This study uses the provincial panel data of industrial enterprises in China during 1998~2012 to examine the direct and indirect effects of environmental regulation on TFP. It shows China’s environmental regulation has obvious influence on R&D input and has significant direct and  indirect effect on TFP, which suggests environmental regulation brings significant  “innovation compensation effect”, but because of the high cost of regulation, most of the innovation compensation effect are offset by “cost effect”. The study also finds whether “compliance costs” of environmental regulation can bring more “innovative compensation effect” depends greatly on the choice of measures and tools of regulation.