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Impact | Peer pressure

Volume 19, Number 10
October 2013

Firms don’t have to adopt regulatory policy set elsewhere, yet they often do. A recent study by Adam Fremeth shows why.

fremeth-impact-09.jpgThe U.S. electric power industry, a large contributor of greenhouse gases, faces a rapidly changing regulatory environment. With the U.S. federal government still divided over the issue of climate change, individual states are setting standards for how much electricity must come from renewable sources. These standards vary from 25 percent to none at all, creating challenges for electric power utilities that operate across states.

Ivey Professor Adam Fremeth is interested in the dynamics between public policy and firm strategy, particularly in the environmental area.  In a recent study to be published in the Strategic Management Journal, he and co-author Myles Shaver, of the University of Minnesota, focused on the U.S. electric energy sector. “We were looking at the impact of policy proliferation on the competitive dynamic between firms,” he says. “We wanted to better understand why a firm would choose to respond to a particular policy when it doesn’t have to.”

In the study Fremeth focused on 132 large U.S. electric utilities from 2001 to 2006. For each utility he tracked changes in how much power came from renewable sources, such as wind, hydro, solar, geothermal, and biomass. He measured these changes against two factors: the renewable energy policies of peer firms operating in the same state, and the renewable power standards set by neighbouring states. 

For example, Idaho Power is an electric utility that operates only in the state of Idaho. Although the state does not require any electricity to come from renewable sources, Idaho Power is active in this area. Idaho Power competes directly with two utilities who are advanced in the use of renewable energy, and who operate in other states with stringent renewable energy standards. Some states that border Idaho also have stringent standards.

There are many similar examples in the industry, which raises the research question: why are some electric utilities active in renewable energy when they don’t need to be? Are they reacting to the policies of their competitors, or are they reacting to the renewable power standards of neighbouring states?

It turns out that electric utilities choose to respond to policies that their competitors face rather than those established in neighbouring jurisdictions. Fremeth found clear evidence from his study that firms adopt more stringent operating practices when peer firms face more stringent regulations in external jurisdictions. “A firm does not sit idly by while its peers learn new technologies that might leave it at a competitive disadvantage,” he says. “In the electric energy sector we show that this competitive pressure creates an impetus for a firm to act strategically and increase its own renewable energy even if it’s not required to do so.”

On the other hand, Fremeth did not find that firms adopt more renewable power when neighbouring states enact more stringent regulations. This surprised Fremeth at first, because one would expect regulations in a neighbouring state to foreshadow future regulations in the state where the firm operates.  He believes, though, that the finding can be explained by changes in the affected market. A higher policy standard creates more demand for renewable resources, which makes them more expensive to source. This may lead a firm to actually move away from renewable power, or sell its capacity to those firms in the neighbouring jurisdiction that need it.

Fremeth also found that the firms most likely to respond to competitive pressure from peers were those who themselves were less technically competent. “If you’re a laggard firm, and you don’t have a lot of technical skill in bringing on different types of power, you’re more likely to act,” he says. In addition, he found that this relationship was most persistent when a firm was less stringently regulated than its peers.

Fremeth’s study has important implications for managers. When assessing the regulatory landscape, they should be aware of policy changes beyond their jurisdiction. “Managers really need to be outward looking - not just outward looking in terms of what policies are adopted elsewhere, but what they mean for the competition.”

Policy makers should be aware that the choices they make in a particular jurisdiction could have much broader implications. Some states, like California, already understand the wider impact of their policies. “What policy makers are unaware of, perhaps, is that this process will play out in the competitiveness of firms  - how other firms will respond to the firms that you’re regulating directly.”

Fremeth’s finding - that firms in a changing regulatory environment respond to policies set elsewhere – is consistent with the literature. But existing research has overlooked the competitive dynamic that leads to this result.  “It’s interesting that firms don’t need to respond to policies set elsewhere, but yet they do,” he says. “What we show is that they’re responding for a strategic reason.”


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