Environmental liability and the capital structure of firms

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 gives 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. A solution which has been suggested is to extend liability also to lenders such as banks. 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 both theoretically and empirically the impact of different environmental liability regimes on the capital structure of firms, and in particular how much bank debt they will use.

We use US industry-level data to estimate a reduced-form model of bank borrowing by polluters. We show that the introduction of environmental liability only on firms caused bank borrowing to increase, but when liability was extended to banks, borrowings returned to a level only slightly higher than with no liability. Our findings suggest that extending environmental liability to banks does not have drastic consequences for bank lending to firms.

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