Debt structure and environmental compliance

Abstract

We develop a model of a firm with a production project that may cause environmental pollution. The firm can borrow funds to pay for pollution abatement but faces an underinvestment problem due to debt overhang. We investigate how the interaction of public regulatory enforcement and private loan contracting works towards ensuring environmental compliance. To force the firm to internalize the externality, there is a minimum required level of public enforcement, which is increasing with the size of the pollution. When this minimum requirement is met, the firm effectively complements the public effort with private based oversight in its loan contracting.