In light of climate change and other environmental threats, the relationship between insolvency law and environmental protection is gaining importance. Additionally, empirical research suggests that violations of environmental law by “brown” firms increase in the year before the firms file for insolvency. It is no wonder then that some scholars view insolvency law as a disincentive. This invites the question whether insolvency reform may contribute towards mitigating these problems.

In a forthcoming chapter, I make two novel contributions. First, I explain why creditors’ incentives to support debtor-driven climate-change mitigation measures are limited. Second, building on this insight, I explore the possible effects of various proposals for insolvency reform and show that they risk impeding creditors’ incentives and reduce insolvency law’s potential to help battle climate change. It is organized as follows:

Empirical studies show that a growing number of physical assets are at risk from the effects of climate and environmental change. Moreover, business is affected by transition risk in a world of changing regulatory frameworks and the need to adapt supply chains and business operations to phenomena such as increasingly frequent floods, heat waves, and other natural disasters. Despite these mounting risks, creditors have less incentive than shareholders to demand adaptive measures. First, the upside potential for creditors is lower than for shareholders. Holding fixed claims, they may not participate in gains above a threshold defined in advance. Second, in insolvency, creditors profit from a better position than shareholders in the distribution of proceeds. This explains why creditors’ incentives to engage in climate-change mitigation and “greening” business are lower than those of holders of equity. Activist debt investors face a fundamental problem, afflicting both private and public debt claimants: limited governance rights. Creditors’ claims do not entail voting rights relating to the going concern as a whole. Especially in the case of green bonds and green loans, investors act within the confines of the project they finance.

Building on this general framework, I analyze possibilities and limitations of insolvency reform, taking up proposals in recent insolvency scholarship. First, I demonstrate why the idea of mandating liquidation of insolvent carbon-intensive businesses is misguided. Mandatory liquidation would end carbon-intensive operations, thus solving the issue of ongoing emissions. Such a reform, however, would not only be dubious public policy, it would also impair creditors’ incentives to pursue greening strategies in a corporate reorganization.

Second, I examine priority as a tool to integrate sustainability concerns into insolvency law. At least for claims and liabilities defined by law, the system of priority and conditions for a discharge can contribute towards advancing the public interest in safeguarding the environment and protecting the population against harm from polluting activity. Many creditors will or should react by demanding better environmental policy. Closer inspection, however, uncovers a plethora of difficult ramifications rule makers would need to consider, especially issues like judgment proofing. Moreover, preferring environmental claims over, say, those of employees invites thorny questions of distributional justice.

Third, I show why proposals to implement an environmental trustee as an institutional representative of the environment and related stakeholders as party to the insolvency proceedings falls short. If invested with strong rights, the trustee would impair creditors’ incentives to reorganize. There may be a case for a weaker version to open the path for green creditor activism, especially when tied to a system placing environmental claims high on the priority ladder.

Finally, I explain the value of money-oriented creditor value maximization in insolvency, contending that it protects minority rights. For example, Section 1124(2)(d) of the U.S. Bankruptcy Code covers “claim[s] or . . . interest[s] aris[ing] from any failure to perform a nonmonetary obligation” and denies impairment if the plan “compensates the holder of such claim or such interest . . . for any actual pecuniary loss incurred by such holder as a result of such failure. . .” Should nonmonetary goals become a valid factor compensating for an impairment of financial claims, the door is open for manipulative strategies to the detriment of minority shareholders. Considering the large room for manoeuvre and the uncertainty of long-term climate-change mitigation strategies, the most powerful creditors hold a lever enabling them to justify impairments of claims of smaller creditors. Just as with the many-masters problem in corporate law, there will always be an interest legitimizing a decision.

Acknowledging that, compared with shareholders’ incentives, creditors’ incentives to engage in climate-change mitigation and greening business are limited has important implications for insolvency reform. Recent proposals risk impeding creditors’ incentives and reduce insolvency law’s potential to help battle climate change. The most promising approach is to award priority or non-dischargeability to environmental liabilities in insolvency. However, considering various evasion strategies such as judgment proofing, it requires careful regulatory planning.

Thilo Kuntz is a professor of private, commercial, and corporate law and managing director of the Institute for Corporate Law at Heinrich-Heine-University Düsseldorf, Germany. This post is based on his recent book chapter, “Creditors’ Incentives and ESG in Insolvency – Creditors Are not Shareholders,” forthcoming in Insolvency Law and Environmental, Social, and Corporate Governance and available here.