.

To investigate how institutional pressure influences corporate innovative activities, we focused on the effect of SCAPs on a firm’s patents. There are practical advantages to concentrating our empirical analyses on patents to map firm technologies. First, patent information is completely codified and public. Second, it is possible to distinguish different types of patent, including those directly related to the environment and those that are not.

Causal effect on innovation output

By examining the causal impact of SCAPs on innovation in general, measured as the number of patent applications, we find that SCAPs significantly increase firms’ innovation output, as evidenced by the log of the overall number of patent applications.

Specifically, firms located in states where SCAPs have been enacted experience a 5% increase in innovation performance. When we use a non-logged version of our outcome variable, this corresponds to almost fourteen patents more. Notably, this effect does not stem from additional R&D investments but from a more efficient use of existing R&D resources. Indeed, we find not only that R&D spending does not increase, but also that the effect on innovation output remains significant even when controlling for overall R&D expenditure.

It is reassuring to see that, before the treatment enactment, firms in the treated and control groups do not experience any significant divergence in innovation outcomes. However, a substantial difference starts emerging after SCAPs are enacted and tends to persist over time. Overall, without decomposing innovation outcomes into more nuanced categories, one would immediately conclude that institutional environmental pressures indeed increase innovation.

However, a fundamental question remains: Does this additional innovation output primarily consist of environmental innovation, as previous research suggests? We find that this is not, in fact, the case. When we decomposed innovation output into more nuanced categories, we find that the effect of SCAPs on environmental innovation is substantially lower than the effect on non-environmental innovation. Specifically, environmental innovation increases by about 1.2%; whereas non-environmental innovation increases by 4.6%. This finding runs counter to the common wisdom that institutional pressures increase environmental outcomes only.

Given that environmental innovation increases less than non-environmental innovation, the key question is: What kind of environmental innovation rises or falls as institutional pressures intensify? To probe this deeper, we re-estimate our baseline specifications, decomposing them into more fine-grained categories of green innovation.

The effect across different types of environmental innovation seems to be heterogeneous. On one hand, “brown innovations” decrease by 1.3%. On the other hand, general efficiency innovations increase by about 3%. Significantly, green innovations do not increase.

Overall, the results show that, following an increase in institutional pressures, firms are increasingly likely to innovate. Notably, the fact that greater innovation outcome is not related to greater innovation input (R&D) suggests that institutional pressure exerts a disciplining effect on managers. (This is consistent with Porter and Linde's hypothesis that regulation can stimulate innovation in companies that fail to efficiently allocate their resources, possibly due to agency problems.)

Key finding

Even more striking is our finding that innovation not directly related to environment increases more than environmental innovation: SCAPs might prompt firms to reassess and optimise their overall resource allocation in the search of new and more sustainable business models. This reallocation could lead to efficiency gains and innovations across all business areas, not just environmental ones. Firms might find more immediate cost savings and productivity improvements through non-environmental innovations. Indeed, non-environmental innovations, which may include improvements in operational efficiency, product features or business processes, might offer immediate and tangible benefits.

These innovations can be integrated into existing operations with relatively lower risk and investment compared to developing new technologies specifically aimed at reducing carbon emissions. For example, innovations that improve productivity or reduce costs without fundamentally altering the company's core environmental practices can yield quick returns and provide competitive advantages in the short term.

On the other hand, environmental innovations focused specifically on reducing carbon emissions, such as developing new green technologies, typically require significant investment in research and development, longer time horizons for implementation, and involve greater uncertainty regarding their effectiveness and return on investment. Firms may perceive these innovations as riskier and more resource-intensive, particularly when faced with immediate pressures to comply with regulations or demonstrate responsiveness in the short term.

This explanation also aligns with the reasons why we find a differential effect across different types of environmental innovation. Indeed, firms produce more “general efficiency” innovation, which implies they adopt more comprehensive strategies that focus on reducing overall energy consumption as a primary means of lowering their carbon footprint. This approach often leads companies to invest heavily in efficiency improvements across their operations to reduce carbon emissions.

Other strategies may focus on optimising logistics and transportation networks to minimise fuel consumption. And, in manufacturing settings, firms might implement advanced process control systems that maximise energy efficiency in production lines.

Instead, firms may concurrently make limited investments in “green” innovations. Specifically, although aligned with societal expectations, such discoveries are often associated with longer-term horizons and a risk of technological spillovers.

Notably, firms disinvest from "brown" environmental innovations as these technologies become progressively misaligned with prevailing societal values and market expectations. This trend is consistent with sustainability studies which demonstrate that firms tend to align their internal actions with external expectations, including environmental concerns.

The most likely explanation for our results is that institutional pressure drives firms to search for new and more sustainable business models. If this is the case, we would also expect to observe (i) that SCAPs lead companies to reduce emissions, and (ii) that the treatment effect is more pronounced for companies experiencing higher levels of institutional pressure. We analyse both of these hypotheses.

The results

Our findings are striking. First, contrary to conventional wisdom, our analysis reveals that institutional pressure affects non-environmental innovation more significantly than environmental innovation, leading to greater increases of the former compared to the latter. Additionally, in the realm of environmental innovation, this institutional change exerts a stronger influence on "general efficiency innovation" compared to "green" and "brown" innovation. This suggests that while institutional pressures drive firms to engage in environmental innovation, they are more likely to focus on improving efficiency and reducing emissions through existing technologies than on developing new renewable technologies or refining fossil-fuel technologies.

Our study contributes in three key ways. First, the traditional interpretation of Porter’s hypothesis often emphasises that regulatory pressure directly leads to more environmental innovations. However, our findings suggest a more nuanced response where regulatory pressure may trigger firms to innovate broadly across various domains, including those not directly related to environmental concerns.

Second, our work emphasises the importance of distinguishing between environmental and non-environmental innovation, on one side, and different types of environmental innovation, on the other side.

Finally, our quasi-experimental design provides causal evidence on the effects of institutional pressures on environmental strategy.

These findings have significant theoretical and practical implications. Theoretically, the study suggests that institutional pressure might lead to indirect pathways for innovation. It underscores the importance of understanding the broader context in which firms respond to institutional pressures, including the potential for innovative activities that are not immediately recognised as environmental but still contribute to overall efficiency or strategic goals.

Practically, our findings imply that policymakers should consider how institutional pressures are designed. If the goal is to foster environmental innovations, policies may need to be more targeted or include incentives for specific types of environmental R&D.