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Sustainability
The hidden rules of green innovation: What leaders get wrong about regulation
Environmental policy doesn’t drive green innovation equally everywhere. Our research shows it falters in advanced economies, accelerates innovation in emerging ones, and relies on informal networks where formal institutions fall short.
Rapid read:
- Environmental policy is not a universal innovation trigger: In advanced economies, where market, capital, and competitive pressures already drive green innovation, additional regulation delivers only marginal gains and can shift focus toward compliance.
- In emerging economies, policy is a powerful catalyst: Credible environmental regulation reduces investment risk, substitutes for weaker institutions, and significantly accelerates corporate green innovation.
- Informal institutions matter more than leaders expect: Trust networks, social norms, and relationships play a critical role in enabling innovation where formal legal and market systems are less developed.
For two decades, governments around the world have intensified their push toward a greener economy. Carbon pricing mechanisms have expanded, emissions standards have tightened, and sustainability disclosure requirements have proliferated rapidly. At the same time, companies face relentless pressure from capital markets, customers, and employees to innovate more aggressively in support of the net-zero transition.
Given this momentum, a critical question becomes: do environmental policies actually stimulate the green innovation that the world depends on for a successful energy transition, and if so, does the answer differ based on where a company operates?
We examined this question using a uniquely comprehensive dataset of 1,831 publicly traded firms across 34 countries from 2002 to 2020. By analyzing how firms respond to national environmental policies, both market-based mechanisms like carbon taxes and emissions trading, and nonmarket regulations such as emissions limits and technology standards, we sought to understand not only whether policy works, but why and under what conditions.
What we found is not a simple linear story. Instead, the impact of environmental policy on corporate green innovation depends profoundly on the institutional context in which firms operate. Policies do not act in a vacuum. They interact with a country’s formal systems, informal norms, and competitive pressures in ways that either amplify or dampen innovation.
Understanding this dynamic is crucial, not only for governments designing the next wave of sustainability measures, but also for companies developing strategies in an environment where expectations around climate performance continue to rise.
The missing link between policy and innovation
Across industries – energy, transportation, manufacturing, technology – executives routinely voice a belief that clearer, stronger environmental policies will unlock green innovation. And in many cases, this belief is justified. Policy can de-risk investment, provide long-term direction, and catalyze the development of new markets.
But our cross-country analysis shows that the relationship is not universally positive. In fact, the impact varies dramatically depending on whether firms operate in developed or emerging economies.
This divergence helps explain the long-standing contradictions in academic research. Some studies find that policy boosts innovation; others find the opposite. Our work reveals that these inconsistent findings stem from an important oversight: economies differ systematically in their institutional foundations, and policies interact with these foundations in fundamentally different ways.
“Developed economies typically possess strong, stable formal institutions.”
Institutional strength shapes how firms respond to policy
Every firm operates within a web of institutions that shape incentives and constrain choices. Some are formal institutions, such as legal systems, regulatory bodies, capital markets, or intellectual property protections. Others are informal, including norms, cultural expectations, reputation systems, or trust networks.
Developed economies typically possess strong, stable formal institutions. Innovation is supported by reliable intellectual property systems, deep financial markets, predictable regulations, and competitive industries. Firms already face well-established pressures to innovate, whether or not new environmental policies are introduced.
Emerging economies, by contrast, often grapple with institutional voids. Legal systems can be less predictable, contract enforcement less reliable, and intellectual property protections weaker. In these environments, firms face elevated risk when investing in long-term green technologies. Yet these economies also possess powerful informal networks (community expectations, relational ties, political and social relationships) that help firms navigate uncertainty.
These institutional differences create deeply different innovation landscapes. And when national environmental policies enter these landscapes, they interact with them in ways that determine whether innovation accelerates or stalls.
These forces together constitute a powerful underlying driver for green innovation.
Why new regulation has limited impact on innovation in advanced economies
In developed markets, our data shows that additional or more stringent environmental policies, whether market-based or nonmarket, do not significantly increase corporate green innovation. In some cases, nonmarket regulations even exhibit a slightly negative effect.
This finding often surprises policymakers, but the explanation is intuitive. Firms in advanced economies already face strong competitive pressure, demanding stakeholders, sophisticated capital markets, mature innovation ecosystems, and extensive voluntary sustainability commitments.
These forces together constitute a powerful underlying driver for green innovation. Adding more regulation on top does not fundamentally change incentives, but it can change behavior.
When new rules are introduced in mature institutional settings, firms often shift into compliance mode. Managerial attention moves toward meeting reporting requirements, mitigating legal and reputational risk, and adjusting internal controls. These are necessary activities, but they can crowd out exploratory innovation.
Consider the recent expansion of sustainability disclosure requirements in Europe. While these measures improve transparency, they also require substantial internal resources, potentially drawing attention away from the development of new technologies and green business models.
In short, when the underlying system already pushes firms toward innovation, marginal regulation produces marginal gains and sometimes unintended consequences.
In effect, environmental policy in emerging markets becomes a catalyst that compensates for weaker formal institutions and strengthens informal ones.
Why environmental policy is a game-changer in emerging economies
The story in emerging markets could not be more different. Here, environmental policies, both market-based and nonmarket, have a strong, statistically significant positive impact on corporate green innovation.
Because formal institutions are less stable, policy acts as a substitute for missing institutional support. It provides clarity, predictability, and legitimacy. All this reduces the risk that discourages long-term investment.
- Market-based policies create economic stability. Carbon taxes, emissions trading schemes, and renewable energy incentives provide clear price signals that anchor investment decisions. In uncertain institutional contexts, these mechanisms offer the stability firms need to pursue new technologies. This pattern is visible in the rapid rise of China’s solar PV industry and Brazil’s progress toward cleaner manufacturing in the presence of environmental taxes and incentives.
- Nonmarket policies reinforce informal norms. In emerging markets, informal institutions – community expectations, trust-based relationships, political networks – play a significant governance role. Nonmarket policies such as emissions limits or performance standards tend to “mirror” these informal norms, amplifying their influence. By aligning with societal expectations, these policies help firms build legitimacy and confidence, catalyzing more green innovation.
In effect, environmental policy in emerging markets becomes a catalyst that compensates for weaker formal institutions and strengthens informal ones. This dual function explains why its impact is so much stronger than in advanced economies.
Why informal institutions matter more than we think
Our findings also highlight the importance of informal institutions, a factor often overlooked in policy design. When formal systems of protection (like IP enforcement) are weaker, informal networks become essential mechanisms for governing innovation. They help firms protect know-how, reduce opportunism, coordinate across supply chains, build legitimacy with government and society, and accelerate adoption of new technologies.
In these environments, national environmental policies work best when they align with or strengthen these informal structures. This is why nonmarket policies in emerging economies have particularly strong effects. They reinforce existing norms rather than trying to replace them.
For both policymakers and executives, this underscores a critical insight. Innovation ecosystems are social systems, not just economic or regulatory ones.
Key conclusions for leaders
After nearly two decades of data across dozens of countries, our research yields three clear lessons for policymakers, boards, and executives:
- In advanced economies, additional regulation offers limited innovation gains and may redirect energy away from innovation. Because firms already face strong market and competitive pressures for green innovation, new rules add only modest stimulus. They may even shift some attention toward compliance rather than exploration, which tempers the overall impact of regulation without stopping innovation.
- In emerging economies, environmental policy is a catalyst for green innovation. Where institutional stability is still developing, credible and consistent policy signals are often the only force that reduces risk enough for firms to invest in green technologies.
- In markets with weaker formal protections, informal norms help firms commercialize green innovations. Trust-based relationships and shared expectations make it easier for firms to collaborate, safeguard know-how, and push new green solutions forward even when legal protections are not fully dependable.
Our study shows that environmental policy effectiveness depends fundamentally on institutional context. In emerging markets, policies act as catalysts that substitute for weak institutions and mirror informal norms, significantly boosting green innovation. In advanced economies, firms already face strong innovation pressures, and additional regulation offers only marginal gains, sometimes shifting attention toward compliance rather than exploration.
As the world confronts the global challenge of decarbonization, understanding the interplay between policy and institutions is essential. Environmental regulation can unlock green innovation, but only when it aligns with the institutional context in which firms operate. Leaders who understand this dynamic will be best positioned to design, influence, and respond to the policy frameworks that shape tomorrow’s sustainable economy.
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