Modern environmental regulation holds polluters strictly liable for the costs of the pollution they cause. But does this liability extend to the banks that fund polluting firms? And if not, should it? New ESRC-funded research led by Professor Alistair Ulph explores the impact of legislation like the UKs Environment Act on bank lending and risk management.
His team of lawyers, economists and financial analysts finds that:

The UKs 1995 Environment Act appears to exempt lenders from liability for environmental damages caused by insolvent borrowers. But this finding has yet to be tested in the courts and, according to the teams survey of the UK banking sector, banks are a little concerned that they could still be held liable.

There is no consensus among UK banks whether they would respond to environmental liability legislation by raising or lowering their margins. And while banks have gone a long way to integrating assessment of environmental risks into their overall risk assessment procedures, the survey reveals that there is a concern that the costs of obtaining adequate information on risks is inhibiting the creation of environmental insurance products.

Analysis from the US, where environmental liability has been extended to banks, shows that it has a significant negative impact on their willingness to lend to environmentally risky industries. In the past, when environmental liability had been introduced for firms but not yet extended to banks, firms had incentives to use bank debt since this gave some protection to equity owners. When liability was extended to lenders, it significantly reduced their willingness to lend to firms.

If liability is to be extended, it needs to be designed carefully. The competitiveness of the banking sector is an important consideration in that design and harmonising environmental liability regimes without harmonising banking regimes could be damaging. In a very competitive banking sector, increasing liability on lenders may cause them to increase interest rates, reducing the incentives for firms to take care. In this case, it may be desirable to set quite low levels of lender liability. In a less competitive banking sector, an increase in lender liability may lead banks to reduce interest rates in order to induce borrowers to invest more in taking care of the environment. Then, quite high levels of liability on lenders may be desirable.

Examples of recent environmental regulations that hold polluters liable for the costs of their pollution include: the 1980 Comprehensive Environmental Response Compensation and Liability Act (CERCLA) in the US, the Council of Europes 1993 Lugano Convention, and the UKs 1995 Environment Act, all of which relate principally to hazard waste sites.

The rationale for these pieces of legislation is that by internalising the environmental costs of their actions, polluters will have incentives to take steps to reduce environmental damages to an appropriate level. But if environmental damages are high and polluters are protected by limited financial liability, then they may escape much of the environmental liability. This will reduce their incentives to take appropriate care.

The thinking behind extending liability to lenders is to mitigate this judgement proofness problem, giving banks the incentives to ensure that firms take appropriate steps to reduce the risk of environmental damage as a condition of getting access to credit. But the central problem of extending liability is that if lenders find it difficult to monitor the environmentally riskiness of certain projects, they may respond by simply refusing credit to certain classes of risks, with potentially damaging effects on investment financing decisions.

For further information, please contact Professor Alistair Ulph; or ESRC Media Consultant Romesh
Vaitilingam

NOTES FOR EDITORS

1. The research project The Financial Implications of Environmental Legislation, by Professor Alistair Ulph and colleagues in the Departments of Economics and Management and the Faculty of Law at the University of Southampton, was funded by the Economic and Social Research Council (ESRC).

2. The ESRC is the UKs leading independent funder of research and postgraduate training in social and economic issues. It currently has an annual budget of around £65 million from the Government.