Does Pollution Control Foster Innovation? Quasi‐Experimental Evidence From China's Two‐Control Zone Policy

ABSTRACT This paper studies the impact of environmental regulation on firms' innovation by analyzing the two‐control zone (TCZ) policy in China. This policy imposed stricter sulfur dioxide emission requirements on firms in regulated cities. Leveraging its uneven implementation across regions, we compare the innovative development of firms in cities subject to stricter environmental regulations with those that were not. Using a comprehensive dataset of firm patent applications between 1995 and 2007, we find that firms in regulated regions increased their patent applications following the introduction of the TCZ policy compared to those in unregulated regions, suggesting an innovation‐enhancing impact of stricter environmental policies. Channel analysis reveals that this positive impact was associated with firms' innovation capabilities through human capital and R&D investments, government support, financial resources, and market selection favoring innovative firms. We also find stronger effects among firms in low‐emission industries and cities with stringent policy enforcement. These findings align with the weak variant of the Porter Hypothesis that predicts a positive effect of environmental regulation on innovation.