Promoting supplier's environmental innovation via emission taxation

With growing concerns about pollutant emissions from manufacturing processes, market-based instruments with emission taxation have become increasingly popular by many governments to incentivize firms' emission reduction efforts. In some industries, however, the amount of pollutant emissions from manufacturers largely depends on the quality of the raw materials provided by their suppliers. In that case, motivating the suppliers' environmental innovation efforts could be crucial for an effective regulatory control of pollutant emissions. Nevertheless, many governments adopt the “polluter pays” principle and impose emission taxes on the manufacturers rather than the suppliers. Hence, a key question for the regulator is whether placing an emission tax burden on manufacturers can effectively incentivize their suppliers' environmental innovation efforts through supply chain contracts that are often times chosen by profit-maximizing manufacturers. Thus motivated, this paper studies the impact of supply chain contracts on suppliers' environmental innovation in the presence of emission taxation. We consider two variants of the wholesale price contract, which are commonly used in this type of settings: the quality requirement contract and the cost sharing contract. We show that the economic incentive of the manufacturer and the environmental incentive of the regulator may not coincide (i.e., the profit-maximizing manufacturer may prefer the quality requirement contract whereas the environmental innovation is much higher under the cost sharing contract). We then show that increasing a tax pressure may discourage the supplier's innovation efforts. More importantly, our results show that a very mild level of tax intensity can maximize the supplier's investment in environmental innovation effectively. We also find that the double counting of emissions (i.e., charging the emission tax on the supplier as well) may discourage suppliers' environmental innovation.