Although the UK’s 1995 Environment Act appears to exempt lenders from liability for environmental damages caused by insolvent borrowers, a survey of the UK banking sector shows that banks are not confident the exemption would hold up in court.

The research , The Financial Implications of Environmental Legislation, funded by the Economic and Social Research Council (ESRC) – also reveals that the costs of obtaining adequate information on risks could be inhibiting the creation of environmental insurance products.

US banks are held liable for environmental damages and research shows this has a significant negative impact on their willingness to lend to environmentally risky industries. Prior to the extension of environmental liability to US banks, firms had incentives to borrow from banks since this gave some protection from environmental damages liability to equity owners.

If liability is to be extended to UK banks, it needs to be designed carefully, according to the ESRC research.

The research warns that designing and harmonising environmental liability regimes without harmonising banking regimes could be damaging. UK banks do not yet agree whether they would respond to environmental liability legislation by raising or lowering interest rates. In a competitive banking sector, increasing liability on lenders may cause them to increase interest rates, reducing the incentives for firms to borrow. In this case, it may be desirable to set quite low levels of lender liability.

In a less competitive banking sector, ESRC believes 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 Europe’s 1993 Lugano Convention
  • the UK’s 1995 Environment Act, all of which relate principally to hazardous waste sites.

By including liability for the environmental costs of their actions, such legislation hopes to provide polluters with incentives to reduce environmental damages to a more sustainable 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 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 remains 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.

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