Existing soil and groundwater contamination are likely to affect future industrial development and investment in Central and Eastern Europe, as large-scale pollution cleanup costs are potentially tied to industrial property transactions in that area of the world and the division of liability for these costs is uncertain. Determining how pollution cleanup costs should be allocated between governments and current or future property owners will not be easy. Retroactive liability is unlikely to be a desirable or a feasible means of assigning such costs for several reasons—one reason being its costly impact on the large number of thinly capitalized firms in the region. Publicly financed liability funds, by widely distributing cleanup costs, create a more desirable climate for foreign and domestic investment than does a U.S.-style system of retroactive liability, and will lead to a better prioritization of cleanup efforts. However, pooled fund programs should be operated on a short-term basis only, as they may reduce private incentives to invest in pollution reduction.
Privatization and market reform in the economies of Central and Eastern Europe are occurring against a backdrop of severe environmental degradation left by decades of inadequate government attention to environmental conditions. The legacy of soil and groundwater pollution inherited by the new governments of Central and Eastern Europe not only creates direct health and ecological costs but is also likely to affect future industrial development and investment. The contentious development and expensive implementation of legal and regulatory approaches to mitigating environmental degradation in the United States and the European Economic Community (EEC) suggest that environmental problems in Central and Eastern Europe—where economies are much weaker, environmental problems much greater, and legal and regulatory institutions much less developed than in the West—will only be resolved at great economic and political cost.
In theory, an effective environmental liability system in Central and Eastern Europe will serve to deter the future generation of pollution by threatening polluters with liability costs arising from improper waste generation or disposal. However, a more immediate, practical consequence of new liability rules is the assignment of responsibility for existing pollution. This assignment raises an important question—namely, how should the costs of removing or reducing existing pollution be allocated between governments and current or future property owners? The answer is complicated by the financial weakness of both governments and property owners in Central and Eastern Europe, the costs and uncertainty involved in the quantification of environmental risks, the political nature of liability reform, and the need to promote domestic and foreign investment.
While the costs of remediating existing pollution in the former Soviet bloc cannot be precisely estimated, they are clearly huge. The estimated cost of meeting EEC or U.S. environmental standards in Poland, for example, is as high as $300 billion. There is great uncertainty regarding the costs of remediating existing pollution due to the lack of lending and insurance institutions familiar with risk assessment and to the virtual nonexistence of accounting, zoning, or regulatory requirements for documenting risk-generating processes or technologies. Large-scale pollution costs are thus potentially tied to transactions involving industrial property in Central and Eastern Europe.
Determining how responsibility for the costs of remediating existing pollution should be allocated between governments and property owners is complicated by uncertainty regarding cleanup costs and potential liabilities; this uncertainty impedes domestic and foreign investment.
Uncertainty regarding potential liabilities is exacerbated by the lack of established liability concepts, legal precedent, and consistent enforcement principles in Central and Eastern Europe. The formerly communist countries have no common-law traditions—such as those in the United States—that allow environmental claims based on concepts such as nuisance, trespass, negligence, or strict liability. Instead, they use a civil law approach that imposes damages almost exclusively in cases where there has been a violation of a government standard or regulation. A civil law, rather than a common law, definition and enforcement of liabilities presents an opportunity for governments to coordinate and achieve cost-effective resolutions to the cleanup of existing pollution. However, it also creates uncertainty for potential investors. Because such a system is defined neither by precedent nor by a consistent application of judicial principles, the scope and division of potential liabilities is unclear.
The unique environmental and institutional conditions in the countries of Central and Eastern Europe argue for liability approaches that may differ from those advocated in countries with more advanced legal systems, less pollution, and greater economic vitality. Given these unique conditions, the environmental liability systems established in Central and Eastern Europe should be influenced by two goals. First, in light of the need for economic growth, liability rules consistent with the promotion of privatization and foreign investment should be favored. Second, because Central and Eastern European governments lack the funds to pay the entire cost of cleaning up existing pollution, legal and regulatory policies should be designed to target public revenues toward the environmental hazards that pose the greatest threat.
To pursue these goals, liability initiatives in Central and Eastern Europe should distinguish between the timely and effective implementation of liability rules governing the creation of future environmental risks, and the efficient cleanup of pollution generated in the past. These are entirely different issues. The first concerns the question of how to create incentives for future pollution reductions, while the second concerns the question of how to efficiently achieve a distributional goal—that is, how the costs arising from pollution created in the past should be borne. With respect to the latter, it can be easily argued that both moral and legal responsibility for existing pollution lies primarily with the former Soviet bloc governments themselves. The question of who should bear the costs of remediating existing site contamination is particularly important since it is likely to affect patterns of foreign and domestic investment, and clearly affects the value of initial asset endowments distributed in the process of privatization.
The argument against strict and retroactive liability
One liability approach that might be instituted in Central and Eastern Europe is strict and retroactive environmental liability. This type of liability holds the current owner of a property fully liable for pollution cleanup and compensation costs, even when the pollution was generated by past owners or users of the property. While strict and retroactive liability strongly deters the future generation of pollution, its application in the United States has prompted debate over its inequitable allocation of responsibility for cleanup costs and its potentially adverse impact on property development.
Independent of judgments about its effects on pollution reduction and economic activity in the United States, strict and retroactive liability is unlikely to be desirable or even feasible in Central and Eastern Europe for several reasons. First, given the weak condition of the economies of Central and Eastern Europe—which is due in large part to capital scarcities—such liability could impose costs high enough to force many domestic producers to declare bankruptcy or liquidate their assets. Given the magnitude of existing environmental hazards, the full internalization of costs based on a strict and retroactive application of liability might yield negative real asset values for a significant fraction of industrial properties. These consequences are inefficient, since bankruptcy and asset dissolution involve costs in the form of abandoned capital, lost firm-specific human capital, and reduced competition. In any event, shortages of capital and the tenuous financial position of newly privatized firms suggest that liability rules dependent on firms' ability to liquidate or otherwise free capital to compensate for environmental damages will be ineffective.
In Copsa-Mica, Romania, the land that farmers tend is black from soot emitted by factories. Here, as elsewhere in Central and Eastern Europe, a precise technical—let alone legal—separation of responsibility for the costs of existing pollution and the costs of pollution being generated by new property owners may be unrealistic
Second, a strict and retroactive liability system is not likely to lead to an effective prioritization of cleanups. Under such a system, only the most unpolluted properties would be sought for development, and resources would therefore be devoted to the cleanup of relatively unpolluted properties.
Third, a strict and retroactive liability system will likely stifle foreign investment, which is critical to the acquisition of skills, technology, and capital by Central and Eastern Europe. Foreign investors' concerns about retroactive liability derive from their experience with huge retroactive liability costs in domestic markets, the fact that their firms' capital is relatively available to be tapped in the event of liability actions, and the lack of political stability—and hence investor influence—in Central and Eastern Europe.
Fourth, the political and ethical "polluter pays" motivation for strict and retroactive liability does not in general apply in Central and Eastern Europe. Because former governments and managers of cooperatives are most to blame for existing pollution, there is little ethical justification for the new owners of privatized properties to be liable for the past sins of others.
Fifth, the distributional impact of strict and retroactive liability poses a threat not only to the success and timeliness of cleanups of existing pollution but to the success of liability rules aimed at future pollution reduction. As in the West, environmental policies in Central and Eastern Europe will be derived and enforced in a political context, and their distributional impacts will largely determine their legislative and political success. The fact that liability rules have large distributional, and hence political, consequences can influence the evolution and enforcement of environmental pollution law. Because the profitability (or existence) of new enterprises is potentially threatened by strict and retroactive liability, resources will be directed at the political system to redistribute costs. One natural way to do this is to seek changes in the liability rules themselves. Given the political context in which liability laws are formulated, it follows that rules dealing with future liabilities should be separated from rules dealing with retroactive liabilities in order to enhance political acceptance of a tough prospective liability system. A more equitable distribution of the costs arising from existing pollution makes laws aimed at future pollution reduction more politically and economically sustainable.
Strict and retroactive environmental liability is likely to be undesirable in Central and Eastern Europe, as it could force domestic producers into bankruptcy or asset liquidation; such liability is not likely to lead to an effective prioritization of cleanups but is likely to stifle foreign investment.
From a practical standpoint, however, separating the costs of existing pollution from the costs of pollution being generated by new property owners is difficult, since precise definitions and divisions of responsibility for pollution require costly risk assessment efforts. Even in the United States and EEC, an initial, noncomprehensive environmental audit can cost hundreds of thousands of dollars for a major industrial site. Because the risk assessment capabilities of Central and Eastern European governments and industries are greatly inferior to those of their counterparts in the West, it is unlikely that an accurate division of responsibility for pollution is possible at a reasonable social cost. When existing pollution is widespread but difficult to detect with conventional site assessment methods at the point when ownership of a property is transferred, and when advanced risk assessment technologies and expertise are in short supply, a precise technical—let alone legal—separation of responsibility for pollution cleanup may be unrealistic.
Contractual mechanisms for allocating retroactive liability
Given uncertainties regarding the scale of and the liabilities implied by existing pollution, different contractual mechanisms to allocate liability may be needed to improve the efficiency of privatization and foreign investment decisions. The desirability of alternative contract forms is largely a function of the type of information available and the point in time at which information is acquired. With respect to the latter, assessment of liabilities may occur either ex ante, at the point of transaction, or ex post, following the transaction.
Knowledge of either responsibility for or the extent of pollution may be available to only one of the parties to a property transaction. For example, a government may have knowledge of existing pollution risks but choose not to reveal them prior to a transaction. On the other hand, if the government is unable to ascertain when pollution was generated and grants amnesty for retroactive liability, an investor might inflate the value of risks he or she claims to have inherited at the point of sale.
One imperfect but potentially desirable way to distribute the costs of existing pollution while creating incentives for the reduction of future pollution generation is to provide relief from retroactive liability through the provision of government funds earmarked for cleanups.
In the unlikely event that both the buyer and the seller have complete knowledge of all the risks posed by pollution on a property, there are two primary contractual possibilities. One is for the seller (the government) to guarantee that no liability will be assessed for existing hazards. The other is for the government to impose strict retroactive liability on the buyer but discount the price of a property to account for the costs of such liability. The virtue of the latter approach is that the property transaction would be immune to "renegotiation" by the government. Therefore, subsequent disputes over which hazards did or did not exist at the point of sale would be avoided.
When the buyer cannot observe contamination of a property ex ante, he or she is purchasing an asset of unknown quality. Given this, an optimal contract requires insurance against levels of risk that differ from those revealed by the seller. Should the seller know that the property is clean, that person can simply guarantee to compensate the buyer for expenses resulting from any subsequently revealed contamination; alternatively, he or she can absolve the buyer of liability. If contamination created before the sale can be separated from that created after the sale, an optimal contract would release the buyer from retroactive liability costs. Having done so, the asset price would reflect the property's value net of retroactive liabilities. When the buyer cannot observe contamination ex ante, retroactive liability for the buyer is clearly not desirable, since the costs of liability are not known at the point of sale and so cannot be accurately discounted from the asset price.
If pollution generated by the buyer cannot be separated from pollution existing at the point of sale, however, a liability amnesty would give the buyer a loophole to escape the costs of the pollution he or she generated. In this case, government assumption of liability may be inefficient. The conflict between buyer uncertainty over liability and the creation of loopholes by liability amnesties underscores the importance of environmental audits, which allow for an accurate separation of responsibility for pollution.
If a clear separation of responsibility is not practical, the question that remains is how to distribute the costs of existing pollution while creating incentives for the reduction of future pollution generation. An imperfect but potentially desirable approach is to provide relief from retroactive liability through the provision of government funds earmarked for cleanups. Two distinct forms of liability funds exist. One form is pooled funds, which provide public money for cleanups and compensation—money that would be provided by property owners in a Superfund-type liability system. The other form is the liability escrow account, in which a fraction of a property's purchase price is set aside and earmarked for cleanup costs defined at a later date. A crucial difference between the two funds is that escrow funds provide money to clean up pollution at one specific property, while pooled funds provide money for the cleanup of any number of properties.
Pooled funds
Pooled funds, which are conceptually related to "no-fault" pollution insurance, have been instituted or proposed in several countries to deal with large-scale environmental risks. They can differ in terms of duration, limits on the nature and scale of costs covered, and criteria—such as compliance with regulatory standards—that must be met in order for property owners to be eligible for reimbursement of cleanup costs. In all cases, however, only a fraction of liabilities are borne by property owners, with the balance being borne by the pooled fund.
Pooled funds, which provide public money for cleanups and compensation, widely distribute the costs of environmental cleanups and thus may represent the least economically disruptive mechanism for dealing with large retroactive liabilities.
Pooled funds are contrary to the notion that the polluter should pay cleanup costs. However, the use of public moneys for cleanups in Central and Eastern European countries is more easily justified than in western countries, since decades of state ownership and central planning in the former imply that responsibility for existing pollution lies largely with the governments of Central and Eastern Europe.
Because they widely distribute the costs of environmental cleanups, pooled funds may represent the least economically disruptive mechanism for dealing with large retroactive liabilities—liabilities that could otherwise force the abandonment of properties or the bankruptcy of property owners. The administration of such funds allows for the coordination and rationalization of a nation's risk reduction activities. With centralized control of the system, pollution mitigation measures at sites presenting the greatest social risks could, in principle, receive priority. The caveat is that an effective, centralized system of risk identification and ranking does not currently exist and is difficult and costly to implement.
Firms that expect large retroactive liabilities to ultimately force the closure of their enterprises pose a particularly serious pollution threat. If the enforcement of liability is delayed due to an overburdened legal system or the slow pace of regulators in identifying pollution sources, such firms have no incentive to reduce pollution in the period before enforcement occurs. Faced with the likely prospect of closure due to existing property contamination, such firms will find it profitable to pollute at will until the government forces them to cease their operations. A benefit of publicly provided cleanup funds, then, is that they increase the expected value of the firms, reduce the likelihood that firms will close as a result of retroactive liability costs, and thus lead firms to make investments in pollution control based on the now realistic ability to continue profitable operation well into the future. Since legal and regulatory enforcement of liability claims is likely to take some time in Central and Eastern Europe, this benefit of publicly provided cleanup funds is particularly important.
There are potentially significant problems associated with the use of pooled funds, however. Because the current owners of properties where cleanups are to be conducted will be reimbursed for the costs of cleanup, one problem is that price competition in the market for risk remediation services may be lessened unless the government polices a bidding process for such services. The market for environmental cleanup services, while sure to become increasingly competitive, is currently not competitive. Another problem is that property owners have an incentive to engage in costly cleanup activities that might have little social benefit because the owners are, in effect, insured by the government. Limited fund levels combined with inflated remediation costs could swiftly deplete a pooled fund's reserves.
Publicly provided cleanup funds increase the expected value of firms, reduce the likelihood that firms will close as a result of retroactive liability costs, and thus lead firms to make investments in pollution control based on the realistic ability to continue profitable operation.
A more fundamental problem associated with pooled funds derives from the inability to adequately separate risks existing before a fund is set up from those created during the fund's lifetime. If pooled fund programs cannot effectively distinguish between retroactive and prospective sources of pollution, amnesty for retroactive liability would carry a significant danger—namely, that newly created hazards will be claimed as hazards created in the past, thus allowing property owners to escape liability for pollution they generated. Realistically, a complete assessment of retroactive liabilities in Central and Eastern Europe will take years. Thus, while pooled funds may have desirable short-term benefits, it is unequivocally undesirable for them to become a permanent fixture in a government's environmental policy portfolio. If firms believe that all or even a fraction of their potential future liabilities will be borne by a subsidized government fund, the private incentive to invest in pollution reduction would be reduced. Thus an important political question is how a pooled liability fund program can be effectively operated on a short-term basis and then phased out to create liability assignments that effectively internalize environmental costs.
Escrow funds
Several governments in Central and Eastern Europe allow fractions of up to 100 percent of the purchase price of a property to be set aside in escrow and used for the cleanup of pollution on the property. In practice, escrow funds guard against the incentive problems created by a pooled, no-fault liability fund by placing clear limits on the amount of public funding that will be provided for cleanups. In addition, because they typically expire after a period of months, escrow funds limit the ability of new property owners to escape the costs of pollution that they generate in the future.
Like pooled funds, escrow funds provide some insurance against existing pollution costs for property purchasers. Compared with the alternative of strict and retroactive liability, such insurance discourages a government from setting a costly standard for cleanups once it sells a property. The reason is that costly cleanups deplete the escrow funds—which would revert to government coffers if not drawn down.
However, new property owners may have an incentive to deplete escrow funds as much as possible, since for them the funds represent a source of costless pollution remediation financing. The result is that government funds that could be used to address pressing environmental problems might instead be used to address relatively unimportant environmental problems. Investors will clearly seek to purchase the least polluted properties. If funds are dedicated to the further cleanup of these relatively clean properties, government revenue that could be used to reduce environmental risks at relatively polluted sites would be reduced. As compared with escrow funds, pooled funds provide the government greater authority to determine the allocation of cleanup funds.
The creation of an effective liability system
Both pooled fund and escrow fund systems will create a beneficial form of insurance against pollution liabilities, and thus will stimulate foreign and domestic investment and potentially smooth the transition to a tough future liability system. However, public funding of pollution remediation should be viewed as only a short-term means of addressing existing soil and groundwater cleanup issues in Central and Eastern Europe. Any permanent government subsidy of soil and groundwater cleanups will only continue to distort private property owners' incentives to reduce pollution.
The challenge for Central and Eastern Europe is to publicly fund remediation of existing pollution in a way that leads private property owners to believe they will be responsible for the social costs of polluting activities in the future.
Pooled funds present the best opportunity for targeting public funds to the cleanup of pollution posing the greatest health and ecological threats. However, they also represent a form a subsidy that might be politically difficult to dismantle. The challenge for the governments of Central and Eastern Europe, then, is to provide public funding for pollution remediation, but in a way that leads private property owners to believe that in the future they will be responsible for the social costs of polluting activities. While it may be tempting to give generous liability amnesties to foreign firms in order to encourage investment, doing so may lead foreign firms to export environmental risks to Central and Eastern Europe. Limitations on existing liabilities are desirable, but there is nothing to recommend investment incentives created by weakened liability rules aimed at reducing future pollution generation.
The strict enforcement of private property rights (and the assignment of liabilities) is not a particularly effective way—in the short term—to guarantee a rational social approach to pollution reduction. The reason is that private interests pursued through a liability system need not coincide with the social interest when resources are severely limited. The economies of Central and Eastern Europe are not currently robust enough to support large resource expenditures aimed at the resolution of legal disputes.
It remains the case that the costs of existing pollution must be distributed in some fashion. Moreover, a system of incentives for future risk reduction is desperately needed if current environmental conditions are to improve. Pooled liability funds are likely to be the most politically and economically effective mechanism for distributing costs and reducing risks. However, they should be subject to safeguards—specifically, a limit on the duration of coverage, and requirements for eligibility to claim reimbursement of cleanup costs (such as the installation of pollution reduction technologies). Pooled funds are a necessary compromise between strict and retroactive liability and unrealistic attempts to perfectly and quickly separate responsibility for existing and future pollution.
James Boyd is a fellow in the Energy and Natural Resources Division at Resources for the Future.
A version of this article appeared in print in the June 1993 issue of Resources magazine.
A version of this article appeared in print in the June 1993 issue of Resources magazine.
