Abstract: This paper examines the role of liability for past environmental contamination in the privatization processes of Central and Eastern Europe. The theoretical section establishes a link between a risk-averse investor's amount of information regarding the extent of past environmental contamination (and its cleanup costs) and the investor's willingness to pay for a particular enterprise, i.e., bid. As the investor obtains a more precise estimate of the uncertain cleanup costs, the investor faces less risk; therefore, the investor's risk premium falls and the investor's bid rises. This link generates four hypotheses regarding a privatization agency's responses to the investor's knowledge of cleanup costs. The empirical section of this paper proposes to test these hypotheses with forthcoming analysis using data from the Czech Republic.
 

Non-technical Summary: Under the former communist regimes in the Central and Eastern Europe, economic activities severely degraded the region's environment. Various types of economic facilities severely contaminated the air, water, and soil surrounding their sites by emitting and dumping numerous pollutants. Therefore, most commercial and industrial sites in Central and Eastern Europe are presently contaminated, if not severely so. Such contamination was widely reported shortly after the communist regimes fell.

Strangely enough, privatization agencies in Central and Eastern Europe responsible for the transfer of ownership over these facilities were taken aback by investors' concerns over the liability for any remediation of this widespread and severe contamination. Foreign investors were especially concerned by the potential liability for two reasons. First, they correctly believed that governments wished to tap the foreign investors' "deep pockets" for financing the cleanup of this large-scale degradation. Second, foreign investors recalled their previous experiences in Western industrialized economies over retroactive liability for environmental contamination, such as Superfund liability for hazardous waste contamination in the United States.

After acknowledging the investors' concerns, privatization agencies responded with policies to reallocate liability for the cleanup costs. First, they responded with price reduction policies, but only on an ad hoc basis. Later, privatization agencies in some countries developed more systematic and thoughtful policies, such as indemnification of private liability using reimbursement schemes. Moreover, governments decided to gather more complete information on cleanup decisions before rushing into compensation schemes.

These government policy decisions were designed to facilitate the privatization process and presumably to increase the sales revenues generated by direct sales, auctions, and other privatization methods. Investors facing liability for cleanup costs would be expected to discount their bid for a contaminated enterprise commensurate with the extent of required cleanup. Of course, investors did not understand the extent of contamination and therefore cleanup costs with perfect certainty. Instead, most investors understood the level of cleanup costs with great uncertainty. As long as investors are risk-averse, the existence of uncertainty (i.e., risk), will prompt them to seek a risk premium to compensate them for bearing this risk. This risk premium drives down the investor's bid for a contaminated enterprise. Therefore, an inverse relationship exists between the precision of the investor's estimation of cleanup costs (i.e., information about cleanup costs) and the investor's bid. Given this connection, privatization agencies should be expected to offer greater compensation to investors in the form of price discounts when the investor's estimation of cleanup costs is imprecise. This logic generates the first of four testable hypotheses: when the state offers only price discounts without indemnification, the degree of price discount is inversely related to the amount of information known by the investor.

This logic extends to the policy of offering compensation in the form of indemnification from private liability (e.g., reimbursement for cleanup costs). Of course, in this case the state bears the indemnified cleanup costs. In addition, the state faces other expenses associated with indemnification. These expenses may include administrative expenses for operating any reimbursement program. They also may include costs claimed as past environmental contamination by the investor yet generated after privatization. This possibility is quite feasible since it may be very difficult, if not impossible, to separate past and current environmental contamination. Less obviously, indemnification may generate higher future cleanup costs by undermining the polluter pays principle and degrading deterrence of future contaminating activities.

Given these additional indemnification expenses, the inverse relationship between the investor's amount of information and his/her bid drives the choice between zero and full indemnification and the choice of partial indemnification. When the state is deciding between zero and full indemnification, it is more likely to offer full indemnification as the investor's information degrades because the risk premium is more likely to exceed the administrative expenses associated with indemnification. The opposite result follows as the investor's information improves: the state is more likely to offer zero indemnification. These predictions represent two additional testable hypotheses. Finally, consider the case where the state is selecting any level of indemnification (including zero, partial, and full). In this scenario, indemnification lowers the investor's risk premium similar to information because indemnification limits the scope of the investor's liability. Yet, these two factors are assumed to be complements; that is, indemnification reduces the investor's risk more when he/she possess poor information about cleanup costs. Given this relationship, the state raises the level of indemnification as the investor's information degrades because indemnification becomes a stronger tool for lowering the investor's risk premium. This prediction represents the final testable hypothesis.

The empirical section of this paper proposes to test all the noted hypotheses with forthcoming analysis of the privatization process in the Czech Republic.
 

Acknowledgements: I wish to thank the following people for their assistance, advise, and support: Don Lien, Tom Weiss, Rick Lotspeich, Jiina Jilková, Zdenek Svoboda, and James Boyd. I also thank the feedback from participants at the 1999 Association for Comparative Economic Studies (ACES) meetings and the 1999 American Law and Economics Association (ALEA) meetings. Finally, I acknowledge the financial assistance of the New Faculty General Research Fund Award and the International Research Award from the University of Kansas.
 

Relevant JEL Classification Numbers and Keywords:

D80, K32, Q24, Q25

liability, privatization, risk, environmental contamination