AbstractThe paper defines and uses the concepts environmental policy cycle and innovation cycle and explores the links between the two in search for an environmental policy that creates incentives for innovation in environmental technology. We conclude that key factors are shortening the period the bureaucracy takes for preparing new environmental requirements, transparency and consistency of bureaucratic and political decision‐making and fast and strict implementation with environmental policy instruments that give pollution sources freedom in their choice of suitable technology. Economic instruments provide strong incentives for innovation because they speed up implementation. Large R&D subsidies may be needed to make technology development profitable under the conventional policy of direct regulation by emission standards and regulation by way of covenants. Copyright © 2006 John Wiley & Sons, Ltd and ERP Environment.