Environmental Regulation and Industrial Performance : Evidence from Unexpected Externalities in China

The neoclassical model argues that environmental regulations impede industrial performance. In this paper, we shed light on two features of environmental regulations in developing countries that have received little attention and that give rise to unexpected outcomes with respect to industry performance. First, compliance to regulations is likely to provide positive forces leading to improved productivity because a) induced innovation and/or the adoption of cleaner technologies among polluting firms enhance industrial activities, and b) regulations stimulate market dynamics through the entry of more efficient firms and the exit of less efficient ones. Second, regulations carry externality effects for non-polluting energy-intensive firms, when the energy sector is prone to regulations. By exploiting plausibly exogenous variation in regulatory stringency generated by the Two Control Zone policy in China across cities and across industries, we find evidence that pollution-intensive firms substantially improved economic performance, whereas energy-intensive firms received negative externalities. The findings are robust to the inclusions of city-specific trends, industry-specific trends, and key ex ante determinants of firm growth