Does potential environmental liability inhibit commercial development of properties in urban industrial areas (brownfield sites)? Researchers at Resources for the Future recently investigated whether uncertainty about aspects of liability under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and related law discourages the sale and redevelopment of brownfield sites. They find that such uncertainty—say, the difficulty of predicting the allocation of liability in the event of a site cleanup—could interfere with sales of brownfield property, although to what extent remains unclear. Given high taxes, congestion, and other factors that hinder redevelopment in brownfield areas, CERCLA-related liability may contribute relatively little to inefficiencies in markets for industrial real estate. Even so, the RFF study suggests policy reforms that would minimize distortions due to such liability in these markets.
Under U.S. environmental statutes, someone buying a commercial property may acquire a substantial pollution cleanup liability. Experts familiar with environmental liability and commercial property markets widely presume that such liability will have a substantial and adverse effect on the purchase and redevelopment of property in old, urban industrial areas (brownfield sites). According to these experts, the threat of potential environmental liability makes it increasingly likely that commercial development will occur in previously undeveloped areas in suburban or exurban locations (greenfield sites) where environmental contamination may be comparatively unlikely. The result of this shift from brownfield development to greenfield development, it is argued, is urban sprawl, which brings with it a host of environmental and other problems.
Absent uncertainty, pollution and liability associated with brownfield sites do not necessarily increase the relative desirability of greenfield sites: if a property is known to be polluted, land prices would fall to adjust for the costs of owning a contaminated site.
Anecdotal evidence suggests that potential environmental liability is affecting commercial development. In a recent survey conducted by the Independent Bankers Association of America, one out of five of the association's member banks reported a mortgage loss or default on commercial property as a result of the environmental contamination of a property. And seven out of ten banks revealed that they will not write certain classes of loans because of environmental liability concerns. Financial officers of industrial corporations and their managers of real estate report that such concerns have affected their corporations' decisions about where to locate and whether to expand their enterprises and also made it difficult to determine whether they can redevelop the property they already own. Similar concerns have prompted congressional proposals to legislate the redevelopment and reuse of contaminated urban land, as well as calls by lenders and borrowers to free property sales from onerous environmental liability provisions.
With support from the U.S. Environmental Protection Agency (EPA), we recently attempted to determine the effects on commercial development of environmental liability, such as that related to the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, also known as Superfund), its amendments, and related state and local provisions. Our first step was to describe conceptually the nature of uncertainty associated with environmental liability and how this uncertainty may encourage the underdevelopment or even the abandonment of formerly industrial properties in favor of greenfield sites.
Our concept of uncertainty extends and refines what is typically the focus of the environmental liability debate—namely, the uncertainty of estimating cleanup costs and of identifying parties responsible for paying these costs. We identified several additional sources of uncertainty in the legal and administrative treatment of polluted properties. These include the outcomes of (1) the environmental evaluation of a site, which is the first step in the process of determining whether a site is contaminated; (2) the scientific evaluation of the extent of the site's contamination; and (3) the decision concerning what amount of cleanup is necessary.
Our second step was to use our conceptual analysis as a framework to study the nature of uncertainty involved in actual (and then-ongoing) brownfield property sales. We developed case studies of twenty brownfield sites—some located in small cities and some in large cities—that taken together house a variety of industries and businesses.
We conclude from our analysis that uncertainty associated with environmental liability has the potential to interfere with sales of brownfield property. However, the magnitude of the effect of this uncertainty on decisions about where industrial sites are located or expanded remains unclear. Many industrial areas with potential environmental liability problems have been declining economically for decades, a trend that significantly predates the enactment of CERCLA. Redevelopment in these areas is hindered by high taxes, low-quality government services, racial tensions, crime, and congestion.
Relative to these problems, potential environmental liability may have only a marginal negative impact on markets for industrial real estate. Given this, we cannot say that CERCLA-related liability is a significant cause of inefficiencies in real estate markets. Instead, we focus on changes within the existing context of Superfund policy—changes that can be expected to reduce any inefficiencies created by the current system.
Uncertainty about environmental liability may distort real estate markets, causing properties to be withheld from the market, making financing for commercial development projects unavailable, or biasing developers toward greenfield rather than brownfield development.
A common, but flawed, perception exists that development of greenfield sites enjoys a cost advantage over development of brownfield sites. On the contrary, commercial development of greenfield sites is itself costly, as zoning laws and community opposition can often impede such development. Moreover, nonurban lands may themselves be polluted due to past uses and may require costly risk assessments.
More generally, pollution and liability associated with brownfield sites do not necessarily increase the relative desirability of greenfield sites. The reasoning is as follows. If a property were known to be polluted, land prices would fall to adjust for the costs of owning a contaminated site. If clean properties sell for $100,000, a property with $20,000 worth of contamination would sell for $80,000. Because markets lead to discounted prices when property is polluted (or otherwise undesirable), prospective buyers should be indifferent to the choice between purchasing a clean property and purchasing a dirty, but cheaper property. This reasoning requires, of course, that the presence of contamination is common knowledge and that the assessment of the cleanup cost is relatively certain.
If markets function as they do in the preceding example, CERCLA's impact on development decisions would be expected to be minimal. Our concern is that markets may be functioning less well than they otherwise might be because of the uncertainty associated with many aspects of environmental laws and regulation. Such uncertainty could cause properties to be withheld from the market, make financing for commercial development projects costly, or bias developers toward greenfield rather than brownfield development.
Sources of uncertainty
Each of the sources of uncertainty that we studied can be traced to ambiguities and inconsistencies in current federal and state environmental statutes and their enforcement. The environmental evaluation, which determines whether a site is contaminated and ranks sites on the basis of the health and ecological risks they pose, is a key determinant of subsequent regulatory scrutiny and a signal of potential cleanup costs. The evaluation can employ either CERCLA's ranking system or state programs' hazard ranking systems. While the quantitative standards employed by these systems provide needed consistency in evaluation across sites, the criteria used by the federal and the state systems can differ. Moreover, many uncertainties are inherent in the data and risk analysis that form the basis of these ranking systems. From the perspective of a current or potential property owner, the outcome of the preliminary site evaluation and listing process is highly unpredictable.
The cost of the site remediation that will be mandated once a site is slated for cleanup is also difficult to predict, as no consistent, objective standard exists for the level of cleanup that will be required. In general, individual cleanups are viewed as unique problems requiring unique solutions: there is bureaucratic latitude in selecting the remediation process, and cleanup goals and definitions can vary. There is also no method, even after a site remedy has been "completed," by which current or prospective developers or property owners can determine whether the cleanup is "permanent," because no statutory or administrative definition of a completed cleanup exists.
Perhaps the greatest source of uncertainty facing developers and property owners is how liability will be allocated in the event of a site cleanup. Common law historically has included concepts such as negligence, trespass, and nuisance in adjudicating environmental issues. CERCLA and its attendant case law have altered typical common law standards of liability and made cleanup liability strict, retroactive, and joint-and-several. This means, among other things, that both past and current property owners are liable for the cleanup of pollution created years ago and that a single producer who shipped waste to a site may be held liable for the costs of cleaning up waste shipped by other producers. The intent of these liability provisions is to obtain cleanup costs from potentially responsible parties.
The practical impact of this change is that it is difficult for former, current, or prospective property owners of an abandoned factory site, for example, to know whether they will be held liable for cleanup costs, irrespective of whether they caused the release of pollution. The current liability approach sends a strong signal to polluters and those with whom they do business that they may eventually pay for the costs of environmental damage. In their current form, however, environmental liability rules can introduce a great amount of uncertainty into real estate markets.
CERCLA and its case law have altered traditional common law standards of liability, making it difficult for former, current, or prospective property owners of an abandoned factory site, for example, to know whether they will be held liable for cleanup costs, irrespective of whether they caused the release of pollution.
"Innocent landowner" provisions, which set forth the conditions under which a new property owner will not be held liable for contamination created by a previous owner, are an important legal approach that could reduce the uncertainties created by CERCLA-related liability. While these provisions now are defined more precisely than they were at CERCLA's inception, they do not remove uncertainties associated with ownership. For instance, a new landowner may not be found "innocent" if he or she bought a previously contaminated property at a particularly low price, since this could be a signal that the property was contaminated. However, courts may find it difficult to determine objectively how low a "low" price is.
Effects of uncertainty
We argued above that a developer should be indifferent to the choice between purchasing a contaminated property and purchasing a similar but uncontaminated property if contamination costs are discounted from a property's price by the market. However, uncertainties created by CERCLA-related liability, along with the aversion of buyers and sellers to taking risks, could make contaminated properties less desirable than uncontaminated properties.
As an illustration, consider a transaction involving a former gas station site worth $3 million to a potential buyer and $2 million to the current owner. It is in both parties' interest to trade the property, since the gain from trade—or the difference in the value placed on the property by the buyer and by the seller—is $1 million. Now if both parties knew that the property was contaminated and that the cost to clean it up was $1 million, that knowledge would not reduce the gains from trade. Given the contamination, the property would have a net worth of $1 million to the seller if he or she does not trade the property and a net worth of $2 million to the buyer if he or she purchases the property.
The difficulty of predicting the outcome of a preliminary site evaluation, the cost of site remediation, and the allocation of liability in the event of a site cleanup can make contaminated properties less desirable than uncontaminated properties.
Now consider a case in which the buyer and seller are uncertain of the liability associated with the property. In such a situation the buyer and seller would face a gamble concerning the size of their liability if they owned the site. If they are averse to risk, then uncertainty about liability would reduce the value of the transaction—that is, the gains from trade. The reason is that risk-averse individuals or firms require a "premium" to compensate them for taking risks. Concretely, this reduces the set of prices at which the buyer and seller are mutually willing to trade the property. Thus, the redevelopment of brownfield properties, all else equal, may be less attractive than the redevelopment of comparable but unpolluted sites.
Contractual limitations on liability
Liability can be contractually assigned to either real estate sellers or buyers through indemnity agreements. If the seller indemnifies the buyer, he or she in effect offers a warranty that absolves the buyer of liability attached to the property. Covenants-not-to-sue are a related arrangement in which a state government or the federal government will agree not to impose liability against a new owner of contaminated property.
By limiting liability or providing insurance against liability, both indemnity agreements and covenants-not-to-sue can reduce the negative impact of uncertainty and thus reduce distortions that lead to the greater relative desirability of unpolluted sites. However, such mechanisms are limited in scope relative to the many ways in which a property owner can be found liable under CERCLA and state environmental laws. They are also easily contestable by the government and other potentially responsible parties (PRPs).
The concept of contribution is central to indemnity. Under case law related to CERCLA, a PRP who pays to resolve his or her liability may in turn seek to have other PRPs "contribute" to that payment. An indemnity agreement thus prohibits one PRP—the party providing the indemnity—from seeking contribution from another PRP—the indemnified party.
Any single indemnification agreement, however, provides little insurance against liability given the many pathways by which liability can be imposed. Under joint-and-several liability, a property owner can be sued directly—by the state or federal government or by neighboring property owners—or indirectly via contribution by PRPs that have not indemnified the owner. Similarly, a state covenant-not-to-sue does not bar federal enforcement actions, and vice versa. Moreover, covenants-not-to-sue do not bar liability claims brought by other PRPs, public interest organizations, or injured neighbors.
While indemnity contracts and covenants-not-to-sue can reduce, in principle, the uncertainty associated with the cost of liability, overlapping jurisdictions and the joint-and-several standard of liability reduce their effectiveness. Such covenants provide meaningful assurance only when both state governments and the federal government agree not to sue a new property owner.
The existing liability system limits the effectiveness of contractual mechanisms—both indemnity agreements and covenants-not-to-sue—to assign liability and thus to reduce the negative impact of uncertainty on commercial development.
Lender liability and property financing
Property purchases are typically financed by a lender. As exposure to liability increases the lender's expected costs, the availability of finance for brownfield properties could be restricted, making greenfield development increasingly attractive. CERCLA exempts some lenders from liability under certain conditions; but if lenders are in a position to influence the borrowers' environmental decisions, then lenders would be potentially liable. This potential liability on the part of the lender affects the cost of a loan, since the lender will require compensation for the risks incurred by financing a brownfield investment.
Lender liability serves a beneficial purpose, as well, in that it encourages lenders to assess the environmental risk posed by a site. In addition, it encourages them to take other steps to protect the value of their loans. For instance, lenders may choose to make state-of-the-art waste management by borrowers a condition for a loan.
Even in the absence of CERCLA, lenders would have an incentive to take such steps, because environmental liability can lead to the bankruptcy of the borrower and the foreclosure of his or her property. When this occurs, the collateral on which the loan is based is devalued and may even become worthless. Moreover, with the borrower in default, no further interest payments can be collected by the lender, independent of whether the lender is liable.
In other words, lending to a property owner whose site is contaminated is not likely to be profitable. All else being equal, finance costs arising from lenders' liability exposure will decrease the relative attractiveness of brownfield development.
Detection of contamination and the supply of brownfield sites
Given tight budgets for enforcing environmental laws and the difficulty of detecting environmental contamination, the government's ability to identify contaminated properties is limited. An effective way to avoid the discovery of contamination—and the costs of cleaning it up—is to keep property off the real estate market. Entering into property transactions greatly increases the likelihood of detection, because it is in the interests of both buyers and lenders to investigate environmental conditions.
It is easy to illustrate why a site would be withheld from the market if the current owner fears that contamination will be discovered. Suppose that the value of a property—absent liability—is $4 million to the current owner and $5 million to a buyer. In this case, the property would be purchased and redeveloped by the buyer.
Brownfield sites may be withheld from the market when their owners fear that contamination will be discovered during a sale. As a result, the supply of such sites shrinks, and buyers are encouraged to seek development on unpolluted properties.
Now suppose that the site has $2 million worth of contamination but that this contamination would be revealed only if the property were sold. In this case the property would not be traded, as it would sell for at most $3 million (the maximum value placed on it by the buyer minus the liability). This amount is less than the value of the property to the current owner if the property were withheld from the market ($4 million).
When sites are withheld because of fears that contamination will be discovered, the supply of brownfield sites shrinks. This shrinking supply encourages buyers to seek development of unpolluted properties.
Recommendations
Our case studies of urban commercial property sales suggest that all the above-noted uncertainties associated with environmental liability can distort undesirably the market for brownfield and greenfield property. The studies reveal that these uncertainties are to some extent discouraging brownfield redevelopment. In particular, they indicate significant practical limitations regarding the use of indemnity agreements and covenants-not-to-sue and instances in which it can be argued that property is being withheld from the market in order to avoid detection of contamination.
The case studies also suggest actions that would minimize distortions of the market for brownfield and greenfield properties. Policy changes aimed at reducing uncertainty for investors—such as consistent and quantifiable cleanup standards and enforceable indemnity agreements and covenants-not-to-sue—would reduce the impact of liability on choices of properties for redevelopment. For the same reason, clarifications of and limitations on lender liability would be desirable, particularly given that lenders already have incentives to conduct due diligence assessments. Finally, more timely and conclusive efforts to detect contamination would allow property sales to proceed, because current liability would be more definitively established than at present.
As long as the sale of property triggers regulatory scrutiny, the supply of available brownfield sites will be restricted while owners "wait out" their liabilities. With improved detection efforts, real estate markets would function better, as owners of brownfield properties with redevelopment potential are more likely to offer those properties to the market when their environmental liabilities are more precisely known and discounted.
James Boyd is a fellow in the Energy and Natural Resources Division at Resources for the Future. Molly K. Macauley is a senior fellow in the division. The issues in this article are detailed in discussion paper 94-03, "The Impact of Environmental Liability on Industrial and Greenfield Commercial Real Estate Development," by James Boyd, Winston Harrington, Molly Macauley, and Mary Elizabeth Calhoon.
A version of this article appeared in print in the January 1994 issue of Resources magazine.
A version of this article appeared in print in the January 1994 issue of Resources magazine.
