The extant literature has paid scant theoretical attention to the tripartite interaction among increasing environmental regulations, the resulting decision by a polluting firm to upgrade its capital stock, and the impact of innovation on this decision. Hence, the authors theoretically analyze this tripartite interaction when a polluting firm faces adjustment costs to upgrade its capital stock. First, they construct a dynamic model of regulation driven investment by a polluting firm. Second, they specify the conditions characterizing efficient investment. Third, they study the impact of an unanticipated increase in innovation on the polluting firm's steady-state capital stock. Fourth, they analyze the impact of an anticipated increase in innovation on the polluting firm's steady-state capital stock. Finally, the authors discuss the relationship between the polluting firm's internal shadow price of capital and the stock market value of a unit of this firm's capital.
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