Print
E-MailShushu Jiang is an Assistant Professor of Accounting at the National University of Singapore. This post is based on an article forthcoming in the Journal of Accounting & Economics by Professor Jiang; Stacey Choy, Ph.D. Student in Accounting at the University of Toronto; Scott Liao, Professor of Accounting at the University of Toronto; and Emma Wang, Assistant Professor of Accounting at Cornell University.
Corporate environmental pollution is a classic economic problem characterized by negative externalities from corporate activities. Public regulatory enforcement has been the primary force in compelling firms to internalize the negative externalities of corporate environmental pollution. However, such enforcement may not be sufficient to tackle the rapidly growing environmental challenges due to resource constraints or regulatory capture. As a result, there has been an increasing call for joint efforts between the public and private sectors to address environmental issues. In this forthcoming article, we examine whether and how public environmental enforcement affects private lenders’ environmental monitoring efforts and the effectiveness of such monitoring in curbing corporate pollution. We focus on private lender monitoring due to the growing importance of sustainable finance in fostering a green environment and lenders’ ability to influence borrowers’ operations through loan covenants.
To monitor borrowers’ environmental activities, lenders can use three major types of covenants (environmental covenants, hereafter): 1) disclosure covenants require borrowers to disclose material environmental matters to lenders or discuss environmental matters with lenders upon lenders’ request, 2) action covenants require borrowers to remedy or prevent environmental damages, and 3) audit covenants require borrowers to hire professionals to conduct environmental audits. Disclosure and audit covenants help lenders obtain information to assess and address environmental risks in a timely fashion, whereas action covenants prevent violations of environmental laws and reduce liabilities in the event of violations.
We argue that public environmental enforcement may incentivize lenders to monitor their borrowers’ polluting activities through the use of environmental covenants by increasing the benefits of such monitoring. First, borrowers’ environmental liabilities and credit risks may increase with public enforcement intensity because stringent regulators are more likely to detect environmental violations and penalize polluting borrowers. Hence, the benefit of lender monitoring in reducing borrowers’ environmental liabilities increases with public enforcement intensity, especially in the case of highly polluting borrowers. Second, public enforcement may increase lender environmental liabilities directly because lenders deemed as management may be held accountable for cleaning up contamination on real property used as loan collateral. Therefore, the benefit of lender monitoring in reducing their exposure to environmental liabilities also increases with public enforcement intensity.
We further expect public environmental enforcement to enhance the effectiveness of lender monitoring in reducing borrowers’ polluting activities. Specifically, regulators’ timely detection of borrowers’ environmental violations can assist lenders in monitoring borrowers’ compliance with environmental covenants. For example, regulators’ public disclosure of environmental violations may prompt lenders to request that borrowers provide additional information, conduct audits on environmental activities, and perform immediate remedial actions to control pollution and minimize environmental liabilities.
By analyzing loan contracts, we observe that 42% of loans in our sample include at least one environmental covenant, suggesting that they are prevalent but not ubiquitous in loan contracts. Of those, 51% use only disclosure covenants, compared to 8% that use only action covenants and none that use only audit covenants; 29% of contracts bundle disclosure covenants with either action or audit covenants; and 13% include all three covenants. To capture public environmental enforcement intensity, we measure the average number of environmental inspection and enforcement actions per manufacturing facility within a state in a given year.
Our findings support our predictions. We find that borrowers facing higher regulatory intensity are more likely to have environmental covenants when they are more polluting or when their loans use real property collateral. Moreover, borrowers with environmental covenants experience a larger reduction in toxic chemical releases after loan initiation when they are exposed to higher versus lower enforcement intensity. Overall, our results are consistent with the predictions that stringent public enforcement strengthens lenders’ monitoring incentives and the effectiveness of such monitoring.
We further document mechanisms that corroborate our inferences on the effects of public enforcement on enhancing lenders’ environmental monitoring efforts and the effectiveness of lender monitoring. First, our results are more pronounced when borrowers have higher bankruptcy risks, suggesting that lenders’ concern over credit risks is an important mechanism explaining the interplay between public enforcement and lender monitoring. Second, to triangulate the result of pollution reduction, we show that borrowers with environmental covenants are more likely to invest in pollution abatement through product modifications when located in states with higher enforcement. Third, we find that bundling disclosure covenants with audit or action covenants, or both, in loan contracts leads to greater emission reductions for borrowers in states with stringent enforcement. Last, further supporting the unique role of environmental covenants in lenders’ environmental monitoring, we find robust results after controlling for financial and general covenants. We also fail to find evidence that financial or general covenants produce the same effect as environmental covenants concerning the reduction of borrowers’ toxic releases or the increase in their abatement investments in response to public enforcement.
Our study contributes to understanding the roles of governments and private sectors in tackling corporate pollution. Our evidence that lender monitoring more effectively curbs corporate pollution in the presence of more stringent public enforcement suggests that governmental oversight is crucial to induce firms to internalize environmental externalities through the channel of private monitoring, highlighting the complementary relationship between the two sectors. We also contribute to the environmental, social, and governance (ESG) literature by documenting lenders’ use of environmental covenants in loan contracts to monitor borrowers’ polluting activities and the influence of public enforcement on the effectiveness of these covenants.
This paper is available for download here.
