Foreign investor liability for Environmental Damage: does the form of capital matter?

Foreign investors may finance and benefit from environmentally damaging activities, but then escape liability because victims of such harm are unable to obtain remedial relief from their domestic judicial system. A debated response to this problem is the idea that foreign investors be held liable by their home governments for the negative environmental impacts of their foreign investments. This article examines how such a liability regime can interact with the mode of financing to affect the optimal provision of incentives. In the model, domestic agents – who have a moral hazard incentive – can finance their activities by either issuing equity or borrowing from the international financial market. Monitoring by foreign investors partially ameliorates the moral hazard problem. We show that neither mode of finance is unequivocally better for environmental quality, which crucially depends on the quality of financial and legal institutions.

Keywords: capital flows, environmental damage, environmental impact, foreign investor liability, international environmental law, foreign direct investment, FDI, debt, moral hazard, environmental quality