An essay on innovations for sustainable development

Environmental Sciences September 2006; 3(3): 163 – 174

ENVIRONMENTAL ESSAY

An essay on innovations for sustainable development

YORAM KROZER & ANDRIES NENTJES Cartesius Institute of the Netherlands Technical Universities and Groningen University

Abstract Ongoing environmental innovation is the only way to reduce pressures on environmental qualities while maintaining income growth. However, the views on how to initiate and foster environmental innovations differ. In the essay we discuss three theoretical approaches. From neo-classical economic theory we distill the message that research and development of new technology thrive on economic incentives. The evolutionary theory describes patterns in technological development but in our view it exaggerates the importance of technological interlinkages that cause lock-in, as barriers to environmental innovation and it overlooks the organisational impediments within the firm. From the behavioural theory of the firm we learn that innovations can only get through in situations of urgency. The conclusion is that a strict environmental policy can create the sense of urgency and strong incentives for environmental innovation. Ambitious and inflexible targets at macro-level but flexibility at micro-level of the firm are unsurpassable as a policy to foster environmental innovation.

Keywords: Environmental innovation, theory, policy

1. Introduction To achieve and sustain good environmental quality in economies that will continue economic growth, environmental pressures per unit of output must be reduced by a factor of 4 to 10 in high income countries during the next fifteen to twenty years (Weizsa¨cker et al. 1998; Weaver et al. 2000). The question is how such ambitious goals can be achieved, or in policy terms, what has to be done to foster sustainable development. In our view, environmental innovation, which aims at reducing environmental pressure per unit of produced value through new technology, is the key to success. In this paper we explore what theory, mainly based on economic disciplines, has to say about the policy to encourage environmental innovation. A first necessary step to lower environmental pressures is to use available technology and substitute labour and capital for increasingly scarce environmental resources. Yet, the substitution alone can bring only temporary relief because of decreasing marginal yield of the substitution when the global economy with pollution continue to grow. More than three decades ago economists already pointed out the progress towards sustainability as a race between different types of technical progress: on the one hand labour and capital saving technological development that drives up output with its complementary pollution and on the Correspondence: Dr. Yoram Krozer, Iepenplein 42, 1091 JR Amsterdam, The Netherlands, 00-31-20-6631963. E-mail: [email protected] ISSN 1569-3430 print/ISSN 1744-4225 online Ó 2006 Taylor & Francis DOI: 10.1080/15693430600804354

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other hand environment-oriented technological change. In a growing economy, the environmental impact of the economic output can only be improved if the second type of progress, or environmental innovation as we shall call it, exceeds the first type of technical progress that tends to increase total output (Kuipers & Nentjes 1973; Solow 1973; Weitzman 1977). The question of how to foster environmental innovation depends on the view what forces drive innovations. The views diverge between the three different approaches that will be discussed in this essay. We shall assess what they offer and use them as a framework for our own ideas on technological change towards sustainable development. Before embarking on this task we have to reject the suggestion of some researchers that the process of income growth changes the structure of the economy automatically towards lower impact on the environment. The view is underpinned by two findings: firstly that in high income countries, the labour-intensive service sector takes a larger share in the total output, which reduces the pollution per unit of output and secondly, that the resource-intensive sectors of industry have reduced their use of fuel and raw materials and lowered emissions per unit of output (Ja¨nicke et al. 1986, 1997; Selden & Song 1994). Such changes suggests a shift from the polluting industry-based economy to the low pollution service-based economy. It has led to the proclamation of the so called green Kuznets curve. The argumentation is that in the early stage of economic development, growth of national income is associated with increasing pollution but that in the later phase income growth goes hand in hand with less pollution due to an increasing share of services in total output. It looks too good to be true and indeed, the belief in the green Kuznets curve is undermined by studies of international material flows, which show that material use, emissions and income grow at the same pace (Ayres 1997; Bringezu 1997; Bruijn & Heintz 1999). Having recognised that the green Kuztnes curve provides an over-optimistic view, we look for the more spohisticated ideas on technological development and the environment. We distinguish three theoretical approaches: mainstream neoclassic economic theory with its focus on price of inputs, the evolutionary view that investigates the dynamics of innovation in relation to technological and institutional conditions, and the behavioural theory of the firm that is geared to decision making within the firm in its process of adjusting to changing circumstances. The coherence and empirical foundation of the neoclassical and the evolutionary theories with regard to environmental innovations have been discussed by Jaffe et al. (2002) and Ruttan (2002). We discuss the two theories primarily from the perspectives of policy makers and innovators asking the question what guidance they have to offer in the quest for effective innovation policies. The behavioural view has been very much neglected in the literature on environmental innovation. We shall cover it extensively and argue that it offers a more fruitful approach to environmental innovation than evolutionary theory and a sharper view on how incentives work out for firms’ innovation decisions than neoclassic economics (Krozer 2002). After discussion of the three theories in sections 2, 3 and 4 we give our conclusions in section 5. 2. Neoclassic theory The neoclassic theory concludes that welfare losses from pollution are unintended consequences of failures in market organisation and in public sector performance. Market failure appears where property rights with regard to environmental goods, like the right to use the environment as a sink for pollutants, have been imperfectly defined. Consequently, parties that suffer from pollution cannot develop trade with parties who benefit. Since a market for scarce environmental goods does not emerge spontaneously, scarcity remains un-priced suggesting to polluters that there is no scarcity at all. One option for the victims of pollution is

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to try to make polluters liable for environmental damage. Such lawsuits clarify the rights of respective parties, laying the basis for negotiations and elimination of market failure. However, if the sources and the victims of pollution are manifold, remedial action through private law breaks down. In such circumstances, which in high income countries are typical for the past five decades, control of pollution is a public good and a task for national governments with international coordination of their actions when trans-frontier and global pollution is involved. Public sector failure occurs where governments fail to take appropriate action. In the neoclassic view, the consequence of such failures is that the environmental scarcities are not signalled, neither in price of pollution, nor in any other restrictions on pollution that can be imposed by regulations. If pollution is for free then the economic incentive to contain emissions is lacking and even more so the incentive to invest in research and development of environmental technology that would provide the means to reduce, or prevent pollution. In its policy advice neoclassic economics has a clear preference for instruments that mimic a market. On the instruments of direct regulation, which is the cornerstone of actual environmental policy, the verdict is negative. Setting a price on pollution has two effects on polluters: it signals environmental scarcity and it provides polluters with an incentive to take action, while leaving them flexibility in their search for the best approach, including the search for and development of new more effective technologies. That is the main reason why a neoclassical economist will emphatically advise authorities to rely on a policy of pricing and not on direct regulation, arguing that the latter simultaneously kills the incentive for lowering pollution and flexibility. Following this view, since the late 1970s, a large body of knowledge has been developed about the policy instruments that are expected to support development of environmental technologies, which can be found in the reviews of the literature (Bohm & Russel 1985; Downing & White 1986; Nentjes & Wiersma 1987; Prince & Milliman 1989), although it is emphasised that the knowledge is largely based on situation in the high income countries with developed institutions (Angel 2000). The recommendation to price pollution in order to foster environmental innovations is founded on the theory of induced technological change theory. It states that cost minimising firms develop and apply technologies to counter rising input-prices caused by resource scarcity (Heertje 1973; Stoneman 1983; Grilliches 1996). Applied to environmental issue, the idea is that using the environment as a sink for the residuals of production is similar to exploiting a natural resource. Setting a price on such use of an environmental resource would encourage users to search for alternative solutions. The theory is supported with findings from agriculture that indicate that high relative price of agricultural inputs does bring forward technologies (measured by patents) that use the most costly inputs sparingly (Ruttan 1971). Yet, the theory of induced technological change has not remained uncontested. Its critics are of the opinion that the role of input-prices in steering technological development is exaggerated. In support of their view they refer to the development of prices of raw materials in comparison with the use of raw materials as input in production. Based on neoclassic theory one would expect that low prices of raw materials induce a more intensive material use. In reality the opposite has occurred: real average resource prices have declined further over the last century (Rosenberg 1975, pp. 229 – 248; Dasgupta & Heal 1979, pp. 439 – 470) and the share of materials per unit of product has diminished as well, as shown by many examples on national, sector and product levels (Larson 1986; Herman et al. 1989; Tilton 1991; Wright 1997). The findings suggest that resource prices have not been the main determinant of resource-saving technological development and they support a theory that reverses the causality between technological change and material prices. Development of new production methods is viewed as an ongoing process within firms, independent of input prices. It delivers

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steady improvements that enable firm to cut down the use of raw materials as an input of production. The reduction in the demand for raw materials then becomes a factor in depressing prices of raw materials, next to other causes. In this view the neoclassic argument that environmental innovation are invoked automatically by a higher price on pollution is valid only when firms can choose between several available technological options but it could be less so for technology development. To explain the technological change of resource use, including environmental resources, one has to look for other causes than resource prices. Let us therefore investigate ideas of the two other theories: evolutionary theory, which focuses on technological lock-in as barriers to environmental innovations, and the behavioural theory of the firm, which perceives the decision making in the firm as barrier for innovation. 3. Evolutionary theory In evolutionary economic theory, technological development is viewed as a process of search for technical options that follows a specific path, determined by past developments and context-specific selection of the most suitable options along the path (Dosi & Orsenigo 1988). The path is seen as a system of interlinked technologies. The system evolves as an innovation in one sector which triggers development and use of other related technologies in various sectors (spin-off); for example the development of computers started and has fed the production of software, the emergence of the internet and so on. In this way, an innovation is linked with other activities in a path-dependent pattern with positive effects on productivity. The negative side of path-dependency, as evolutionary scholars have recognised, is that an established technology is difficult to substitute by a potentially superior option precisely because of linked activities. The established technology pattern has become a pervasive system (Arthur et al. 1989; Arthur 1990). Even partial replacement is difficult because the activities linked with the established technology do not fit with the new technology and consequently the whole system would collapse. An example to illustrate the problem is the idea of substituting a hydrogen-based energy system for the present fossil fuel based energy system. Such an overhaul of energy would require huge capital investments in a new energy infrastructure to replace the present infrastructure that will have to be dismantled. Technology is locked in because the huge capital investments made in the past for the infrastructure and organisations crafted on the established technology are sunk costs. Next to that, economies of scale and learning by doing effects also help to keep costs low. Consequently, the costs of continuing the established technology system are low. The users of the established technologies are locked in since the investment and other costs necessary to start and fully implement a new alternative technology system look forbiddingly high compared to sticking to the established system. The evolutionary theory, in particular the notion of locked in path in environmental technology, has inspired scholars to explain why it is so difficult to reduce pollution drastically (Christensen 1991; Cramer & Schot 1993; Kemp 1997; Saviotti 2005). From the end of the 1980s on, a recurrent theme in the evolutionary theory on environmental innovation is the distinction between a preventive versus curative approach in development and application of environmental technology. The preventive approach is associated with process-integrated technologies, also called cleaner technologies, which are expected to prevent generation of pollution. They are supposed to be superior to the treatment technologies, called add-on, or end-of-pipe technologies, which are typical for the curative approach, and can only remove pollutants after they have been generated. The argumentation in the evolutionary view of environmental technology is that policies in the past have favoured treatment technologies, or even made them mandatory, thus laying out a dominant path of large investments in


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treatment technologies. The policy created a technological lock-in for the present, impeding dissemination of process-integrated technologies, which could bring higher emission reduction at lower cost. For example, past and present water pollution control policies would laid out on ‘curative’ technological path of wastewater treatment plants, which would create a lock-in, blocking the introduction of ‘preventive’ solutions such as process-integrated water recycling. The curative approach has been motivated by the policymakers’ wish to achieve emission reduction as fast as possible, hence implementing regulations based on use of available treatment technologies instead of process integration, which would be more costeffective in the long run. Adepts of the technological lock-in hypothesis have reflected on the question how the conditions for a breakout towards a new technology path could be created. The policy measures they recommend are among others: focused support of innovations in market niches, making innovative technologies mandatory as well as public investments in innovations. A broad range of policy interventions is advocated to shift technologies into a new ‘‘clean pattern’’. For example, in the discussion of changes in the transport system Kemp and Moors (2003) recommend to create market niches for promising technologies that help to bridge the gap between the current regime and a new sustainable one, identify and stimulate such technologies, explore different pathways and others. Such actions should not be ad hoc, but undertaken as part of a transition programme. For a successful policy, the policy makers have to play different roles such facilitating, initiating and finally regulating (Kemp 1998; Arentsen et al. 2001). The Californian zero emission vehicles regulation to introduce electric cars is often presented as an illustrative case of such a policy of forcing environmental innovations with a benefit to the US manufacturers because they gain competitive advantage by experience in the state. But precisely this example also shows how non-compliance with the regulations has invoked successive policy amendments to weaken its stringency, which discouraged the innovative spur (Calef & Goble 2005). In our view, the notion of breakout of the established conventional technology that is polluting, towards a cleaner one that performs better, is too simplistic. There is ample counterevidence. In the 1950s, nuclear power was expected to provide unlimited, clean electricity but it became to be considered as environmentally unacceptable in the 1980s. Return packaging, imposed by many regulators a decade ago as a cleaner product, is now perceived as having doubtful environmental effects. On the other hand, railway transport, which for Pigou (1921) in his theory of environmental externalities served as an illustration of a dirty technology, is nowadays considered relatively clean and recommended as a cleaner alternative to ‘dirty’ cars and planes. The recommendation to base decisions on the assumed dichotomy between types of environmental technology is also dubious because it supposes an environmental authority with almost perfect foresight of future developments, able to pick the winners before the race has started. Policymakers must be cautious in their judgements about superiority of a new technology versus an old one because they are ignorant about what the future will bring forth and consequently not able to discern whether a perceived lock-in in an inferior environmental technology is real (Rothwell 1992). Picking the winners is also risky because the new technologies often compete with improvements of the available technologies that gradually become more effective. For example, a steady 5% increase of effectiveness by improvement of existing technologies reduces emissions by a factor of four within thirty years, which can be better than searching for completely new solutions. Such a rate of improvement is not exceptional in processintegrated technology. For example, a tenfold higher energy performance of locomotives, measured by pulling power per mileage, has been achieved in the 20th century (Heel en Jansen 1999), fuel use per flight passenger kilometre was cut by half in the period 1970 – 1990

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(Flemming 1996). A high rate of improvement can also be observed in treatment technologies during the last two decades of the 20th century; for example, the degradation of biological matter in wastewater treatment plants increased from about 40% up to more than 95% nowadays. These examples illustrate that a breakout towards new process integrated technology is not necessarily the option for sustainability because far-reaching emission reduction may also be achieved by sustained improvement of available add-on technologies in all categories. We see the breakout towards process integrated technology and steady improvement of add-on treatment technology as competing types of technological development. However, if policymakers, following the evolutionary view, decide to subsidise the cleaner technology heavily, but the adaptations of available technologies go on without subsidy, this then contradicts the rule that rivalling technologies should compete on a level playing field. As a result, breakthrough technology may come out as winner of the competition, even though it is not actually the most environmentally-benign solution. The idea of path-dependent development and lock-in in stagnating old technology are indisputably new insights into the process of technological change. The evolutionary view, however, does not provide causalities to foresee determinants of the process and reliable guidelines for policymakers (Nelson 1995). For that reason, the question of how useful evolutionary theory is has been vividly discussed (Stoneman & Diederen 1994; Metcalfe 1994; Ruttan 1997; Dosi 1997). The message of evolutionary theory that decision-makers can choose cleaner technology is appealing as it suggests a steering capability. Hence, it is understandable that environmental scientists have picked up the paradigm as a new approach to environmental policy issues. Our main criticism is that the theory does not provide guidelines on how to avoid wrong decisions, whereas its focus on new revolutionary technologies can provoke wrong choices. The discussion has led to a more prudent formulation of policy recommendation. For example, van den Berg et al. (forthcoming) mention explicitly that evolutionary policy should refrain from picking winners but focus on influencing conditions of the selection environment and promoting diversity. We wonder how this can be done without some form of pre-selection of perhaps not one, but at least a restricted set of potential winners and how can policymakers promote diversity of technological options, which implies convincing people to pay for costly investments that eventually remain unused. As a last and more general critical note on the lock-in argument we want to point out that this type of dilemma is basically not different from the choice a firm faces when it has to decide whether to go on with an old product, with the cost advantage of sunk investments, or to replace it by a new production line and undertake high investments with high fixed costs of depreciation and interest, but lower running costs of labour and raw materials (Balmann et al. 1996). Would such a firm get stuck in a lock-in in old technology, or dare to break out? The question of whether to go on with old installed environmental technology with sunk costs, or to invest in a new more effective (cleaner) technology is in the same category. The behavioural theory of the firm offers a suitable analytical framework to discuss these problems. 4. Behavioural theory of the firm In their seminal work ‘‘A behavioural theory of the firm’’ Cyert and March (1963) criticise neoclassical economics for modelling the firm as a single-minded profit maximiser, possessing all relevant information on the options from which it can choose, and acting without internal coordination problems, as if it were one person. In contrast with the holistic conception of the firm of neoclassic economics, the behavioural theory has a pluralistic view. It sees the firm with its different management functions at different levels as a conglomerate of interest


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groups, each with its own specific objectives imperfectly coordinated by the firm’s top management, due to incomplete information and control. We shall clarify this view, using three key concepts: satisfying, organisational slack, conflict solution. Satisfying behaviour means that a department’s objectives are set as aspiration levels, mainly determined by extrapolation of results achieved in the past. For example, sales volume for the marketing department is raised when sales targets have been met in the past. If an objective is not achieved, options to solve the problem are taken into consideration one by one, starting with least incisive option and within the department where the problem has emerged, for example a drop in sales has to be solved in the first instance by the marketing department. The search for options stops if an option which promises to meet the aspiration has been found. Conflicts between potentially competing objectives of the different departments, for example aspired sales level and profit aspiration, can be avoided because each group does not go for the unknown best but for a satisfactory outcome, given its aspiration level, and because organisational slack, also known under the name X-inefficiency, offers a buffer. Slack is expenditure that is not really necessary, which is a form of waste that tends to rise in good times when the firm’s management units achieve their aspiration targets. The search for better options, which starts when aspiration levels are not achieved, will result in detection and reduction of X-inefficiency, or absorption of slack as Cyert and March (1963) call it. When circumstances become even more difficult and the search for alternative options has to be widened, solutions requiring more drastic changes and involving higher risks are taken into consideration. Next to satisfying behaviour and the organisational slack buffer, a third element that helps to avoid outright confrontation is the established internal procedure for decision-making, in particular the guideline that in case an aspiration level is not achieved, the decision unit whose objective is not achieved has to come up with a solution. For example, a drop in sales below the aspiration level can be countered by the marketing department through slack reduction: i.e. more effective marketing effort with unchanged budget. Other groups come in when the problem cannot be fixed locally; for instance production is adjusted when stocks increase due to lower sales. The company’s top management intervenes when problems at lower decision levels accumulate and its major objective—the aspired profit level—is not achieved. From the behavioural theory emerges a picture of the firm as a plural organisation that relies on conventional solutions and is sluggish in adjusting to changing external circumstances. Such actions do not automatically lead to the optimal solutions predicted by neoclassic economics. In short, firms decide under bounded rationality. March (1971) has investigated the implications of the behavioural theory for innovation. In line with his notion of the firm’s behaviour as satisfying aspiration levels by conventional actions to solve problems, considering a restricted number of options for solutions in a hierarchic order, he argues that innovations are not the result of spontaneous, voluntary actions. On the contrary, the established positions of management units in decision-making form main barriers to change because innovations are perceived as a risk. The dominant positions prefer the conventional internal mechanisms for problem solving, thus avoiding the risks involved in exploring new ways. Innovations only come in sight when several options for solutions have been considered and have been found to fail. Studies of companies’ decisionmaking confirm that decisions on controversial issues are usually delayed in favour of traditional patterns of doing things and that more deliberation about the controversy does not help much because it often ends up with the demand to postpone decisions because firms tend to keep various viable options open (Colinsk 1996). March advocates creation of organisational units high in companies’ hierarchy that focus on innovations; he calls for a dose

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of ‘foolishness’ in decision-making, which leaves scope for the exploration of new ways. The bounded rationality in companies’ decision-making has gained a lot of empirical support and triggered theorising about mechanisms for adjustment to changing circumstances. Empirical studies confirm the view that risk-taking is rarely spontaneous. Making the decision to innovate is rather probabilistic and rarely formalised (Rosenberg 1973; Allen 1988). Risk of innovation is taken only if it is necessary in view of dramatic events that make a turnaround necessary, because the conventional actions are unsuccessful and a new pattern of activities is needed. How that new pattern will look like is impossible to deduct before the innovation took place on the basis of the conventional patterns from the past because the process of innovation generally proceed by ‘‘trial and error’’. The observation that firms are reluctant to innovate unless they are pressed to take a risk of innovation has invoked much theorising about risk reduction strategies for environmental innovations. Several scholars have argued that social networks dedicated to social health and environmental quality, which would create market niches, enable introduction of environmental innovations. The networks would foster know-how, create sales opportunities and reduce the risk of investments (Verheul & Vergragt 1995; Kemp et al. 1998; Johansson et al. 2004). The practice is, however, more restrictive as it is found that building coalitions between various interests to create a market niche is extremely difficult (Szejnwald-Brown et al. 2003) and that companies must be able to cope with demands for ethical values and functional qualities though these are often contradictory (Krozer 2004). Building on our earlier work (Van Driel & Krozer 1987; Klink et al. 1991) a view on innovation can be brought together and integrated in the framework of the behavioural theory of the firm. Under the conventional policy that is direct regulation with mandatory performance standards that can be met with technologies available from the shelf, that task of environmental management is to comply with the standard at lowest cost. The environmental management is a technical routine task as the requirement and the technologies are largely pre-selected by the policy makers. Hence, the firm’s decision is delegated to an environmental unit low in the management hierarchy, possibly a sub-unit of the production department. Even when it comes to acquiring the environmental license allowing a plant to start operations, the tasks of installing conventional BAT technology does not affect profitability of the firm because technologies are pre-selected that are expected to be affordable for the firm. The task can be left to the environmental unit and the firm’s top management remains at a distance: it has no motive to interfere. It is not a climate favourable for environmental innovation because the environmental unit has no authority to make research and development decisions and if it considers presentation of proposals to do so to the units higher in company’s hierarchy it will not be able to explain how that unconventional option, not belonging to the firm’s core business, contributes to the firm’s prime objectives. The position of environmental management would become different, however, if a drastic change in policy would bring new and very strict regulation, demanding such high investment in off-the-shelf control technology that the costs threaten to depress the profits of the firm below aspiration level of the top management. Even more threatening is the exceptional step of the technology forcing performance standards to be achieved within a number of years with sanctions for non-compliance, or in case competitors are expected to accrue a share of market by environmentally benign products because these comply with policy targets or satisfy demands of customers. The environmental unit is unable to fix the problem on its own and other departments must be involved. There is a task for the top-management to initiate and coordinate a search for options to meet the problems. Among the first, least costly options are lobbying for less stringent regulations, postponement of the compliance date, criticise competitors and even legal actions to delay compliance. When these options are expected not


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to deliver the aspired recovery of profits a range of more incisive options has to be considered, among them starting research and development of new more effective environmental technology, or participation in a joint innovation project. The research and development necessarily involve the production department because new environmental technology may require adjustment of production methods. The procurement and sales departments have to participate if the input mix, in particular raw materials and fuels, has to be changed and product characteristics and possibly product image have to be changed. The more different departments become stakeholders the more it will be necessary to move the problem up in the firm’s hierarchy and to face and take the risks of unconventional solutions. Innovation is an option, which is not necessarily taken because it is costly and risky. Only under circumstances of urgency and potential high rewards of successful research and development investment, one can expect that firm accepts the costs and risks inherent to such a strategy and innovate. The more the very last option comes in sight of having to reduce or shift production as the way to meet environmental demands the larger the probability that environmental innovation is given a try. Depending on the perceived option the research and development may either focus on ambitious improvements in add-on technology, a total redesign of production, or an intermediary solution. In short, the behavioural theory of the firm suggests that environmental innovations can only be expected if high-rank management senses the urgency of and anticipates tough environmental demands in the future and under exceptionally promising market conditions. 5. Conclusions Let us sum up what our own position is with regard to the question of how to foster environmental innovation. In doing so we shall select useful elements from each of the three theories. Neoclassic economics has made it clear that innovation, which includes environmental innovation, does not come out of blue, but is a product of research and development. Investment in research and development is a risky enterprise that will only be undertaken if there is a good prospect of profit. Without incentive, no environmental innovation, that is for us the essence of the neoclassic message. The prices play a secondary role in this context. Evolutionary theory has argued that the technological development can get stuck in a technical lock-in because of linkages and sunk cost. The supposed lock-in in add-on pollution control technology, which blocks the introduction and diffusion of process-integrated cleaner technologies, however, is an issue at the level of the firm. Applying the technical lock-in theory at firm level overlooks the most formidable barrier to environmental innovation, namely the structure of decision-making in companies. The behavioural theory of the firm offers relevant guidance for understanding the problem. We have argued that a very strong challenge—we have even used the term urgency situation—is needed to overcome resistance against environmental innovation. In this respect, the behavioural theory of the firm underlines the neoclassic message: incentives are necessary and they should be really strong. For public policy the question how to strengthen environmental innovation boils down to the question how the relevant incentives—the prospect of profits and prevention of losses— can be fostered. Conventional firm’s problems solving leave hardly any scope for environmental innovation under the usual public policy of regulating pollution through performance standards based on BAT that is available and financially affordable technology (the covenant becomes a second instrument, but it owes its existence to threat of direct regulation if negotiations do not reach agreement). Instead of the performance standard, the public authority would have to set a credible technology forcing demand and allowing a number of years to research and develop new technologies with sanctions such as high

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penalties per unit excess pollution and in extreme even closure for non-compliance. This type of policy creates sense of urgency that opens the door to environmental innovations. We would like to point out that the performance standards address specific emission sources in the companies, which create a problem of how to attune the standards for different types of companies. A strict cap on total emission of all companies together and flexibility for all in their way to control emission would be a solution that leaves much more scope for diverse type of innovation compelling in effectiveness and costs. The European scheme on CO2 emission trading and similar older schemes in the US demonstrate how such systems, combining hard inflexible emission targets at macro level with maximum flexibility at micro level of a firm, can function in practice. Neoclassic economics praises the efficiency of such schemes in emission control and we think that their importance as superior instrument of environmental innovation deserves even more appreciation. The major message of this essay is that by far the best incentive for innovation for sustainable development is an environmental policy, with clear, stringent and credible goals for the future that are fixed for the aggregate pollution and flexible for the compliance by individual polluters. There is no good substitute for that. In comparison, all other policies on environmental innovations are stopgaps.

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