18 Jun 2021

(by Peter Ormosi) Morrisons recently announced that all their food will be sourced from carbon neutral farms by 2030 (10 years before the 2040 net-zero commitment of the National Farmers’ Union). This has immediately triggered speculation as to whether, and how quickly, their rivals will follow suit. Although it may not be outright obvious, Morrisons’ move raises a number of interesting questions for competition policy, especially given that its announcement is not unique, and we are witnessing a growing number of markets where firms are increasingly competing not only on factors such as price, or quality, but on sustainability as well. As sustainability is gaining more central attention in competition policy, it is useful to ask how much of our conventional wisdom from competition economics we can use to understand the market incentives behind businesses’ sustainability investments. This thought experiment is useful for regulators to understand which are the industries where regulation may be necessary, and which are the ones where market forces and competition may be more effective in delivering more sustainable business behaviour.

The link between competition policy and sustainability has become a widely discussed topic in policy circles. In Autumn 2020, the OECD dedicated a session to this topic, and in February 2021, the European Commission organised a conference on Competition and the Green Deal. A catalogue of relevant questions was addressed and a large number of expert submissions are now available to the public. These cover topics such as green collusion, state aid, government coercion of green standards, a new regulatory landscape, and a mechanism to exempt certain behaviour from the application of competition laws. What I found less pronounced in these documents is a comprehensive account of which types markets are more conducive to sustainability efforts from businesses. What can we say about the relationship between market conditions and the incentives to invest in sustainability?

Businesses are spending an increasing amount of money on sustainability. Some of this is due to regulatory requirements, but an equally important part may be due to competitive pressure. However, sustainability investments may not be equally important for firms in all markets. The following thought experiment attempts to use simple IO theory to explain why.

Assume that sustainability expenses are driven only by market forces (e.g. no regulatory requirement to comply with environmental standards, and no subsidies). A monopoly has no competition, no pressure from rivals to compete on sustainability spending. As such, businesses may not be pushed by customers to produce in a sustainable way. As competition intensifies, firms are driven to outdo their competitors, and invest in sustainability in order to offer a product that gives higher utility to the environmentally conscious consumer. This would mean a positive relationship between the level of competition and environmental spending. However, beyond a point, as the number of competitors grows, other effects will kick in. For example, with lower profit margins, businesses have less to invest to make outstanding sustainability investments. Moreover, it is also possible that with more competitors there is an increased chance that others copy these sustainability investments, which again would mean that extra benefit to be gained from increased spending gradually erodes away. A stylised plot of this thought experiment would display the following pattern.

The figure bears close resemblance to the familiar inverted U-shape relationship between competition and innovation. Of course, I deliberately set the above discussion up to get to this visual representation. But drawing parallels between sustainability investments and innovation is not far-fetched at all. Most green developments in the economy are the product of innovation activities from private entrepreneurs. And making this link is useful because it means we do not necessarily need to reinvent the wheel when thinking about market incentives for sustainability. Instead we can draw from the extensive literature on innovation and competition, and analogously use findings such as the well-known inverted U-shaped curve from Aghion et al. (2005).[1]

Probably the most important lessons we can take home from the relationship between competition and innovation are that it is complex, overall generalisations are difficult to make, and instead, it is more prudent to rely on a case-by-case approach. As Richard Gilbert expressed: “It is not that we don’t have a model of market structure and R&D, but rather that we have many models and it is important to know which model is appropriate for each market context”. I argue that a similar approach is warranted in the area of sustainability and competition. But how do we know which market conditions incentivise more sustainability investment?

There are many conceptual devices that could help answer this question. Carl Shapiro identifies three factors (contestability, appropriability, synergy) to reconcile the spirit of Arrow and Schumpeter regarding firms’ innovation incentives. These give a simple structure to a hugely complex and widely research problem.[2] Analogously, I argue that the same three factors can be particularly useful when thinking about the heterogeneity in businesses’ incentives to invest in sustainability.

The Contestability principle tells us that firms are able to increase their profitable sales by offering a greener product to consumers. In this sense what matters is that firms’ sales are contestable, i.e. a firm can attract demand away from rivals by becoming more sustainable. This is not always the case. In markets with high switching costs, and/or large consumer inertia, the contestability principle does not hold, and there would be lower incentives to invest in sustainability . A monopolist for example has no contestability problem, there is no demand that she could compete away, therefore there is no drive to spend on sustainability. As competition intensifies, incentives to spend on sustainability and ‘beat the rivals’ increases.

The Appropriability principle means that if the sustainability developments in one firm can be easily copied by their rivals, there will be a lower drive to make these investments. The intuition is simple, if all firms improve their sustainability a similar way, then no single firm will be able to capture the social benefits of this improvement, which will lessen their incentive to spend on sustainability. A monopolist can fully appropriate its investment. As competition intensifies, this becomes more difficult (for example the rivals can imitate or simply free-ride sustainability investments).

One can think of the contestability and the appropriability principles as two opposing effects that drive the incentive to invest in sustainability but with a diminishing marginal effect. With increasing competition, the contestability effect gets stronger, but with a diminishing effect. Equally, with lessening competition, the ability to appropriate sustainability investments increases, but with diminishing marginal benefits. These two effects would crudely explain the inverted U-shape relationship plotted above.

Finally, it is also useful to think of the synergies in the process of increasing sustainability. There is a strong argument that firms are better at improving the sustainability of their production when they do not act in isolation. Synergies are especially relevant in industries where value creation includes inputs from multiple firms. Such arguments are also more likely to apply for small businesses, who, individually, would be unable to make sustainability improvements on their production.

This thought experiment may seem simplistic and it is likely that, akin to the many studies on innovation, one would find that the precise relationship between sustainability investments and competition is largely heterogeneous, varying not only from market to market, but across different firms as well. But this sort of general analogy can be very useful in targeting better policies. For example, understanding how the underlying sustainability incentives are driven by market conditions is hugely important if governments want to impose regulations to spur sustainability spending. A clearer framework helps regulators understand in which industries regulation might be necessary, and in which markets competition may be more effective. Moreover, whereas calls for harnessing possible synergies in sustainability cooperation have been increasingly frequent (see the draft guidelines by the Dutch competition authority, which give a green light to sustainability cooperation between competing businesses), it is crucial to first try and understand how these exemptions affect business incentives to compete on prices, quality, and sustainability before hastily exempting certain behaviour from competition law.

[1] Aghion, P., Bloom, N., Blundell, R., Griffith, R., & Howitt, P. (2005). Competition and innovation: An inverted-U relationship. The quarterly journal of economics, 120(2), 701-728.

[2] Shapiro, C. (2011). Competition and innovation: did Arrow hit the bull’s eye?. In The rate and direction of inventive activity revisited (pp. 361-404). University of Chicago Press.