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It is estimated that the costs of cleanup associated with on-site contamination in Central and Eastern Europe (CEE) will easily be several hundred billion dollars. The existence of such a large pool of environmental liabilities has created major challenges as CEE countries attempt to privatize their capital stock, and it is also generally agreed that poor handling of those liabilities has greatly inhibited markets for state-owned enterprises in Central and Eastern Europe. This research uses an analytical model to identify optimal policies for minimizing the damage caused to the privatization process by environmental liabilities. Policy simulations are conducted which evaluate the effects of the use of indemnifications and environmental audits on privatization sales, prices and government revenues net of environmental costs. The major finding of the paper is that privatization and social welfare maximization goals require equivalent environmental liability policies. In particular, full indemnification of all enterprises being privatized maximizes both sales and goverment revenues net of environmental liabilities, and therefore is likely to be a socially optimal liability policy for CEE governments. The current emphasis on privatizing as quickly as possible in many countries in the region is therefore found to be optimal. It is also found that the use of environmental audits, which reduce adverse selection of enterprises by managers and improve the privatization pool, is likely to reduce costs on privatization markets and therefore reduce equilibrium prices. This fmding suggests that the primary benefit derived by CEE governments investing in environmental audits is increased enterprise sales rather than increased prices as has been proposed in the past.


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