Different phases of economic development call for different institutional arrangements. When an institution outlives the economic circumstances for which it was designed, it can lead to unintended negative consequences. The limited liability of corporations, at least under certain conditions, represents an example for such an institution.
Limited liability is one of the key features that distinguishes a partnership from a business corporation. When a partnership goes bankrupt, it is not just the capital of the partnership that is liable but also the private wealth of each of the partners. When a corporation goes bankrupt, by contrast, the reach of the creditors is limited to the capital that shareholders have invested in the corporation. They are off the hook as far as their private wealth is concerned.
It is easy to see why this arrangement leads to a significant increase in the capital that corporations are able to raise compared to partnerships. Which investor would turn down a setup with significant potential upside in terms of capital gain but limited downside? The justification for limited liability from a social perspective is equally obvious. Separating individual property from corporate property in this way hugely enhances financing capacity and thus output across the economy.
Limited liability under climate change
Limited liability worked well under conditions where any growth was good growth. However, independently of whether that was ever true, it is certainly not true in the 21st century. Some economic growth generates negative externalities in the form of social and environmental costs. Corporations only pay for the private costs of their production, whereas the social and environmental costs are borne by society as a whole.
The classic example in this category are greenhouse gas emissions. Corporations in the fossil fuel sector only pay for the private costs of getting the stuff out of the ground. Beyond the insufficient forms of carbon pricing in place today, corporations do not pay for the human and environmental costs measured in human deaths, respiratory disease from pollution, extreme weather events such as heat domes or atmospheric rivers, food shortages due to droughts, and loss in biodiversity. The results are overproduction and overconsumption of carbon-intensive products at inefficiently low prices.
Investor liability as a complement to carbon pricing
The conventional wisdom in the discipline of economics tells us that the most efficient way to reduce fossil fuel production and use to efficient levels is a form of carbon pricing, for example by charging a carbon tax. It is true that carbon taxes could be effective if they were both high enough and progressive. However, they clearly fall short on both counts today.
The above considerations point to a complementary regulatory lever. Under conditions of climate change, the justification for limited liability breaks down. Letting shareholders off the hook is not a good idea when doing so amplifies irresponsible corporate behaviour in the form of overproduction. Instead, in order to convince corporations to meet the challenge of producing sustainably, we have an interest to ensure that both the corporations and their investors have some skin in the game.
Note that this does necessarily imply that investors would have to be liable with all of their wealth, but a limited liability rather than zero liability would encourage corporations to price in negative externalities right away rather than wait for adequate levels of carbon pricing. One might also envisage a progressive form of liability where wealthier investors have more skin in the game than their less well-off counterparts. Indeed, if they did not, their incentives to invest responsibly would be reduced.
Extending the corporate time horizon
Corporations, their managers, and their shareholders are often criticized for maximising profit in the short-term. The current forms of carbon pricing have not succeeded in changing that. Redefining limited liability in the way sketched above promises to have an immediate impact in this regard. After all, under this arrangement, and in contrast to carbon pricing, it is not primarily up to the government to ensure that negative externalities are priced in, but it is up to the corporation and its investors. If the corporation and its shareholders get the numbers wrong, they will have to pay for it.
Some people will no doubt object that liability of this sort would represent a form of red tape restricting private business activity. They have things the wrong way round. Limited liability for shareholders is an enormous privilege bestowed on the corporate sector and its investors. As shown above, this privilege is no longer warranted, at least not for sectors with significant negative externalities. Today, corporations in the fossil fuel sector are able to privatise gains while they socialise losses. This is untenable. Reforming liability arrangements for these kinds of corporations offers one promising path of reform.
