What is Environmental Liability?
Environmental liability refers to the potential environmental costs that a buyer incurs when purchasing or leasing an asset. The liabilities arise when a buyer is conducting due diligence on the property and will be required to take ownership of the asset and all liabilities associated with the asset post-acquisition.
Environmental liability is especially important when the buyer is buying a business or asset that exerts an impact on the environment. For example, when purchasing an industrial machine that is likely to cause air or water pollution, the buyer will conduct an environmental assessment to determine the types of environmental liability associated with the asset being purchased.
Types of Environmental Liabilities
The various environmental liabilities vary depending on their source. Usually, environmental liabilities are associated with federal, state, or local laws, and are enforced by public agencies at each level of government. Here are the common environmental liabilities:
#1 Compliance obligations
Compliance obligations are the regulations that guide the manufacture, use, and disposal of chemicals and other harmful substances in the environment. When purchasing an asset to be used in the manufacturing process of goods, a business must consider existing compliance regulations and the possibility that new laws will be enacted. To ensure compliance with current laws, a business will be required to incur certain costs that protect it from future liabilities.
One of the costs is the administrative cost incurred to record processes, label chemicals, and train staff tasked with handling the chemical substances. A business may also incur costs to contain chemical spills, manage the harmful effects of air emissions, waste treatment, and exit costs for closing disposal sites. Failure to manage the effects of the wastes on the environment can attract lawsuits and legal actions by government agencies against a business.
#2 Remediation obligations
Remediation obligations require businesses to manage the effects of pollution or industrial activities that pose a risk to human health and the environment. Environmental liability is associated with compliance obligations since managing the current obligations can help reduce the remediation obligations that the business will be required to meet in the future.
Remediation obligations may comprise water treatment, excavations, monitoring, evaluating the environment for adverse effects, relocating communities to safer areas, re-constructing damaged properties, and response costs incurred by government agencies. An entity may face remediation obligations for negative impacts on the environment for formerly owned or used sites, sites it never owned but contaminated, and sites it owns and has not contaminated.
#3 Fines and penalties
An entity may also be required to pay fines and penalties for non-compliance with applicable laws and regulations that protect the environment from pollution and degradation. The costs are added to the cost of compliance that a firm is required to pay and are used to fulfill punitive functions.
The cost of the fine or penalty can be predetermined or assessed by a public agency when assessing the extent of the non-compliance and the effect of non-compliance on humans and the environment. Typically, the amount of fines is set in a way that equals the costs that the firm saved through non-compliance. It can vary from a few dollars to several million dollars for every violation against the environment committed by the firm.
#4 Compensation obligations
Compensation obligations comprise compensation for damages that a firm caused to individuals or their property. This is caused by the release of harmful substances to the environment. A firm can face compensation obligations even after being in compliance with all the other environmental obligations. Compensation obligations may be classified as a personal injury, property damage, or economic loss.
Compensation for personal injury may include bodily injury, pain, and wrongful death, while compensation for property damage may comprise loss of farm crops and livestock, and damage to real estate and vehicles. Claims for economic loss may comprise loss of equipment, lost profits, and loss of the sources of livelihood.
#5 Punitive damages
Punitive damages serve the same purpose as compensation obligations, but they charge high costs than the latter. The goal of punitive damages is to discourage the conduct of a firm that disregards other stakeholders in the environment and deter other firms that operate in the same industry from engaging in similar conduct. Punitive damages are rarely assessed, and they usually exceed the cost of the damage or loss caused to a person, community, or the environment.
When discussing with the seller of an asset or business, the buyer must conduct due diligence to identify the various environmental liabilities that the business will be required to meet in the future. On the other hand, the seller must be prepared to provide the actual records of their past environmental obligations and any obligations that may arise in the future.
If the buyer determines that there are remediation costs that will be incurred in the future after the purchase of the asset, he can negotiate for the purchase price to include an allowance for the costs of meeting all the future environmental liabilities.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: