Environmental Liability and the Capital Structure of Firms

The research for this paper was undertaken as part of a project on The Financial Implications of Environmental Legislation funded by the ESRC (L320253226), for which support we are very grateful. We are grateful to our collaborators on this project-especially Tim Jewell and George McKenzie-for useful discussions, which contributed to our thinking on this paper. An earlier version was presented at a seminar at CSERGE, UCL, and we are grateful to participants for comments. The paper was presented at the Tenth annual conference of the European Association of Environmental and Resource Economists, Crete, June 30-July 2, 2000. We are grateful to participants at the conference for useful comments. The usual disclaimer applies. ABSTRACT A number of countries have recently introduced legislation which holds polluters liable for the costs of cleaning up environmental damage they have caused. While in principle this can give polluters appropriate incentives to reduce the risk of environmental damage, these incentives are weakened if polluters enjoy limited liability and can avoid paying large damages through bankruptcy (the 'judgement proofness' problem). This has led to suggestions that liability be extended to lenders such as banks, who will have incentives to condition loans on the effort made by firms to reduce environmental damage. However, this in turn can be confounded by problems of asymmetric information, and the costs imposed on banks in monitoring the environmental risks being incurred by firms. This in turn leads to fears that holding banks liable for environmental risks could substantially reduce the use of bank debt by firms. In this paper we analyse the impact of different environmental liability regimes on the capital structure of firms, and in particular with how much bank debt they will use. We use a simple theoretical model to show that introducing environmental liability only on firms who have limited liability will cause them to increase their use of bank debt (essentially to protect their shareholders); extending liability also to banks has an ambiguous effect on bank borrowing, but under plausible assumptions will lead to lower bank borrowing than with liability only on firms, but higher or lower bank borrowing than with no liability at all. The US has had the longest history of environmental liability legislation (CERCLA, 1980), and there have been differences over time in the extent to which banks have been held to be liable for environmental damages of insolvent firms. We use US industry-level data …