Recently, concerns have been growing that stringent environmental regulations will force firms to invest a lot of financial resources for compliance and that their competitiveness will be lost against those in countries with lax environmental regulations. In contrast to this argument, an increasing number of people now claim that stringent environmental regulations will actually enhance the competitive position of firms through innovation.

Since the long-term industrial performance depend significantly on innovation, process as well as product, this research examines the effects of environmental regulation on technological change in the Japanese and European chemical industries. To address this question, first, the stringency of environmental regulation is measured. Then the trends in the levels and growth rates of the R&D activity, productivity, and patents of firms in Japan and Europe are examined with aggregate data analysis and in-depth case studies. As the chemical industry is diverse in terms of production process and product, several subsectors, e.g. chlorine and caustic soda and fertilizers, are selected for comparison. Also, as the institution of environmental regulations varies significantly between different countries, it is of interest to examine the effects of heterogeneous environmental regulations on technological change in Japan and Europe.

Attention is paid to the economic implications of various kinds of technological change by making a distinction between the installation of end-of-pipe technologies, physical modification of the production process, and modification of the chemical reaction (including product innovation). While modifications of the chemical reaction system are more desirable for a drastic reduction of emissions, they often introduce complicated and unexpected impacts on the main product. Therefore, exclusive attention to the by-products is not sufficient, nor appropriate. In other words, modifications of the chemical reaction system will involve both process and product developments, making the separation between them very difficult.

Innovations are enhanced not only by the demand factor (i.e. environmental regulation), but also by the supply factor (i.e. expansion of technological opportunities). One of the mechanisms for the exploitation of technological opportunities would be to increase knowledge spillovers from other scientific and technological fields. In the case of chlorine and caustic soda production, the development of membrane cell technology was realised through the merger of chlorine and caustic soda technology with material technology (i.e. ion exchange membrane). As the frame of the search process for new technologies is constrained by the history, experience, and expectation of each company, regulations could create a new environment in which researchers are encouraged to pay more attention to findings in different disciplines which have been ignored previously.

Another mechanism through which technological opportunities expand is increased knowledge sharing among companies in the same industry. Due to the asymmetric information between the industry and the consumers, a company cannot differentiate its own image from others in the same industry, and, therefore, firms have the common interest to improve the image of the industry as a whole. In addition, due to the asymmetric information between the industry and the government, the ratcheting-up of environmental regulation may happen based only on the best among other technologies at any moment, and to avoid that firms have incentives to control the information flow to the government. In the European fertilizer industry, companies share and exchange information about technologies through conferences and booklets on best available techniques. As the transaction costs of information sharing and co-ordination between firms would be high, industrial associations could play an important role in taking the initiative.

It is often argued that environmental policy has the possibility of "locking-in" technology to potentially inferior one, for example, by requiring firms to adopt a static approach and invest in the best available technology at that moment. In the case of chlorine and caustic soda production, however, it seems, in retrospect, that governmental regulation has picked up the right technology (i.e. membrane cell technology) in Japan whereas the European industry have their technology "locked in" to an inferior one (i.e. mercury cell technology). After the Minamata accident, the Japanese government forced firms to switch from the mercury cell process to the membrane cell process, which, although originally uneconomical, has turned out through innovation to be superior economically as well as environmentally. This example shows that environmental regulation can stimulate innovative activities in a relatively mature industry, and benefits can be achieved in the environmental as well as economic senses.